Finance Assignment – Debt Finance

1.0 Definition of gearing

As David and Wei (2009) proposed gearing equals the debt equity ratio, which is the measure for a business to estimate the financial leverage of a business organization. The financial leverage means extent for the company to make use of the money borrowed. And the debt equity ration can be calculated by the following equation.

Debt equity ratio = Total liabilities/ Total equity

And Frank and Goyal (2009) also hold the idea that since the debt equity ratio is used to denote the long term debt and some related issues with the shareholders’ equity, the historical data especially the financial data in the previous is important for the business to calculate this ratio. As we have an overlook at the definition and formula of the debt equity ratio, let’s make this much clearer by an illusion. Supposing the long term liabilities of the organization is $ 5,000 and the total equity of the shareholders is $11,000, then we can get the debt equity ratio equals 0.45 ($ 5,000/ $11,000), which shows the assets of this organization have been operated by equity rather than debt primarily. And then supposing the total equity of the shareholders is $5,000 the same as the long term liabilities, the debt equity ratio equals one ($ 5,000/ $ 5,000), which shows the debt and equity of this organization is in the same amount. And then supposing the total equity of the shareholders is $15,000 and the total equity of the shareholders is $11,000, then we can get the debt equity ratio equals 1.36 ($ 15,000/ $11,000), which shows the organization manage its assets mainly by incurring debt financially. In a sum, if the debt equity ratio is less than one, which is good news for both the lender and investors of this business that they can consider to lend money or invest more to this business, which have a good equity situation. and if the debt equity ratio is less than one, which may denote that these lenders and investors should take the situation into account serious that it may not so wise to continue invest or lend money to this organization based on the financial situation.

In addition, proposed by Elliott Et al. (2008), for these investors of the organization, the debt equity ratio is often used to the degree of the risk engaged in buying the equity via the organization’s stock or purchasing the bonds issued by the organization. And if the organization has a relatively high ratio, it may prefer to issue a relatively high interest rate to attract investors to buy its bonds to raise more capital. Meanwhile, it is necessary for an organization to maintain its price of shares in a certain level or its engagement in the bond market with a close reference to its debt equity ratio. If the company can good manage or make efficient improvement in its debt equity ratio, it is possible for this organization to pay off its long term debt. Although it is possible for company to pay off its debt burden by a well management of this ratio, it can’t be realized over a night either, so we suggest the organization to carry out some long term strategy to facilitate its financial management.

2.0 Debt finance

Liang (2010) told us debt finance is a kind of strategy for the business to raise money by borrowing money from a certain kind of people such as the lenders or investors with the clear understanding of the time and amount of the money repaid in the future involving a certain amount of interest rate. As the major players of this business, the company, the shareholders and the lenders gain advantages and disadvantages from the debt finance respectively.

2.1 Advantages and disadvantages to the company

Liang (2010) also claimed that the primary advantage of debt finance for company is that it assists the company to retain its ownership and the right of control of the company. In comparison to equity financing, the company or the owner of the business may be more flexible to carry out some important strategic decisions and keep more profits of the company. The other advantage of the debt finance to the company is that it gives the company a large degree of freedom than the equity finance or other kinds of means. For instance, the responsibility of debt issue may be only limited within the period of the loan repayment, after which investors or lenders of the company may have no right to make any claim on this business further while the investors of equity can also make claims on the business of the company until they sell their stocks. Moreover, if the debt of the company is paid timely, the credit of the company can be enhanced to certain degree, which can assist the company to get more potions on the types of financing in the future. And debt finance is also easy to manage and administrate due to its simple requirements on the reporting and other complicated forms procedures. At last, in contrast to other kinds of financing, debt finance is much cheaper in the long time round, which may save money for the company in the long term.

And Barion et al. (2010) told us that debt finance also owns some disadvantages for the company. To begin with, the main disadvantage is its restriction on business to make the repayment of both the principal and interest to the lenders monthly. For some young business, it is often difficult to make the regular payments especially when there is a shortage in cash flow. And there are also severe penalties including late fees charged, claiming on a earlier due day for the loan and so on offered by these lenders when the company repay their loans late or missed. On this basis, any failure on repaying the loan may have a direct influence on the credit rating of the business and its capability to gain other kinds of financing in the future. The other disadvantage is the limitation on the availability of the company to set up business. Because these lenders have to maintain the security level of their funds, it is difficult for any unproven business to get loans from these lenders such as from banks. Finally, the amount of the loan from the debt finance is also limited, so it also requires the company to resort to other kinds of financing sources.

2.2 Advantages and disadvantages to the shareholders

For one thing, debt finance has many advantages for shareholders of the company proposed by Lee et al. (2009). This financing measure enjoys a favorable policy that there is a tax deductible on the interest of the debt. When the total amount of the repayment of the loans is deducted due to the deduction of the interest rate, the total revenue of the company will increase which will direct increase the dividend gaining of shareholders too. And it is possible for shareholders of the company to turn over the company to the lenders or default their responsibilities once there is a dramatic decline of the financial situation of this firm to avoid further obligation and risks. Furthermore, debt finance is also possible for the company to gain from the benefits of financial leverage to enhance the income of shareholders. Under the circumstance that the profit of investment exceeding the interest of the debt and the fixed debt interest rate of the firm, the rise of pre-tax profit may denote a rise of the total revenue, which will really increase the income of shareholders. Finally, the comparative simple process of the debt finance can also save a lot time of shareholders.

For the other, debt finance owns many advantages for shareholders of the company as Lee et al. (2009) claimed too. Firstly, the debt interest is regarded as a fixed cost which may have influence on the increasing of the breakeven point of the firm. Particularly during the bad economic era, this kind of fixed cost from the interest may increase the risk of the firm to be insolvent. If this happens, the interest of these shareholders will be affected a lot. And if the firm has too much debt compared to its total equity, it is often more difficult for the firm to enjoy real grow, which to the shareholders is bad news. Finally, these restrictions from debt lenders on companies may also have impact on the interest of the shareholders, because any loss of the business may denotes a direct decreasing of the shareholders. So if the company fails to meet the requirements of the debt lenders, the company may face penalties or even more tough financial status, which will decline the income of the shareholders too.

2.3 Advantages and disadvantages to the lenders

With reference to the advantages of debt finance to the lenders, Shock and Tavakoli (2008) told us there are many. The first advantage is these restrictions provided by lenders to the company such as the penalties on late payment or other related situation will work as comparative strong protective means to protect the interest of the debt lenders when they lend money to the business. The second advantage is the limitation of the debt finance on the availability of the company to set up business assisting debt lenders such as the banks to have a better understanding on the situation especially the financial situation of its borrower to avoid the risk of lending money to these unproven businesses and causing future problems. And then as there is a limitation on the amount of the loan in the debt finance, it also helps lenders to avoid the risk of losing more money when its borrowers are faced with bad economy situation and aren’t able to repay the loan on time.

In the field of the disadvantages from the debt finance on lenders, Shock and Tavakoli (2008) also told us there are also some. The first one is the time consuming for the lenders to take back of its money from these borrowers. As the repayment is paid monthly rather than a full repayment in a short time, lenders have to wait for a certain period to take back all of its money. Second, although there are many restriction for lenders to protect their benefits, it may has some risks of losing money, when the borrowers can’t pay off their debts on time or fully and claim a bankrupt.

3.0 Debt to equity ratios analysis

Baker (2011) proposed the structure for a capital is built up on the company’s financial mix to set up the day to day operations. When analyze the operation of a company, it is significant to understand the debt and equity mix of this company that the higher of the ration in debt to equity may indicate the greater risks faced by the potential investment activity.

And the optional mix of the debt and equity for the organization, there are four kinds of ways explored by us such as operating income, capital cost minimization, firm value maximization and a comparable means on the financing mix.

3. 1 Debt ratio of operating income

According to Baker (2011), the first approach beginning with the operating income’s distribution which may be the simplest way to determine the capacity of the firm can afford to borrow. And starting with determining the maximum default probability of the firm and operating income’ distribution as well as cash flow, the maximum capability on debt for the firm can then be carried out.

And there are five steps involved in the debt ratio of operating income. The first step is to evaluate the ability of the firm to produce operating income referring to not only the current conditions but also the past history. The second step is to estimate the required interest and principal payments for the debt in the given level. The third step is the estimation of the possibility that the firm can’t pay off the debt referring to the operating income’s distribution and debt payments level. The fourth step is the establishment of the limit or constraint on the possibility of the firm that it can’t pay off the debt. And the last step is the comparison between possibility of the debt’s default and the possibility constraint for the firm to choose the debt level. (Baker 2011)

On the understanding of the detailed information of this approach, we may regard this approach isn’t the best one for firm to use as the optimal debt ratio, because this approach may be too conservative to limit the investment practices of the firm which limit the access to the financial markets of the firms at a certain point mentioned by Baker (2011).

3.2 Debt ratio of capital cost minimization

Francis and Nanda (2008) claimed we can make estimation of the debt costs and various debt ratios for equity in the cost of capital approach by computing the capital costs and the debt to equity mix yielding the lowest amount of capital for the organization. And the key to applying this approach is to put forward the realistic estimation on the equity costs and the debts according to various debt ratios. And in summary, with the base of market values, we can weigh the capital cost on the average costs of both debt and equity as the following formula.

So the advantage of the cost of capital approach is to help firms to get a more proper and optimal capital structure. But there is also disadvantage for this ratio that the operating income in this ratio may be kept in a fixed level. As everything has its pros and cons, for firms which are willing to get a optimal capital structure with the lowest cost, the debt ratio of capital cost minimization is a good choice (Francis & Nanda 2008).

3.3 Debt ratio of firm value maximization

In the adjusted present value (APV) approach, according to Koller and Goedhart (2010) we begin with the value of the firm without debt. As we add debt to the firm, we consider the net effect on value by considering both the benefits and the costs of borrowing. The value of the levered firm can then be estimated at different levels of the debt, and the debt level that maximizes firm value is the optimal debt ratio.

In the APV approach, we evaluate the firm’s value in three steps. At first, we value the firms’ value with no reference to the leverage. Next, we the interest tax savings at the present value will be estimated via the amount of the money borrowed. And then, the impact of the borrowing on the probability that there is a situation that the firm will go bankrupt and there is a cost of the forthcoming bankrupt.

As the APV approach may offer firms with comparatively clear outline of some components of the influences of the debt, it has some practical meanings when firms are engaged in evaluating the possible adding debt. In this situation, this debt ratio is suggested.

3.4 A comparable means on the financing mix

This last debt ratio approach is the most common one for a firm to make the comparison of its leverage with the leverage of these similar firms. There are two way to perform this approach. The former one is to make the comparison of the firms’ debt ratio with the average ratio in its industry. And the latter one is more complete, which is to compare the differences of the firm and the rest in the same industry to calculate the debt ratios (Baker 2011).

In the field of the advantage of this approach, it is very time saving for firms to get a quick answer about the debt ratio and a practical way for firms to get close to the problem in a short time rather than other method, which become the most common approach for firms at the present (Baker 2011).

4.0 Cost of capital and capital structure issue

4.1 Average cost of capital

Pratt and Grabowski (2010) explained the average cost of capital has a close relationship with the cost of debt and the cost of equity. And the cost of equity often reflect the investment risks for firms, while the cost of debt then reflect the cost of borrowing in the long term for the company. To get the exact data of the cost of capital the two factors should be taken into primary concern. In summary, Pratt and Grabowski (2010) regarded the cost of capital as the weighted average between the cost of both equity and debt on the base of the market value.

Weighted average cost of capital = Cost of debt ( 1-t ) × Debt / ( Debt + Equity)

+ Cost of equity × Equity/ ( Debt + Equity)

In terms of this formula, we find there are three basic inputs necessary for us to compute the weighted average cost of capital (WACC) including the after tax cost of debt, the cost of equity as well as debt and equity’s weights. And both the cost of debt and equity will change if the ratio of debt changes. So if we expect to compute the WACC, the first challenge is to compute the three inputs primarily.

4.1.1 Cost of equity

Pratt and Grabowski (2010) claimed that if the debt ratio changes, the equity beta will also change. As a matter of fact, the levered beta can be computed from the unlevered beta and the tax rate of the firm on the basis of the equation:

In the case, we have obtained the unleveraged beta for Gemini PLC, which is 0.85 and the marginal tax rate of this company is 30% and the statistics about the percent of debt, then we can get these statistics as below.

Table 1.0 Levered Beta with different debt percentages

Levered Beta

Unlevered Beta

Tax Rate

Debt %

Equity %

Debt/ Equity

92% 85% 30% 10% 90% 11.11%
100% 85% 30% 20% 80% 25.00%
111% 85% 30% 30% 70% 42.86%
125% 85% 30% 40% 60% 66.67%
145% 85% 30% 50% 50% 100.00%
174% 85% 30% 60% 40% 150.00%
224% 85% 30% 70% 30% 233.33%

Thus, we get the results of Levered Beta and we can compute the cost of equity under different debt percentage.

Table 2.0 Cost of Equity with different debt percentages

Cost of Equity Risk Free Rate

Levered Beta

Debt %

Risk premium

13.33% 6% 92% 10% 8% =14%-6%
13.99% 6% 100% 20% 8%
14.84% 6% 111% 30% 8%
15.97% 6% 125% 40% 8%
17.56% 6% 145% 50% 8%
19.94% 6% 174% 60% 8%
23.91% 6% 224% 70% 8%

4.1.2 Cost of debt

Pratt and Grabowski (2010) proposed the cost of debt for the company can be considered as the function to get the default risk for this company. For example the cost of debt increases may be the result of the more borrowing which will increase the default risk. And the steps to compute the cost of debt can be divided into three. The first step is to get the expense on interest and the dollar debt of the firm on different debt percent. The second step is to get the tax rate for the firm. And the last step is to use these statistics to get the results of the cost of debt using the equation.

After-Tax Cost of Debt = Pretax Interest Rate (1 – Tax Rate)

Table 2.0 Cost of Debt with different debt percentages

After-Tax Cost of Debt Pretax cost

Corporate Taxation

Debt %

4.55% 6.5% 30% 10%
4.97% 7.1% 30% 20%
5.46% 7.8% 30% 30%
5.95% 8.5% 30% 40%
7.00% 10% 30% 50%
8.40% 12% 30% 60%
10.50% 15% 30% 70%

And then we can get the before tax cost of debt = After-Tax Cost of Debt /(1 – Tax Rate), and then we can get the before tax cost of debt

Before-Tax Cost of Debt

Corporate Taxation

Debt %

6.5% 30% 10%
7.1% 30% 20%
7.8% 30% 30%
8.5% 30% 40%
10% 30% 50%
12% 30% 60%
15% 30% 70%

4.1.3 Weighted average cost of capital

As the result of costs of both debt and equity at each debt ratio are estimated, we can get the WACC for each debt percent using this formula:

Weighted average cost of capital = Cost of debt ( 1-t ) × Debt / ( Debt + Equity)

+ Cost of equity × Equity/ ( Debt + Equity)

Table 3.0 Weighted average cost of capital with different debt percentages

WACC

Cost of Debt

Debt%

Cost of Equity

Equity %

T

12.45% 6.5% 10% 13.33% 90% 30%
12.19% 7.1% 20% 13.99% 80% 30%
12.03% 7.8% 30% 14.84% 70% 30%
11.96% 8.5% 40% 15.97% 60% 30%
12.28% 10% 50% 17.56% 50% 30%
13.02% 12% 60% 19.94% 40% 30%
14.52 15% 70% 23.91% 30% 30%

The statistics from this approach may imply the capital structure with the debt ratio at 40% which may have the lowest degree of the capital cost compare with the other six capital structures in the above.

5.0 Market segmentation and causes

5.1 Market segmentation

Errunza and Miller (2000) defined the market segmentation as a strategy to divide a market with a larger size into some subsets by the character of the consumers such as their preference in goods and services offered. And these consumers in the subgroups can be distinguished by these special qualities such as demographics, purposes, requirements and so on. Based on the segmentation of customer, market campaigns then can be designed and carried out. And the reason for involving in market segmentation for companies is that it can help the organization to have a better understanding of the requirements for the certain kind of customer base in the segmentation.

For the capital market, the segmentation of this market is also because it is important to divide the comparative larger capital market into some subgroups, which own the character to make customers such as these investors to have a more clear idea on what they will go to invest and how much the actual return may meet their expected return from this capital market segmentation. And the segmentation of the capita market may also be developed by the character of its consumers such as the character of the investors. For example, in the small capital market, these regulations or mechanism may be comparatively loose because its customers often act personally by their own emotion that there is no urgent need to the standardize the regulation or mechanisms in such market. While in the large capital market segmentation, these regulations and mechanism are more complete due to the comparatively reasonable and considerate investment action made by these big investors. (Errunza & Miller 2000)

5.2 Causes of capital market segmentation

According to Errunza and Miller (2000), the same as the individual firms, in the market there is a capital cost reflecting the capital providers’ expected returns. While the segmentation of the capital market isn’t merely from these providers’ side, there are reasons for the segmentation of the capital market. One is from the capital providers who assist the establishment of these rules and parameters in the capital market. The other is business owners and managers who evaluate and give definition on the risks and returns in the market with different perspectives. Besides the ideas above, Brunnermeier et al. (2009) claimed government rules or regulation is another cause for the segmentation of capital market.

5.2.1 Capital providers

Slee (2011) claimed in the capital market, providers of the capital give definition on the criteria which is important to access capital by the credit boxes. And for these institutional providers of capital, they are more professional that they are able to use theories such as the portfolio theory to evaluate risks to optimize the returns. And according to (Slee 2011), the basis of the portfolio theory is the agreement on the risk accompanied by any single asset when holding in a set of assets. And the credit boxes are often used as a filter to filter asset quality and build up the expectation of returns. In short, when meeting with the credit box, whether loans nor investments ought to promise an adjustment of the risks involved in returns to meet the expectation of these providers.

Meanwhile, Gertner et al. (1994) proposed there is also some other method for capital providers to make management on the risks and returns in the capital market. On the one hand, techniques are often the good choice for providers such as the advance rates or loan terms and other useful ratios to enable providers watch out for the risks by matching the rate on interest with the risk and barriers and various investment methods from different regions and industries. On the other hand, loan covenant is also a useful tool for providers to manage the risks by setting up some behavioral boundaries to support the management of the portfolios. For debt provider, the tool of loan covenants may further segment the market of capital.

Once again, the ability of some providers to adjustment the differences of some perceived risk may segment the capital market further on the explanation of Folkman et al. (2007). For instance, in the middle market of capital, the distinct difference in the risk between providers of equity and providers of debt is obvious. The risk for equity provider is greater than the debt provider because of the legal structure. Because the larger proportion in the small portfolio may increase the risks for equity. For debt providers, the legal rights are comparatively substantial that is often a smaller proportion in the larger portfolio, which may reduce the risks. At the same time, different from debt providers, equity providers in the capital market may be able to spread some risks to other investments related to some given funds for the portfolio. While for the debt providers, the risks are often spread to a comparatively larger investment pool than equity providers in the portfolio. Moreover, the proportion of debt involved in the investment may help investors to reduce the risks when their return is improved by their equity proportion in the investment too.

In addition, Slee (2011) also said the portfolios from both lenders and investors may help them to define of evaluate the limitations from their return expectations and then assist them to deal with these limitations to bring about some fluctuations in the capital market. Similarly, owners often maximize the usage of capital and manage the possibility of risks by the managements of the equity and debt portfolio.

In brief, the differences in capital providers including the owners, equity providers, debt providers and so on from day to day accompanying with the market mechanisms define the segmentation of the capital market.

5.2.2 Owners and managers

Eisfeldt (2008) claimed the other caused of segment of capital market is the business owners and managers who evaluate and give definition on the risks and returns in the market with different perspectives.

In the first place, the evaluation from business owners and managers are useful to balance the relationship between risk and return. And the segmentation of the capital market may further balance the foregoing risks and return, which is reinforced by the actions of these parties. For instance, the reason why a large public listed company who can make 39 times gaining from its stock in capital market acquires a small or lower middle company is that this company may treat the investment in this small or lower middle company as a riskier to invest less to balance the relationship between risks and returns for it and its shareholders. This kind of view from owners or managers in some companies as the investors become the reason of capital market to segment as Eisfeldt (2008) said.

In the next place, Brigham (2010) proposed that in different market the view and definition of risks and returns by owners or managers are diversified. At least, these factors such as financial element, behavioral element and psychic element make up the relationship between risks and returns in each market. And the risks or returns in financial element may imply the reality that the monetary consequence of the investment action should work as the compensation for the risks of involving into the action. And the risks or returns of behavioral element may imply the truth that the action of investment may be aroused by several social expectations. And the risks or returns from psychic element may imply the personal emotional decision on investment from owners and managers.

Additionally, the small business owners or managers may evaluate the risks and returns of the investment more from the personal aspect rather than the basis from conceptual knowledge like shareholders in large companies. And the owners or managers in the mid market may have a more comprehensive view on the investment returns and risks which drive them to understand the relationship between the high costs of capital may return them more for this risk (Eisfeldt 2008).

In a sum, just due to the combination of capital producers and business owners or managers who manage the portfolios and balance the risks and returns from investment finally cause the capital market to segment.

5.2.3 Government regulations and other elements

Brunnermeier et al. (2009) claimed the regulations of government on the capital movements and tax policies may also result in the segmentation of capital market. In different countries, the regulations on capital government and tax policies have different existence. And there are often gaps between the regulation on the behaviors between domestic investors and foreign investors. And different countries may give different policies positive or negative for these foreign investors to invest in that capital market. Additionally, the cultural difference including education background, languages, business habits or other elements may also make the segmentation of the capital market to have its own features (Bruton & Ahlstrom 2008).

Reference

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