The capital structure decision and the cost of capital

The capital structure decision and the cost of capital

 Introduction

The capital structure of a firm refers to the different combination of how a company finances its assets by combining equity or debts or a hybrid of the two or by a combination of securities. The proportion of a company’s long-term and short-term debts determines its capital structure. Also its dividend policy. The capital structure of a company affects its financial risks and the value of the company. The theories in capital structures assist in understanding the relationship that exists directly between the value of the firm and the composition of its capital structure. Weighted average cost of capital is actually the marginal cost of raising extra or additional capital and is generally affected by costs of capital involved and the relative proportion of each source of capital. The three companies to be analyzed are:

Alaska Air Company operates the Alaskan Airlines together with the Horizon Air. They have partnered with regional airlines and together they serve over 95 cities across Hawaii, Mexico and Canada. In the year 2012, they served over 26 million passengers and earned $339 million in customer sales.

The Clorox Company deals in mainly in bleaching and cleaning products that are marketed in over 100 countries worldwide.

Ebay Inc. is a technology Company that facilitates commerce through its three major segments; Payments, GSI and Market places. They achieve these tasks by providing a variety of online platforms, services and tools that assist merchants across the world to trade their wares online. Ebay participates in development of soft ware’s and other digital devices solutions. These also offer marketing, advertising and other classified services.

The long term and short term assets for Alaska air amounted to (all figures are in millions of dollars) to 3768 and short term assets were 1737 which totaled to 5505. Ebay and Clorox long term and short term assets amounted to 1576 and 2979 respectively for long term assets and 21398 and 1376 respectively for short term assets in the year 2012.

Alaska air group long term liabilities amounted to $2583 millions while Ebay and Chlorox each had $5285 and $2429 million respectively. Alaska short term liabilities were $1501 million while Chlorox and Ebay each had $2061 and $10924 million respectively.

The revenues for the three companies, Chlorox, Ebay and Alaska air were $5650 million, $15510 million and $4890 millions respectively. The revenues per share were $11.97 dollars, 43.11 and 69.62 dollars for Chlorox, Ebay and Alaska respectively.

The Debt/Equity ratios for Chlorox, Ebay and Alaska air were 19.9, 3032.10, 50.61 times respectively. Ebay Inc has the highest Debt/Equity ratio though its total debts are just about half of what Chlorox has. EBay’s debt is over 3000 times its equity.

The profit margin for Chlorox, Ebay and Alaska air are 17.77%, 10.18% and 9.7% respectively while the return on assets are 5.6%, 13.58% and 6.75% respectively. The ROE for Chlorox, Ebay and Alaska air are 12.92%, 1895% and 29.25%. The Beta’s for the three of them are 0.8, 0.48 and 1.13.

Ebay Inc’s market capitalization of 66.48 billion has total ROE of 12.92% while Chlorox with a market capitalization of 11.94 billion has 1895.08% ROE compared to Alaska air with a market capitalization of 5.35 billion has 29.25% as its ROE.  Ebay Inc has a market capitalization which is almost six times that of Chlorox while its ROE is 140 times more than that of Ebay. Capitalization. The ROE helps in determining the volatility of a company’s total risk as it’s derived from the Net income/Equity. (Brealey and Myers, 1991)

The risks in a business can be narrowed into to two main groups, these are business risks (originates from its operations) and financial risks (originates from the financing decisions)

Business risks refer to the company’s uncertainty on its return’s as compared to its assets. These risks are normally represented by ROA. Assets are normally equivalent to the investments made hence ROA can also be rewritten as ROI. (ROI = Net Income/Investment = Net income/ Debt + Equity) If a firm is not utilizing any debt capital (an unlevered company) its ROA will turn to be its ROE.

The volatility of the Alaska air is almost similar to the average risks of the market. The beta for Alaska air is 1.13. This means that the stocks of the Alaskan air group are slightly more volatile than the overall NASDAQ stock market i.e. the beta of the NASDAQ itself or the representative index is normally by its own definition equal to 1. The market is being compared to itself. (Tofallis, 2008) The shares of Chlorox whose beta is 0.8 are less volatile compared to the shares of Alaska air lines while the beta of Ebay is the least volatile. These means that the shares of Ebay are the least risky when it comes to the conditions of the stock market, and it’s followed by Chlorox Company and Alaska air group

Debt financing refers to borrowing money that will eventually be paid back. The debt period can either be long term, that’s more than a year or short term that’s less than a year. Equity financing refers to the receipt of funding for actual exchange of the ownership shares for the firm. There is no obligation of debt repayment as in the case of debt financing.

There are many advantages and also disadvantages of funding companies through debt and also maintaining a balanced debt to equity ratio is also critical securing a stable financial growth. One of the major advantages of debt financing is that the company ownership is not diluted by other share holders. The lenders of the loan do not have any claim on the company’s ownership or its later profits in future. Most businessmen find it easier and convenient to raise money from debt than from equity. Debt financing provides tax benefits that’s the interest chargeable are tax deductible. (Brigham, 1989)

The disadvantages are that the debt has to be repaid and the principal amount borrowed together with the interest is considered as fixed cost when the breakeven is being determined. For effective cash flow, the debt financing has to be carefully considered and planned. Debt ratios indicate the how much the company is depending on debt capital to finance its expansion strategies and operations. Debt financing affects the Debt to equity ratio is also negatively affects the company’s reputation in the eyes of the investors who view such companies as having a higher rate of risks. Most debts must be guaranteed by individual owners who must offer collateral and personal guarantees which mean that in the event of inability to repay back the loan then the guarantor must utilize his personal funds to settle the debts.

Chlorox depends minimal debts to service its operations and also slightly to finance its expansion. With a debt/equity ratio of 19.9, it means that most of its other financing is obtained through equity capital. Its debts are less than 20% of its entire equity. The Ebay Inc is more than 3000 times dependent on debts. Its entire financing is wholly reliant on debts. It does not balance at all its capital structure. The most balanced capital structure belongs to Alaska air group. Its debt and equity financing is almost on a 50-50 sharing.

The cost of debt capital was pegged at 6.5% for the debt financing.  Bonds can be utilize to raise funds in form of debts like in the case of Ford Motor group in 1998. The Company’s cost of Equity capital and Debt can be determined in several ways. A company’s cost of debt is usually the rate of interest on the loan such the new issues for bonds. The market price of a company’s debt mostly implies its yield to maturity which is the amount the owner or purchaser would have received if he had purchased and retained the bonds to maturity. The yield to maturity is the cost of debt investors normally demand on a company’s debt. For example, in the year 1998 Ford offered to the public bonds with coupon rates of 6.5% that were due in 2018. The cost of debt capital was pegged at 6.5% for the debt financing.  Bonds can be utilized to raise funds in form of debts.

The advantages and disadvantages of Equity and Debt capital are varied. The major advantage of debt capital is that the lenders of the loan do not have any claim on the company’s ownership or its later profits in future. This case happens only if the debtors can repay back the loan but if they cannot repay the loan then creditors can take over the company or be allowed to be part of the ownership.  Most businessmen find it easier and convenient to raise money from debt than from equity. These can be difficult if the owner has no collateral. Debt financing provides tax benefits that’s the interest chargeable are tax deductible. If the rate of taxes increase so much then it’s no longer a good option. (Barges, 1982)

The major disadvantage of using debt capital is that it has to be repaid and the principal amount borrowed together with the interest is considered as fixed cost when the breakeven is being determined.  In case of hard ship in repayment then loan can be easily converted into shares for the creditor to be part of the owner of the business. For effective cash flow, the debt financing has to be carefully considered and planned. Debt ratios indicate the how much the company is depending on debt capital to finance its expansion strategies and operations. Debt financing affects the Debt to equity ratio is also negatively affects the company’s reputation in the eyes of the investors who view such companies as having a higher rate of risks. Most debts must be guaranteed by individual owners who must offer collateral and personal guarantees which mean that in the event of inability to repay back the loan then the guarantor must utilize his personal funds to settle the debts.

John Linters model (Myers, 1984) indicates that the market stock prices generally responds to unanticipated moves on dividend changes an observation that Miller and Modigliani also noted in 1961. Changes in capital structure relay different messages to investors. Most of the theories relate to optimal capital structure. The static trade of is a framework where a company targets a debt to value ratio that it gradually moves towards it and also adjusts its dividends in the same way towards the payout ratio. The pecking order policy framework prefers the internal financing to external financing and also prefers debt to equity if it deals in securities like the Ebay. The company’s optimal debt ratio as the stated Static Tradeoff Theory is determined by a tradeoff between costs and the benefits of holding a company’s assets, borrowing and investment decisions. (Myers, 1984)

Most companies have different sources and classes of finance i.e. common stock, preferred stock, debt and retained earnings. WACC (Weighted Average Cost of Capital) is calculated by averaging the cost of all the sources after tax deductions have been made. It’s arrived at by multiplying the total cost of finance from each source by its relevant weight and adding the products. Weighted Average Cost of Capital (WACC) is also affected by increase in cost of capital as it also increases and reduces the PVs and NPVs. When interest increases, the interest expenses also goes up and the overall corporate income is affected negatively.

The WACC for Chlorox, Ebay and Alaska air group were 2.8%, 6% and 0.5% respectively. Chlorox has the lowest weighted average cost of capital and it’s followed by Alaska air group and finally Ebay Inc. these is probably because of Ebay high leverage status as compared to the other two companies and Chlorox being the least in terms of debt capital.

The cost of Equity for Chlorox, Ebay and Alaska air group were 5.44%, 6.4% and 7.3% respectively. Chlorox has the lowest cost of Equity and it’s followed by Ebay and finally Alaska air group.

Finally to conclude, a company is supposed to balance and substitute its debt for equity or its equity for debt for some time until the company’s value is maximized. The corrected and new version of MM theory on debt and taxes indicate that any tax paying company gains by borrowing; the more the marginal rate of tax the more the pain. However if a company is paying a lower at a lower rate, it would incur a net loss and instead it should lend at a higher rate in order to gain.

 

 

References

Brealey, R. A and Myers, S.C. (1991) Principles of Corporate Finance. 4th Ed. New

York: McGraw-Hill, 1991.

Brigham, E. F. (1989) Fundamentals of Financial Management. 5th ed. Chicago: Dryden

Press,

Barges, A., (1982) The Effect of Capital Structure on the Cost of Capital, Prentice-Hall, Inc., Englewood

Myers, S.C. (1984) The Capital Structure Puzzle, The Journal of Finance, July 1984, Vol. XXXIX, No 3.

Tofallis, C. (2008). “Investment Volatility: A Critique of Standard Beta Estimation and a Simple Way Forward”. European Journal of Operational Research 187

 

 

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