An analysis of relative capital structures of major Australian companies By Darren Henry, La Trobe University
Investment decision making is the most important ongoing activity for any company, and a company can only increase its share price and the return it provides to shareholders by undertaking positive-NPV investments. What is also of relevance in supporting the investment decision is determining the most appropriate means of financing these profitable investments—the capital structure or financing decision.
This capital structure decision-making process involves an evaluation of numerous factors. These range from simple issues such as the relative advantages of using debt, equity and alternative forms of finance to complicated considerations relating to taxation, profitability and corporate-risk implications and the effect of such decisions on related parties such as major external shareholders and debt covenants established with prior financiers. Beyond these issues, it is of paramount importance to contemplate the nature of the company itself, the ongoing demands and business cycle of the firm’s operations and what, if any, industry-specific determinants may influence or dominate its financing choice.
Critical to any decision relating to capital structure change is an evaluation of the risk profile of the company. Issuing additional debt or equity finance will have obvious explicit cost consequences, either in the form of greater interest payments and debt-servicing costs or an obligation to provide dividends or other distributions of capital over a wider equity base. Similarly, there can be implicit costs associated with such financing decisions, although these tend to be less emphasised or factored into capital structure decision making. These implicit costs relate particularly to the risk profile of a company, with certain companies thought to be more or less risky than others owing to the nature of their activities or the predominant industry in which they operate. It is, therefore, important to consider the general level of risk associated with companies and let such considerations inform financing decisions.
As such, it is important to consider the levels of both business risk and financial risk faced by a company when making capital structure decisions. Various items of information can be considered when analysing these different risk exposures. Business risk relates to the earnings stability of the company’s operations and its susceptibility to industry- or economy-specific shocks. Financial risk is derived from the degree of financial leverage or debt financing employed by the company, which is a company-specific management decision. As such, general risk aversion principles suggest that companies with more certain earnings and less business risk would be more likely to employ greater debt finance whereas firms with higher business risk would be less inclined to increase their overall risk profile by taking on high levels of financial leverage. Similarly, it would be expected that a company with higher financial leverage should provide a higher relative return to equity holders as implicit compensation for their facing greater financial risk
These relationships would be predicted by the Modigliani and Miller, trade-off and traditional theories of capital structure, but are not necessarily consistent with applying a pecking order to financing decision making. One means of evaluating the accuracy of these theories to real-life capital structure decision making is to examine the capital structure and operating characteristics of listed companies. The following table provides information for a number of well-known Australian listed companies as a means of addressing this issue.
|Company information averaged over the 5-year period from 2003 to 2007|
|Company||Industry sector||Debt to
|Return on equity*||Beta
|Woolworths||Food and staples||0.6944||0.3067||0.70||1.157|
|Coca-Cola Amatil||Food, beverages||1.145||0.1728||0.74||0.65|
- * Ratio figures are expressed as decimal numbers. To interpret as percentage figures, multiply the decimal ratio by 100.
- ^ Share return is calculated as the percentage change in the share price from the end of financial year 2003 to end of financial year 2007.
- Using the information provided, calculate the level of business risk for each firm. Is the relationship between business and financial risk levels consistent with what traditional capital structure theory would suggest? If not, outline what theory of capital structure the above companies appear to be following. Business risk can be calculated as the unlevered (asset) beta, using the following equation:
- bU = unlevered beta (measure of business risk)
- bL= levered beta (standard beta coefficient provided in the above table)
- D / E = the company’s debt-to-equity ratio
- Compare the financial information in the above table for the two companies in the materials industry, BHP Billiton and Rio Tinto. Explain any differences that exist between the figures for the two companies and outline what this suggests in terms of capital structure decision making within specific industry sectors.
The level of business risk for each firm can be calculated by solving the unlevered beta. Unlevered beta is the cost of capital with no debt therefore unlevered beta measures the risk of the company’s underlying operations.
This is done by using the following formula:
Company’s unlevered beta for each firm:
BHP Billiton: βU = 1.80/1+0.4662 = 1.2277
Rio Tinto: βU= 1.59/1+ 0.6134 = 0.9849
CSL: βU= 1.22/1+0.4660 = 0.8322
Coca-Cola Amatil: βU=0.74/1+1.145 = 0.3450
Woolworths: βU= 0.70/1+0.6944 = 0.4131
Telstra Corp.: βU=0.61/1+0.9330 = 0.3104
Qantas Airways: βU=0.76/1+1.024 = 0.3755
Is the relationship between business risk and financial risk levels consistent with what traditional capital structure theory would suggest?
Traditional capital structure theory suggests that a firm will achieve wealth maximisation best when assets are purchased at an optimal concoction of debt and equity as well as a positive return on investment (Harris et al, 1990).
Business risk is the equity risk that comes from the nature of the firm’s activities. The greater the firm’s business risk (operational risk) the greater the required return will be. Financial risk is the equity risk that comes from the financial policy of the firm and is derived from the degree of financial leverage or debt financing in use. The greater the level of debt financing the greater the required return will be.
This proves to be consistent with the traditional capital structure theory suggesting that acquiring the best possible combination of debt and equity will prove to be successful.
What theory of capital structure is the company’s following?
Modigliani and Miller (M&M) theory of capital structure has two components these being:
- Proposition I – Firm Value
- Proposition II – Weighted Average Cost of Capital (WACC)
Proposition I advocates that the value of the firm is independent of its capital structure. This means the percentage of debt to equity is irrelevant and will not change the WACC. This theory does not hold in the company’s compared; in the following table it is clear that the level of debt to equity plays a large role in determining the firm value:
|Company||Financial Risk||Business Risk|
It can be seen that a lower unlevered beta corresponds to a higher degree of financial leverage. For example Coca-Cola Amatil has an unlevered beta of 0.345 and employs 115% debt to equity as opposed to BHP Billiton which has an unlevered beta of 1.277 and uses only 47% debt to finance its operations.
Proposition II proposes that the cost of equity rises as the firm increases its use of debt financing. Equity risk is dependent on two factors 1) business risk and 2) financial risk. This theory (ignoring taxes) shows that firms that are highly leveraged have a lower level of business risk (Ross et al, 2011). In the companies compared this theory appears to hold true. Companies that have a higher debt to equity ratio generally appear to have a lower unlevered beta. Other factors that weigh in include the type of industry sector that each company falls into which does play a role in how the company uses its debt to fund its activities as each company has different activities.
Other theories of capital structure to be considered include the static theory of capital structure, this theory puts forward that a firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress. The pecking order theory is the process of the firm choosing profits, debt and equity in this order to finance investments (Ross et al, 2011)
Additionally, real world factors must also be taken into account when determining a firm’s optimal capital structure. Market imperfections such as bankruptcy and financial distress reduce the attractiveness of debt financing. The possibility of bankruptcy is costly for managers because they lose the benefits of control or reputation. This means that debt can create an incentive for managers to work harder or make better investment decisions (Grossman and Hart, 1982). Optimal capital structure in perfect world is 100% debt however, 100% debt in the real world would mean that the firm s facing bankruptcy. Taxes play a large role in capital structure. This is because interest is tax deductible and therefore generates a valuable tax shield.
Ross, 2011, Fundamentals of Corporate Finance, 5th edition, McGraw Hill Australia Pty Ltd
Harris, Milton and ArturRaviv, 1990b, The Theory of Capital Structure, Kellogg School, Northwestern University
Grossman, Sanford J. and Oliver Hart, 1982, Corporate financial structure and managerial incentives, in J. McCall, ed.: The Economics of Information and Uncertainty, University of Chicago Press, Chicago
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