Several of the directors are not sure whether financing the expansion in full by borrowing is the best route to pursue. They are also worried about the effect acceptance of the covenants may have on their management of the business. Their overriding concern, however is the impact such a loan could have on the company’s shareholder value. Introduction There are two ways to raise capital either from equity or debt. Within these methods are a further set of options.
For example if we were to raise the capital via the equity route we could investigate solutions such as issuing new shares (ordinary or preferred), retained earnings, warrant bonds or convertibles. On the debt side there are a variety of ways including bank loans, debentures (unsecured long term loans) and bonds. A Marketing Problem? The process of raising finance, defining a debt policy, can be seen as fundamentally a marketing problem. The final solution being the one that most appeals to investors and the market i. e. the one that increases their wealth.
This debt policy and the impact on the dividend policy all have a part to play when it comes to the shareholders wealth. This was not the proposition put forward by Miller and Modigliani (Brearly and Myers,2000:476) in their classic 1961 article where they referred to “the irrelevance of dividend policy in a world without taxes, transaction costs, or other market imperfections”. A model based on the assumption of perfect and efficient capital markets. This theory implies that gearing is irrelevant. That is not the market place the company is today facing.
Pecking order theory states that investment should first be funded by retained earnings, then new debt and finally by raising new equity. This is based on the idea of asymmetric information where managers are more knowledgeable than investors. Company’s value is determined by its assets not by the securities it issues. If that was true then all equity financing is the right decision. The view is far too simplistic. Debt Advantages Payments regarded as cost and therefore tax deductible. Government providing a tax subsidy on the use of debt. Interest is tax deductible and thus generates additional value.
As long as the interest tax shields can be used. For this to take place the company must be making profit. Other things being equal, the higher the marginal tax rate of a business, the more debt it will have in its capital structure. Figure 1 The tax benefit of debt financing Adds discipline to management – separation between managers and shareholders Forcing a company to borrow can reduce management complacency Quick to organise Disadvantages When arranging debt financing the company will have to pay agency costs. These costs cover the Covenants – as seen above Charge over the fixed assets
the Cost: arrangement fee and interest payments are largely at variable companies current debt can be hedged, so their exposure to climbing interest rates will be limited. Increases the financial risk due to the relationship with variables interest rates which then impacts the expectancy of the shareholders to higher rates of return on their investment Agency costs Financial Distress Possible financial distress should limit borrowing – especially for risky companys. The higher the debt ratio more likely to fall into financial distress if a serious recession hits the economy.
Bankruptcy costs There are two elements to bankruptcy costs. First there is the cost, direct and indirect. Direct includes legal and other deadweight costs and indirect as the company is perceived to be in financial trouble. The second element is the probability of bankruptcy which will depend on the certainty of future cash flows. The expected bankruptcy costs is therefore directly correlated to the increase in probability of bankruptcy. Increases the expected rate of return on shareholders investment as debt financing creates financial risk for shareholders
Fail to make payments you lose control of the business Loss of future flexibility and therefore if the company is not sure what it may want to do in the future it should use less debt. Alternative Approaches Financing via retained earnings This option has the advantage of being the line of least resistance. What the company has to be careful in regarding is when there are these shifts in capital structure this sometimes forces important decisions about dividend policy. If the earnings are going into a project investment that means they are not available to pay out as dividends.
The fact that this is happening will then impact share price. The impact of which can be limited by providing as much forewarning as possible so as to make sure the action is not misinterpreted. Others benefits of using retained earnings is of control and flexibility. Managers stay in control of their business. That is to say there are no restrictions by covenants or dividend cover. Financing via a Rights Shares The announcement of a new equity issue is usually bad news for investors as it may signal bad news with regard to future profits or higher risk.
In this companies case the risk is not really changing in that the company will still be in the same core business. A company is limited to a maximum no of shares that can be issued. This is known as authorised share capital and is specified in the articles of association. Should the company not be able to raise as much as it requires it would have to obtain the agreement of the shareholders in order to change the quantities. Using this type of finance will reduce theUltimate control of the company’s affairs with voting rights on who sits on the board plus other matters.