Assessing Capital Structure

In this lesson, you’re expected to learn about:
– capital structure evaluation
– calculating the cost of capital
– choosing the right capital structure

For companies, an understanding of debt and equity has the goal of managing the cost of capital. Raising capital isn’t easy and if a business wants to make money, it has to ensure that any prospective projects or operations generate more value and therefore more revenues than the company needs to pay as repayment for that raised capital.

When you borrow money, you want to make sure that you bring in more money than the interest you’re paying on that loan. In other words, if the repayment of loans and equity is higher than the revenues generated, you’re doing it wrong.

You can apply capital structure evaluation in two ways, both of which act in a similar manner:

1) Overall corporate capital structure

The total amount of assets in the company and how efficiently the company is managing them as a whole. This approach helps the company determine how to mange the structure of its overall capital and address important questions.

How much of the required capital should the firm fund using debt and how much with equity? What types of debt and equity should the company use? The answers to these questions can strongly influence how successful a company will be, and ideally you want to answer them before a company even begins operations.

2) Project capital structure management

This approach is a little more focused than overall corporate capital structure. Before deciding whether to take on a new project, you need to determine the project’s cost and weigh the costs associated with raising those funds against the projected future cash flows that the project is going to generate for the company.

Between the total cash outflows and inflows associated with a project, you can calculate the net present value (NPV) of the project, allowing your company to determine the best of several possible projects available.

Calculating cost of capital

The best way to measure the costs associated with raising capital is to calculate the cost of capital. You can calculate these costs in a number of different ways, and if you’re mathematically inclined you can easily play with the particular calculations to make adjustments as needed to meet personal preferences.

Here’s a simple calculation to work out the cost of capital:
Cost of capital = Cost of equity + Cost of debt

The cost of debt comes primarily in the form of interest payments, which is simple to measure and calculate.

The cost of equity comes from several different sources and is a little harder to define. Part of the cost of equity comes down to dividend policy, part of it is the increased tax costs, and the risk of equity also plays a role.

We’ll look at dividend policy in more detail later. 

Calculating the cost of capital allows people not only to determine how much they’re spending through their financing activities, but also where the cost is coming from (equity or debt), the required minimum returns necessary to stay profitable and even how to manage the capital structure of the company to minimize the cost of capital.

Measuring the cost of capital using WACC 

The most common method of measuring the cost of capital is called WACC, which stands for weighted average cost of capital. It is the average rate of return determined from all sources of finances employed by a company, which can be used at a discount rate for investment appraisal decisions.

This particular equation takes the basic cost of capital equation that we just saw and contributes the proportions of total corporate value that each source of capital composes.

The following equation makes WACC clearer:
E = market value of equity
D = market value of debt
V = company value (book value of debt plus book value of equity)
C = cost of equity or debt

The E/V and D/V are simply weighted proportions. The market value of equity is divided by the total corporate value to determine how much of the company’s value is funded by equity.

Cost of Debt 

Debt includes any long- or short-term debt that is used to finance the operations of a business. The biggest influence on the cost of debt is simply the interest rate on debt incurred, measured by using the present value of future cash flows to repay the loans.

You need to consider the following issues: 

1) Default risk

It isn’t a direct cost but a company must anticipate that as the amount and proportion of debt it takes on increases, so too does the rate of return it must promise to attract investors. A company with large amounts of debt or a high debt to equity ratio is at greater default risk, and so to attract more investors looking for debt it needs to offer higher rates. As a result, debt becomes increasingly more expensive as the company relies on it more heavily.

2) Debt expenses 

Debt expenses are frequently tax deductible, decreasing the relative cost of debt. To calculate the after-tax rate applicable for debt capital, you simply multiply the pre-tax rate by 1 minus the marginal tax rate, to get the after –tax rate, which is obviously lower by an amount equal to the proportion deducted for tax purposes.

Cost of Equity 

Equity is any funding raised through the selling of company shares. Different people have different ways of measuring equity.

Some prefer to use the capital asset pricing model (CAPM) or some other form of arbitrage pricing theory (APT), estimating the cost of equity as an amount equivalent to the risk premium on returns paid by the company to its investors.

Another method is to include all dividend payments made by the company. To that amount you then add the influence of share value dilution on treasury shares either at the time of selling treasury shares or at the time of issuing an additional initial public offering. This method takes into account all cash outflows and all depreciated book value on the company resulting from the decision to push extra shares into the marketplace.
Dividend Policy 

The cost of equity is heavily influenced by the company’s dividend policy. When a company makes a profit, that profit technically belongs to the owners of the company, who are the shareholders. So companies have two options regarding what they can do with these profits:

– distribute them to shareholders in equal payments per share as dividends
– reinvest them into the company as profit and loss reserves.

In either case, those dividends are going to increase the value for the shareholders, and so for investors, it shouldn’t matter what the company’s dividend policy is. Either the profits available for distribution as a dividend go to increase the book value of the company or they increase the income of the shareholders, both in equal values.
Dividend Puzzle
This idea that dividend policy shouldn’t influence investor preference, and yet does, is called the divided puzzle, which evolved from the Modigliani-Miller Theorem. This theorem states that, in an efficient market, a company’s capital structure doesn’t influence firm value.
Increasing book value by retaining earnings doesn’t necessarily translate into an increased share price. Profit and loss reserves don’t represent a fixed value and don’t necessarily generate additional income or value over time. Companies don’t always have a use for profit and loss reserves, and so the value of dividends depends on the context of share prices as well as the company’s total book value.

That’s where the study of dividend policy comes from – deciding what approach to dividends is going to optimize corporate capital structure and maximize shareholder wealth.

When deciding on dividend policy, companies have a few options available to them:

1) Preferred cumulative dividends 

Companies have no option but to pay these dividends eventually, and so the influence of cumulative preference shares must be anticipated even before issuing those shares. After the dividends are issued, the company only has the choice of whether to pay them now or delay payment and pay them using earnings later. Even if the company doesn’t report a profit for one year, cumulative dividends are guaranteed and must be paid later.

2) Preferred noncumulative dividends 

These dividends are paid after the cumulative shareholders get all their money first. Noncumulative preferred dividends are paid in a similar manner as cumulative dividend and are guaranteed in the sense that they’re paid anytime the company makes profits. If the company operates at a loss one year, however, these dividends aren’t necessarily paid. If these dividends aren’t declared, they’re forfeited.

3) Ordinary dividends 

These dividends paid on ordinary shares have no guarantee. If any money remains after a company pays all its debt payments, the preference shareholders get their dividends, the company determines its requirements for retained earnings and then the ordinary shareholders get the leftovers as ordinary dividends. The role of these dividends within the capital structure of a company varies depending on how these dividends are managed.

4) Retained earnings 

These earning or profits, that the company retains are the funds kept by the business to fund operations and growth. These earnings are generated after all preference shareholders get their dividends. The company takes it share of retained earnings and then the rest is given to the ordinary shareholders.

Retained earnings is a very popular method of funding growth and operations because it doesn’t increase debt costs or devalue existing value as would the issuance of more equity.

Here are a couple of things to note regarding dividend policy:

– Dividends on ordinary shares aren’t required to be paid, but if the company doesn’t intend to incur the extra costs associated with using retained earnings to expand the company, any unused earnings must be paid as dividends.

– Even on preference shares, dividends are guaranteed only on cumulative preference shares: the shares that accumulate dividend payments over time if they’re not paid during the time promised, generating something called divided in arrears. On cumulative preference shares, these dividends in arrears are dropped from the dividends creditor if they’re not declared.

Investor Warren Buffett explains dividend policy as assessing whether the company or the shareholder can generate greater returns using the same amount of money. In other words, because the company doesn’t own the profits that it generates, it should look at profits as a source of capital funding similar to equity.
When deciding how to fund a future project, corporate growth or operations, companies need to assess the future cash flows generated from retaining those earnings against the average returns generated in market investments. If the business can generate more value for its investors by pursuing projects funded by retained earnings than the investors are likely to generate by reinvesting dividends back into the market, the company should retain the earnings; otherwise, it should pay the dividend. This dividend attracts more investors, and so maximizes the translation of value on profits to share price.
Choosing the right capital
From the company’s perspective, investing, debt and equity all come back to the original question of how to fund its operations and how properly to balance the amount of debt or equity that’s being used to raise capital.

When setting the company’s policies regarding capital structure, the goal is to minimize the costs associated with raising capital – which means, when applicable, choosing the cheapest option for capital funding. If interest rates on debt are going to be too high, issuing equity may be the cheaper method. If issuing more equity is going to generate more tax burden, generate greater dividend payments or too greatly influence existing shares in a negative manner, issuing more bonds may be the better option.

A business takes and measures this decision within the appropriate context of the present value of the future cash flows anticipated in both options. Another consideration, though of minimal consequence compared to others, is the agency costs associated with each option.

Issuing a new initial public offering tends to be more expensive than taking out a business loan, for example, and the company needs to take this aspect into account when deciding which method is best to raise capital. The increased number of shares can also dilute the value of each existing share, because total company value is distributed across all shares in issue.

In reality, legislation governing corporate finance and the benefits packages of company executives are such that, in the majority of cases, decisions regarding capital structure are going to be those that maximize the value of shares.

This requirement means making decisions that increase earnings per share as much as possible and, in some cases, taking on excessive amounts of risk through higher amounts of debt, plus accepting the greater risk of loss in specific initiatives in order to preserve share value and place a maximum amount of risk on debt.

This approach towards capital structure has been cultivated by a combination of the shareholder wealth maximization model of corporate governance (which requires companies to do whatever they can to increase the value of the company’s shares), but also by executive incentive packages that include a large proportion of share options as well as income based on the performance of the company’s share value.
Jim Rohn