Call At: +919779121071   |
Home > Solution > Question
All agency action can be classified in three categories: quasi-adjudication: order making, judicial quasi-legislation: rulemaking executive
Posted On: Nov. 8, 2017
Author: Shipra

Part A. Critically evaluate the importance of capital structure and the cost of capital in the efficient financial management of large companies. Capital Structure can be simply put as the combination and the types of sources of finances available in an organization. In order to carry out operations , an organization has to make arrangements for its finance. Thse can be arranged in the form of • Long term debt • Short term debt • Common equity and • Preferred equity The long term debt is in the form of borrowing from banks or other financial institutions. In this case the rate of interest need to be taken into consideration as a higher rate of interest would add considerable burden on the financial health of the company. Short term debt on the other hand implies borrowing to meet the expenses on the short term basis. These borrowings are meant to meet expenses of short term nature, such as payment to vendors, short term commitments etc. Equity as the name suggests, means ownership. It can be either common ( i.e., ownership by general public etc , having no special rights ) and preferred ( with special rights and implications / obligations ) Either way , equity is one form of arranging finance for the company. Cost wise, the company has to consider which one is the most economical method. As mentioned, Debts ( both short and long term ) involve payment of interest and this needs commitment from the company. This can not be ignored .Equity is ownership and the dividend or profit is distributed to the owners as and when it is declared. So , one can say that equity is a cheap form of borrowing but then one looses control on the operations of the company as being a equity holder, the person who has a stake also has a saying in the working of the company. Another form of finance is leasing which is generally adopted by companies who wish to purchase items of large value but can not afford to make payment for the same. In this case, the equipment to be used by the company is not bought by them from the suppliers, but given on lease or contract. This way , the company can make use of the item / equipment and the supplier gets payment on a regular monthly basis. It is obvious that the ownership of the equipment remains with the supplier itself. Heavy machinery , trucks, buildings etc are some of the items which are taken on lease by the companies. Generally in every organization, the sources of finances are of two types – owned and borrowed. They are also known as the equity capital and debt capital respectively. Judging the right mix of equity and debt is one of the most complex decisions making of all the processes that the management faces. While the debt is cheap, it is a perpetual liability on the business and eats a large amount of interest from the business’s profits. On the other hand, equity capital is safe but is very costly to maintain and often deprives the company of the tax benefit that it can derive. Cost of capital is also known as the Weighted Average Cost of Capital (WACC) or the required rate of return is the summation of cost of all types of capital available in the firm’s capital structure. The capital structure and the cost of capital are closely associated with each other as the proportion of cost and debt has the direct implications on the overall cost of capital (WACC). WACC is nothing but a simple calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources such as - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. The WACC formula is Where: Re= cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate ( Numerical example Suppose the following situation in a company: The market value of debt = €300 million The market value of equity = €400 million The cost of debt = 8% The corporate tax rate = 35% The cost of equity is 18% The WACC of this company is: 300 : 700 * 8% * (1-35%) + 400 : 700 * 18% ------------------------------------------------ 12,5% (WACC - Weighted Average Cost of Capital) ( The initial theories in respect of the capital structure was propounded by Modigliani & Miller in 1958 which questioned whether the company is having the capital structure which is optimal enough and making money for the investors those who provide it. Although the assumptions of the theory are quite absurd like there is no tax, there is only a single rate for borrowing and lending and market has perfect competition. This kind of situation was never and will never be in the market. Also it is impossible to imagine a world without tax. This is tax only that makes the debt advantageous and provides the necessary leverage to the firm and helps firms maximize their values. It is the tax that motivates the businesses to go for capital gearing and take up more debts for financing their projects. The greater the leverage or gearing, the greater are the tax benefits to business arising out of debt financing. The capital structure is one of the very important factors in deciding about the overall profitability of the firm and it variates from industry and industry and region to region across the globe. While the US and Japanese companies have high amounts of debts in their Balance Sheets, many German and Canadian firms have less debt book value. This has also to deal with the tax laws in the prevailing country. The other significant observation is that the capital structure varies from industry to industry. The capital intensive industries like telecom, automation, power etc have more gearing than the service sectors like IT. In some of the cases, it has also been observed that the tax reforms or the change in them has not impacted the capital structure of the company, like in US. Among the major capital structure theories, first of them is trade – off model which suggests that the capital structure of the company is dependent upon the trade off between tax benefits and risk associated with the high leverage. A model with an inverse relationship between financial distress and optimal leverage in early 1980s (M. Bradley, G. Jarrel, E. Kim, 1984). The model so developed studied 800 firms over a period of 20 years and observed that the findings were consistent with the trade – off model. Another theory is known as Pecking Order Theory which suggests that the real life firms have all sorts of capital structure combinations. It ranges from 100% Equity to 100% between and many in between them. The companies adjust and change this combination according to their needs, financial conditions and prevailing economic situation. Cost of capital is something about which most of the companies are worried about. They want to keep it as low as possible. In the M&M theory do not work in the actual world and the main reason for that they do not take in to consideration the agency cost which is actually a hidden cost in debt financing. It is often mis understood that getting the debt is easier than equity but that is not true. The sources or the providers of the debt are always worried about the safety of their money and often critically evaluate the firm’s ability to service the debt and interest payment. They are also concerned that the firm should not take any excessive risk which could jeopardize the safety of their money invested. In order to save them, they often insist on inserting the covenants in the agreements which restricts the firm to take too much of risky decisions like disposing off the assets, restrictions on the use of the money, putting the first charge on the fixed assets and like. These restrictions are known as agency costs. There are several other factors that need to be taken into the consideration before arriving at the single figure of cost of capital. It is comprised of cost of equity capital, cost of debt, cost of preference capital and the cost of retained earnings. Once the cost of each element of the capital structure is calculated, the same is multiplied by its respective weights in the capital structure and then added to get the WACC. This holds a special position in the financial position and the decision making process of the firm as this is used as the discounting method in evaluating the projects or making any long term decision. The cost of capital is also important from the point of view that it is compared with the Return on Equity and Return on Investment. If ROE & ROI are more than the cost of capital, it is considered that the firm is doing well and reflects the efficiency of the management. Then again the firms have to walk on the tight rope of maintaining the capital structure which can also bring their overall cost of capital to the minimum possible level. In fact, dealing with the capital structure and cost of capital issues is a continuous process and it keeps on changing from situation to situation as per the prevailing economic and financial needs. The ratio of debt to equity is extremely difficult to quantify. It depends on several factors such as the type of industry sector in which a company operates, the life cycle stage of the industry. A low debt and higher equity based companies have better chances of borrowing from the market and people will be wiling to invest in them. Part B Discuss the motives behind corporate restructuring and evaluate the methods by which mergers and takeovers may take place. As the name suggest, Corporate Restructuring is the changing the design and structure of the company as they it used to exist. It means change in the financial structure, management or the controlling of an organization. It is much broader term than we expect and covers many aspects of business reorganization like mergers, takeovers, hostile takeovers, internal or external reconstruction of the financial of the organization and rearrangements. It might be expansion or the shrinking the scale or operations of the organization. Why do companies resort to Corporate Restructuring? There might be ample reasons due to which the company might resort to corporate restructuring. One of the reasons could be reshaping its structure. Like humans companies also take care of their health and want to look slim, trim, active and healthy. When any organization grows to a size that it’s bulky and becomes lethargic due to its own weight, it becomes necessary to adopt lean strategies like spinning off some of its divisions into the subsidiaries, which function as the investment center. The company also sees it as the opportunity to focus on the core business and increase its market share. It also gives the parent company an advantage to take the benefit of tax exemptions. The whole business world is still struggling with the global recession and is still far from over. In the era of turbulent times, the companies also feel the burden of the costs that they are carrying and this prompts them to take steps to restructure their financial management. When the revenues are dropping, margins are squeezing and recession starts taking the toll of the firm’s business, then the organizations often resort to cost cutting and rearrangement of their financials and costing model. They might also resort to cost cutting, scaling down the operations, change the senior management, close the unprofitable businesses or units and even layoffs. Somebody in the business world has compared it as a sea and the presence of sharks can not be ruled out in a sea. One of the very common reasons of corporate restructuring is mergers and acquisitions. While the mergers happens to create a synergy with the willingness of the two businesses to create a new bigger business. On the other hand, acquisitions could be in the form of hostile takeovers or levered buyouts. What ever be the reason, sometime the companies also allows them to be taken over in order to book a profit and exit. Sometimes the acquirer also sees a gain in the acquired company due to the assets it owns and then selling them off at a profit and uses those resources to run the acquired company which could not have been possible without a takeover. Methods of executing Mergers and Acquisitions (Takeovers) Mergers Mergers are the business combinations in which the business come together to form a new company. The merged companies loose their identity in this process. This can be done in the two broad categories: (i) On the basis of nature • Horizontal This happens when two or more companies in the same industry merge together. The main motives behind this kind of mergers are cutting the costs, economies of scale and cutting down the competition. A horizontal merger is when two companies competing in the same market merge or join together. When two extremely small companies combine, or horizontally merge, the results of the merger are less visible. Such kinds of horizontal mergers are quite common. For example if a small pharmaceutical company were to horizontally merge with another local pharmaceutical , the effect of this merger on the pharmaceutical market would be negligible. However, in a large horizontal merger, the ensuing ripple effects can be felt all over the market segment and sometimes throughout the whole economy. • Vertical This kind of merger often happens between tow or more different levels of companies in order to gain the major market share. This is basically done in order to have control over the raw material or the use of the end product and gain with the synergy. The business combination of AOL and Time Warner is one such example. A vertical merger is one in which a firm or company combines with a supplier or distributor. This type of merger can be viewed as anticompetitive because it can often deprive supply business from its competition. For example if a contractor has been receiving raw material from two different firms, and then decides to purchase the two supplying firms, the vertical merger could cause the contractor’s competitors to go out of business. Antitrust concerns are a crucial point of investigation if competition is hurt. • Conglomerate, and This kind of merger also happens in the same industry but the two or more firms are not having any kind of relationship. This is just to have more of a space and focus on diversification. • Reverse Merger This is a unique kind of a merger in which the parent company merges with its own subsidiary to create value and space for it in the market. This creates the economies of scale and better control on the market share. (ii) On the financial basis • Accretive Mergers This kind of mergers happens purely with a focus of maximizing the wealth of the company. The company with high P/E Ratio acquires with lower P/E ratio and helps increase its Earning per Share (EPS) which would help in soaring its market price. Accretive mergers occur when a company with a high price to earnings ratio ( P/E ratio ) purchases a company with a low price to earnings ratio. This makes the purchasing company’s earnings per share increase dramatically For example if IBM purchases a smaller firm software firm , then its P/E would increase • Dilutive Mergers This is just opposite to that of just discussed above. In this case the EPS of the acquiring company is reduced. Warren Buffet often does this with its companies. Acquisitions (Takeovers) Acquisition means acquiring the controlling interest in one company by the other company. This does not involve the extinction of the firms as in mergers. It can be done in the following ways: (i) On the basis of the response of the acquired firm • Negotiated Acquisition This is done by the mutual agreement and understanding of the target company and the acquiring company, where the target company’s management is willing to allow the takeover for an agreed price. • Hostile Takeover This is something for which the target company is not prepared. This is generally done by acquiring the number of share good enough to take control in the target company by the acquiring company. • Bail Out When a financially strong company takes control over a financially weak company for a certain price, it is known as bail out. Sometimes this is done to increase the base or entering in the new market or for some strategic purposes. It is often seen as step taken by the government or public sector companies to help any sick company. (ii) Motives behind acquisition • Strategic When the acquiring company takes over the other company as a part of its overall strategy, it is known as strategic takeover. The strategy could be in respect of beating the competition, or enhancing the capacity or market dominance. This is generally done by offering the ratio of share by the acquiring company to the shareholders of the acquired company. The strategy of the company is determined by top level management. If the top level management feels that the expansion can be done by Merger, then necessary steps will be taken in that direction. Similarly , if the expansion plans are to be achieved by Take over, then those policies will be implemented. • Financial When the promoter of the company itself is the acquirer, it is known as financial takeover. This is generally done to cut the cost, and operate the company in much efficient manner with the best possible available resources. (iii) Method of acquisition • Buying of shares In this case the control of the target company is purchased by buying the shares of the target company in exchange of the acquirer company. The assets and the liabilities of the acquired company remain intact. The shares can be purchased as equity or preferred stock. The ownership issues need to be resolved. • Buying of Assets In this case the buyer takes over the assets and liabilities of the target company and collects money by selling the assets. It then also pays off the liabilities and external borrowers of the target company. This often makes the target company like an empty box when all shares are acquired. Prior to acquiring a company ( by what ever method, it is important to carry out its valuation ) There are several ways of valuation of the company such as Discounted cash flow method of valuation Asset based valuation Replacement cost method Income based valuation Net realizable value method Let us take example of one of the most popular method viz DCF ( discounted cash flow ) METHOD OF CALCULATING DISCOUNTED CASH FLOW The DCF for an investment is calculated by estimating: the cash that you will have to pay out, and the cash which you expect to receive back. The timeframes that you expect to receive the payments must also be estimated. Each cash transaction must then be recalculated, by subtracting the opportunity cost of capital between now and the moment when you will pay or receive the cash. EXAMPLE For example, if inflation is 6%, the value of your money would halve every ±12 years. If you expect that a particular asset will provide you an income of $30.000 in 12 years from now, that income stream would be worth $15.000 today if inflation was 6% for the period. We have now discounted the cash flow of $30.000: it is only worth $15.000 for you at this moment. ( References: • Lumby, S., Jones, C., (2004), Corporate Finance - theory and practice 7th edition, Thomson • ACCA Paper 3.7 (2001) Strategic Financial Management, The Financial Training Company • Rajan, R., Zingales, L., (1996), “What do we know about capital structure? Some Evidence from International Data”, Journal of Finance 50, 1421-1460 • Bradley, M., Jarrel, G., Kim, E. (1984), “On the Existence of an Optimal Capital Structure: Theory and Evidence”, Journal of Finance 39(3), 857 -878. • ‘Cost of Capital’, viewed on 24 June 2009 <> • ‘What is cost of capital’ viewed 25 June 2009 <> • ( • ( • •