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In this part of the assignment, we will focus on the topic of the process of finding out the optimal mix of debt to equity ratios that a company could follow to structure their capital in such a way that it could be best for the company and the shareholders. In particular, we explore in the following four frequently used ways to identify an optimal debt and equity mix: Operating income approach, Cost of capital approach, Adjusted present value approach and Comparative analysis.
Operating income approach
Operating income is the income available to pay interest and other profits. A firm with a lot of operating income, relative to its interest expense, does not really have much of a problem paying the interest and this is true even if operating income declines or decreases. In contrast, a firm with only very modest operating income relative to its interest expense quickly gets into trouble if the operating income decreases (Nelson 2011, p.357). The operating income approach is the most direct and simplest approaches among the four listed ways to identify the optimal capital structure. The steps used in the operating income approach include the five steps as below:
The first step is to access the company’s capacity to generate operating income based on both current conditions and the past history. This step helps the company to see how the income are distributed and allocated in different purposes and also what are the possible situations under different levels of income. The second step is to estimate the cost of the debts and principle payments based on different level and with the expected payments, interests to be paid and estimated probability distribution of the operating income, the third step would be to estimate the possibility that the company could not make those payments. And the fourth step would be to set a limited or constrain on the probability of its being unable to meet the debt payments based on the managers’ experiences. And the last step would be to compare the estimated probability of default at a given level of debt to the probability constraint and make adjust the level of debt based on the constraint (Damodaran 2011, p.394). This approach could be very simple but also difficult because it request the management to have good perception about how large the probability of default could be accept and thus the management’s experience and ability should be good enough to carry out this job.
Cost of capital approach
The second approach which is the cost of capital approach concentrates on the cost paid by the company and the method seeks to minimize the cost of the capital in term of paying the lowest percentage of capital as the total cost of the debt finances and also the equity financing. Take the standard cost of capital approach as an example, the measurement includes three key inputs which are critical in the cost of capital approach: cost of equity, cost of capital and weights of debt and equity. Among these three steps, the calculation of the cost of debts is the most difficult steps because with the change of the debt percentage, the credit rating of the bonds, the interest expenditure, addition to the risk free rate to influence the cost of the debts. And the last estimation of the cost of capital ratio would depend on the proportion of the debts and equities that together decide the final cost of capital percentage. And the selection of the least cost percentage compared to the total capital between different capital structures would be able to identify the optimal debt ratio under this method. But the application of the cost of capital approach is not without constrains. One important constraint is the bond rating restriction. For example, if a company calculate all the cost of equity and cost of debts in different debts percentages based on the process just stated, and identify that when the debts to equity is in a very high level and the credit rating would be very low, the cost of capital would be minimized in term of percentage of the total capital, but actually the company may be constrained from issuing bond in such a low credit rating.
Adjusted present value approach
The adjusted present value approach is targeting at maximizing a company’s value creation which could be defined as the positive difference between the true cost of capital and the long term return obtained from the use of that capital, discounted to net present value and it can be manifested in higher income and/or greater net asset values (Block 2009). In calculation, the net present value of the projects or a company equals the sum of the present value of the unlevered cash flow discounted by the cost of equity of the unlevered firm and the value of the tax benefits of the debt (Lee, C. F. & Lee, A. C. 2010, p.1223). The basic assumption used in this approach is to assume that the major benefit of the loan is a tax benefit and meanwhile the cost of the borrowing is the added risk of bankruptcy. There are three steps in the adjusted present value way: firstly, the company has to estimate the value of the company when there is not debt in the total capital which could be obtained by calculating the expected cash flow in a present value basis; secondly, the company needs to calculate the tax deduction that a loan could bring (assume that the tax rate would not change over time within the period considered); and the last important step is to calculate the anticipated costs of bankruptcy which involves both direct and indirect costs. But one of the defects of this method is the difficulty to measure the cost of bankruptcy because not many managers would have the similar experiences.
The fourth way which is a comparative analysis is to recommend the company to make comparison in term of the debt to equity ratio between the company and other companies and also the industry average. If in an industry, the debt and equity structures tend to be similar, then the large difference between the company’s capital structure and the industry average could suggest some risks and thus a company could use some control policies to maintain the difference as within a controlled level. This approach would be made easier when there is already a widely recognized benchmark in the debt to equity ratio.