I. EXECUTIVE SUMMARY/ABSTRACT
The Part-I of this paper analyzes the Treasury Manager and his various approaches towards the Capital Structure, by showing arguments for and against each theory. We discuss about four types of approaches that may be taken by the treasury manager while considering the Capital Structure of a Company. We have discussed Rolls Royce PLC’s capital structure strategy and analyzed the capital structure of the company over the past 10 years using an empirical case/research. The Part-II of this paper shows the relationship between private equity groups and leverage. We discuss about how the leverage is used by private equity groups to reduce the risk, by showing an empirical case of Blackstone Group.
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Debt structuring can be a handy option because the interest payable on debts is tax deductible (deductible from net profit before tax). Hence, debt is a cheaper source of finance. But increasing debt has its own share of drawbacks like increased risk of bankruptcy, increased fixed interest obligations etc.
For finding the optimum capital structure in order to maximize shareholder’s wealth or value of the firm, different theories (approaches) have evolved.
PART- I
III. TYPES OF CAPITAL STRUCTURE APPROACH
a. Traditional Approach
The traditional theory of capital structure describes the existence of optimal debt to equity ratio, where the cost of capital is minimum and the market value of a firm is maximum. The changes in the financing mix can bring positive change to the value of the firm. Before the changes in the financing mix, the marginal cost of debt is less than cost of equity and after the change; the marginal cost of debt is higher than that of equity. This theory supports the combination of the equity and debt ratio of the capital structure of a firm when the market value is at its maximum. The debt in the capital structure of a firm can only be up to a certain point, any increase beyond that point can cause the increase in the leverage and can result in the decrease in the market value of a firm.
This means that there exists an optimum value of debt to equity ratio at which the WACC is the lowest and the market value of the firm is the highest. It shows
2. Establish how the cost of equity is affected by capital structure decisions by defining financial risk and introducing the levered beta CAPM equation
Finding the perfect capital structure in terms of risk and reward can ensure a company meets shareholder expectations and protects a firm in times of recession. Capital structure refers to how a business puts its money to “work”. The two forms of capital structure are equity capital and debt capital. Both have their benefits and limitations. Striking that perfect balance between the two can mean the difference between thriving versus trying to survive.
c) Optimization of the capital structure is also consistent with the growth of the company. The optimal capital structure
40%/9% Bonds and Common Stock generates a lower EPS, EBT, and Net Income in all years in comparison to the 50/50 option and is therefore not a practical capital structure option. The interest paid on bonds creates a lower EBT, net income, and total income available for common stockholders for all years in comparison to the 50/50 option. A capital structure of this mix might make banks reluctant to loan money due to the organization debt to income ratio. In addition, investors may be hesitant to invest due to the slow capital growth indicated by the
Nevertheless, the use of the Optimal Capital Structure (OCS) is the right techniques to be used in order to acquire the right combination of debt and equity that can maximize the
Generally, firms can choose among various capital structures in order to maximize overall market value of the company. It is proposed however, that
A capital structure policy aims to balance the trade-off between the benefits of debt financing (interest tax shield) and the costs of debt financing (financial distress and agency costs). Every firm should set its target capital structure such that its cost and benefits of leverage ultimately maximise the firm’s value. Graham and Harvey asked 392 firms’ chief financial officers whether they use target debt ratios. Results show that the majority of them do, although the level of strictness of the target policy varies across different companies. Only 19% of the firms avoid target ratios, of which most are likely to be the relatively smaller firms. This clearly
The course project involved developing a great depth of knowledge in analyzing capital structure, theories behind it, and its risks and issues. Before I began this assignment, I knew nothing but a few things about capital structure from previous unit weeks; however, it was not until this course’s final project that came along with opening
The advantage of debt financing is that interests paid on such debt are tax deductible. If a company has the intention of maintaining a permanent debt, the present value of the tax shield can be obtained by discounting them by the expected rate of return demanded by the investors who hold the debt (this is a perpetuity, where in reality would be the maximum possible present value for the tax shield). This tax shield value reduces the tax bill and increases the cash payment to investors, increasing the value of their investments.
There is no universal theory of the debt-equity choice, and no reason to expect one. In this essay I will critically assess the Pecking Order Theory of capital structure with reference and comparison of publicly listed companies. The pecking order theory says that the firm will borrow, rather than issuing equity, when internal cash flow is not sufficient to fund capital expenditures. This theory explains why firms prefer internal rather than external financing which is due to adverse selection, asymmetry of information, and agency costs (Frank & Goyal, 2003). The trade-off theory comes from the pecking order theory it is an unintentional outcome of companies following the pecking-order theory. This explains that firms strive to achieve an
Already in 1958, Modigliani and Miller have pointed the discussion of capital structure towards the cost of debt and equity. According to their first proposition, in a world of no corporate taxes and with perfect markets, financial leverage has no effect on a firm’s value. In their second proposition, they state that the cost of equity equals a linear function defined by the required return on assets and the cost of debt (Modigliani and Miller, 1958).
A firm can choose a mix of three modes of financing i.e. issuing shares, borrowing from the market and use of retained earnings. The ratio of this mix of funds purely depends on the firm and known as optimal capital structure of the firm. This leads to the different capital structure theories. These theories explain their
There is need for them to therefore be familiar with capital structure theory as well as the benefits and drawbacks involved in the kind of method adopted in sourcing for funds.
The pecking order theory ( Donaldson 1961) of capital structure is among the most influential theories of corporate leverage. The pecking order theory is based on different of information between corporate insiders and the market. According to Myers (1984), due to adverse selection, firm prefer internal to external finance. If internal finance proves insufficient, bank borrowings and corporate bonds are the preferred source of external source of finance. After exhausting both of these possibilities, the final and least preferred source of finance is
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm 's capital structure is then the composition or 'structure ' of its liabilities. Simply, capital structure refers to the mix of debt and equity used by a firm in financing its assets. The capital structure decision is one of the most important decisions made by financial management. The capital structure decision is at the center of many other decisions in the area of corporate finance. These include dividend policy, project financing, issue of long term securities, financing of mergers, buyouts and so on. One of the many objectives of