The cost of finance
Debt finance is frequently cheaper than equity finance. This is for the reason that debt finance is safer from a lender’s standpoint. Interest has to be paid ahead of surplus. When it came to liquidation, debt finance is compensated off ahead of equity. This makes debt a safer investment than equity and consequently debt shareholders require a lower rate of return than equity shareholders. Debt interest is also corporation tax deductible (unlike equity dividends) making it even cheaper to a taxpaying organization. Agreement expenses are generally lesser on debt finance than equity finance and once again, different with equity arrangement coats, they are also tax deductible. Generally percentage cost of the funds used to finance organizations assets. Fee of funds is a composite cost of the individual sources of funds as well as retained earnings, preferred stock, debt, and common stock. The overall cost of capital depends on the cost of each source and the percentage that source represents of all funds used by the organization. The objective of an individual or business is to border investment to assets that offer a return that is higher than the cost of the funds that was used to finance those assets. The cost of funds influences the ways in which an organization can raise money through debt. Cost of capital is essentially the rate of return that a firm would receive if it invested in a different vehicle with similar risk.
The current capital gearing of the business
Although the debt is attractive due to its cheap cost, its disadvantage is that interests have to be paid. If too much is borrowed then the company may not be able you meet interest and principal payments and liquidation may follow. The level of a company’s borrowings is usually measured by the capital gearing ratio (the ratio of debt finance to equity finance) and companies must measure this does not become too high. Comparisons with other companies in the industry or with the company’s recent history are useful here. The borrowing limits or debt capacity of the combined organization may affect the ability to raise debt finance and the level of gearing may affect the cost of capital and hence interest cover and earnings per share. Differences in the costs of debt issued by each company should be looked at in relation to possible refinancing. The book values of gearing ratios will be better with acquisition accounting than merger accounting since assets will be revalued but liabilities will remain largely unchanged. A company with high gearing (high leverage) is more vulnerable to downturns in the business cycle becausethe companymust continue to serviceits debt regardless of how bad sales are.A greater proportion of equity provides a cushion and is seen as a measure of financial strength.
Business risk
Business risk refers to the volatility of operating profit. Companies with highly volatile operating profit should avoid high levels of borrowing as they may find themselves in a position where operating profits falls and they cannot meet the interest bill. High – risk ventures are normally financed by equity finance, as there is no legal obligation to pay equity dividend. Risk associated with the nature of the industry the business operates and if the business risk is higher the optimal capital structure is required. The riskiness that would be inherent in the firm’s operations if it used no debt. The greater the firm’s business risk, the lower the amount of debt that is optimal. Capital structure policy involves a trade-off between risk and return. Using more debt raises the riskiness of the firm’s earnings stream, but a higher proportion of debt generally leads to a higher expected rate of return; and, we know that the higher risk associated with greater debt tends to lower the stock’s price. At the same time, however, the higher expected rate of return makes the stock more attractive to investors, which, in turn, ultimately increases the stock’s price. Therefore, the optimal capital structure is the one that strikes a balance between risk and return to achieve our ultimate goal of maximizing the price of the stock. The increased financial risk that comes with increased use of debt tends to moderate the use of debt in the firm’s capital structure.
Operating gearing
Operating gearing refers to the proportion of a company’s operating costs that are as opposed to variable. The higher the proportion of fixed costs, the higher the operating gearing. Companies with high operating gearing tend to have volatile operating profits. This is because fixed costs remain the same, no matter the volume of sales. Thus, if sales increase, operating profit increases by a larger percentage. But if sales volume falls, operating profit increases by a larger percentage. Generally, it is a high – risk policy to combine high financial gearing with high operating gearing. High operating gearing is common in many service industries where many operating costs are fixed. The borrowing limits or debt capacity of the combined organization may affect the ability to raise debt finance and the level of gearing mat effect the cost of capital and hence interest cover and earnings per share. Differences in the cost of debt issued by each company should be looked at in relation to possible refinancing.
Dilution of earnings per share (EPS)
Earnings per share (EPS) are an important indicator of the success or failure of a company. Large issue of equity could lead to the dilution of EPS if profits from new investments are not immediate. This may upset shareholders and lead to falling share prices. To estimate EPS dilution, we follow prior research and create an indicator variable that equals one whenever equity financing will result in greater dilution than debt financing, i.e., whenever the issuing firm’s E/P ratio exceeds its after-tax cost of debt(28). The feeling is that it is better to pay for company on a earning per share ration less than that of the offeror. This is because the market may sometimes value the consolidated earnings of the acquired company at the offeral’s own higher earnings per share ratio and this should lead to an increase in the price of the offeror’s shares after the takeover.
The current state of equity markets
In a period of falling share prices many companies will be reluctant to sell new shares. They feel the price received will be too low. This will dilute the wealth of the existing owners of the company. New issues of shares on the UK stock exchanges have been rare over the last few years due to the bear market. At the time of writing there is some evidence that the bear market is coming to an end. A company considered too highly leveraged (too much debt versus equity) may find its freedom of action restricted by its creditors and/or may have its profitability hurt as a result of paying high interest costs. Of course, the worst-case scenario would be having trouble meeting operating and debt liabilities during periods of adverse economic conditions. Lastly, a company in a highly competitive business, if hobbled by high debt, may find its competitors taking advantage of its problems to grab more market share.
Unfortunately, there is no magic proportion of debt that a company can take on. The debt-equity relationship varies according to industries involved, a company’s line of business and its stage of development. However,because investors are better off putting their money into companies with strong balance sheets, common sense tells us that these companies should have, generally speaking, lower debt and higher equity levels.
Tax position
The second key factor is the firm’s tax position. A major reason for using debt is that interest is tax deductible, which lowers the effective cost of debt. However, if much of a firm’s income is already sheltered from taxes by accelerated depreciation or tax loss carry forwards, its tax rate will be low, and debt will not be as advantageous as it would be to a firm with a higher effective tax rate.. Advantage not much for businesses with unrelieved tax losses, depreciation tax shield as they already have an existing lower tax burden. High tax rates increase the interest tax benefits of debt. The trade-off theory predicts that to take advantage of higher interest tax shields, firms will issue more debt when tax rates are higher. DeAngelo and Masulis (1980) show that nondebt tax shields are a substitute for the tax benefits of debt financing. Nondebt tax shield proxies–that is, net operating loss carry-forwards, depreciation expense, and investment tax credits–should be negatively related to leverage. The tax deductibility feature of interest expense tends to increase the use of debt in the firm’s capital structure. Finally, we examine the relation between debt-equity choice and the tax benefit variables. We find that firms which issue equity have larger tax benefits from option exercise than firms which issue debt. We also find that the net amount of equity issued increases with the tax benefits of employee stock options. In contrast, the net amount of debt issued decreases if the firm has negative pretax income and high tax benefits, consistent with these firms being unable to take advantage of the tax benefits of debt.
Macroeconomic Conditions
Gertler and Gilchrist (1993) show that subsequent to recessions induced by monetary contraction aggregate net debt issues increase for large firms but remain stable for small firms. During expansions, stock prices go up, expected bankruptcy costs go down, taxable income goes up, and cash increases. Thus, firms borrow more during expansions. Collateral values are likely to be procyclical too. If firms borrow against collateral, leverage should again be procyclical.
However, agency problems are likely to be more severe during downturns as manager’s wealth is reduced relative to that of shareholders. If debt aligns managers incentives with those of shareholders, leverage should be countercyclical.