Tuesday, August 6, 2013

Financial Management (2066Q8): What is the best combination of debt and equity in capital structure management? Explain with reasons.

Best (Optimal) combination of debt and equity in capital structure management

Capital structure refers to the mixture of equity and debt finance used by the company to finance its assets. Companies may use different mixes. Some companies could be all equity financed and have no debt at all, even though others could have low levels of equity and high levels of debt.

The biggest questions on capital structure are that do structuring of capital matters for the value of organization? Whether capital structuring has any relevancy for organization's value or it is just irrelevant matter? Such type of decisions as what mixture of equity and debt capital is to have is called the financing decision.

The financing decision has a direct effect on the weighted average cost of capital (WACC). The WACC is the simple weighted average of the cost of equity and the cost of debt. The weightings are in proportion to the market values of equity and debt; therefore, as the proportions of equity and debt vary so will the WACC. Therefore the first major point to understand is that, as a company changes its capital structure (i.e. varies the mixture of equity and debt finance), it will automatically result in a change in its WACC. Latest and well agreed objective of corporate finance is maximizing shareholder's wealth. And wealth is the present value of future cash flows discounted at the investors' required return, the market value of a company is equal to the present value of its future cash flows discounted by its WACC. The lower the WACC, the higher the market value of the company because market value of the firm is calculated as future cash flows divided by WACC.

Hence for optimal or best capital structure we need lowest WACC because when the WACC is minimal, the value of the company/shareholder wealth is highest. So, finance managers make effort to find the optimal capital structure that result in the lowest WACC.

Now another big question is that what mixture of equity and debt will result in the lowest WACC. As the WACC is a simple average between the cost of equity and the cost of debt, one may simply think that the less of expensive one is to be increased the high costly should be decrease. It means that debt capital should be increased as cost of debt is cheaper than cost of equity because debt is less risky than equity and thus required return needed to compensate the debt investors is less than the required return needed to compensate the equity investors. Debt is less risky than equity, as the payment of interest is often a fixed amount and compulsory in nature and it is paid in priority to the payment of dividends, which are in fact discretionary in nature. Another reason why debt is less risky than equity is in the event of liquidation, debt holders would receive their capital repayment before shareholders as they are higher in the creditor hierarchy, as shareholders are paid out last. Debt is also cheaper than equity from a company's perspective is because of the different corporate tax treatment of interest and dividends. In profit and loss account, interest is subtracted before the tax is calculated; thus, companies get tax relief on interest. However, dividends are subtracted after the tax is calculated; therefore, companies don't get any tax relief on dividends. So, it's better to replace expensive equity with cheaper debt to reduce WACC. However, issuing more debt means that more interest is paid out of profits before shareholders can get paid their dividends. The increased interest payment increases the volatility of dividend payments to shareholders, because if the company has a poor year, the increased interest payments must still be paid, which may have an effect the company's ability to pay dividends. This increase in the volatility of dividend payment to shareholders is also called an increase in the financial risk to shareholders. If financial risk to shareholders increases, they will require a greater return to compensate them for this increased risk, thus the cost of equity will increase and this will lead to an increase in the WACC.

In summary, when trying to find the lowest WACC, we may issue more debt to replace expensive equity; this reduces WACC but more debt also increases WACC due to increase in financial risk.

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