Niu (2008) describes the capital structure of a firm as the means through which a firm raises capital required to develop and grow its business operations. Capital structure encompasses a blend of different forms of debt and equity capital as maintained by a firm. These forms of capital are due to the financing decisions made by the firm’s management. A firm's capital structure is a term used in reference to the blend of debt finance and equity that a firm uses to finance its assets.
According to Brealey and Myers (2008), some firms opt to finance its operations wholly through equities, meaning that they have no debt, while others are characterised by high levels of debt and low levels of equity. The manager has to make the financing decision regarding the mixture of debt and equity capital that best suits the corporation. For several for as far back as the late 1930's, researchers have grappled with the question of if variations in a corporation's capital structure could affect its value (Ross et al. 2013), and this has led to the emergence of two rival views that pits traditionalists against modernists.
Traditionalists view markets as being perfect, and have hence developed a number of assumptions. The first assumption is that the lack of personal or corporate taxes: personal or corporate earnings should not attract government taxes (Ross et al. 2016). The view also contends that there should be no risk attached to debt: A firm should always incur debt at a constant cost irrespective of leverage. In other words, traditionalists do not take into account the costs of financial distress (Kaumann 2009). Traditionalists do not also acknowledge conflicts of interest between investors and managers and the associated asymmetrical information. In other words, shareholders should not receive Agency costs. Going by the aforementioned assumptions, traditionalists regard financing decision as a very valuable aspect of the firm. According to Abraham, Glynn and Murphy (2008), traditionalists contend that the corporation should endeavour to identify the package of securities that reduces the total cost of obtaining capital. Traditionalists further view the corporation's cost of capital as chancing depending on its mix of equity and debt securities. Taking into account the fact that a firm's cost of capital is used as a basis for calculating its overall value, traditionalists are thus convinced that we cam maximise firm value at a given optimum debt financing level.
The traditional view to capital structure promotes the theory that there exists a correct blend of debt and equity in regards to capital structure (Lumby & Jones 2003). At this right combination, a firm is said to have attained the maximum market value. Based on this approach, the capital structure of a firm should only contain debt up to a definite level. Beyond this level, any additional leverage leads to a decline in the firm’s value (Niu 2008).
Based on the traditional theory on capital structure, the earnings of a leveraged firm are more likely to be amplified. Consequently, an investor will usually opt for a leveraged firm as opposed to the unleveraged firm. The traditional view holds that for a financially healthy firm, the benefits (as a result of enhanced financial leverage at reduced debt levels) exceeds the shortcoming of increased rate of return and bigger risk that equity shareholders would incur. However, Gulati and Singh (2014) opine that there is no credible explanation “to assume that the investors’ perception about the increase in risk due to financial leverage is different at different levels of leveraging” (p. 17). As a matter of fact, the optimum capital structures hinges on the interest tax safeguard. Modernists sought to argue that the firm’s value was reliant on investment decisions, as opposed to financing decisions (Pandey 2015). Accordingly, the capital structure is of no significance. Modigliani and Miller have further criticized the traditional model based on its assumption that leveraging up to a certain realistic level does not affect the cost of equity.
Franco Modigliani and Merton Miller were instrumental in establishing the modernist's position on capital structure. Modernists opine that in perfect markets, financing decision is irrelevant. What this appears to suggest is that the management should not be concerned with how the firm's finances ought to be structured but should pay more attention to investment decisions (Tyl 2002). This is based on the premise that regardless of how much equity or debt a firm utilises, the firm value and cost of capital does not change. This is to say that modernists do not subscribe to the optimal or ideal capital structure debate. Rather, modernists are of the view that corporate managers should be more concerned with ensuring that the firm’s assets are properly managed as a means of maximising shareholders' wealth, as opposed to engaging in financial market transactions. The modernist view assumes that the trading of securities takes place in a perfect market scenario. It does not also believe in the existence of corporate income taxes (Ross et al. 2013). However, the modernist view has come under criticism over its supposition of the perfect capital market, with the expectation that arbitrage shall work. However, the capital market is characterized by imperfections and as such, arbitrage may not work. This is likely to pave way for inconsistency between the market value of unlevered firms relative to that of leveraged firms.
Both start-up businesses and well-established business have to grapple with the issue of how to finance their business operations. For start-ups, they night be in need of additional finances to buy equipment and machinery, purse R&D , and engage in promotion and advertising activities, among others (Boss 2010). Conversely, a well-established firm may seek additional finances in order to expand its growth in other markets with the goal of increasing revenue and profitability. Firms can seek finances from various sources, depending on control and ownership these sources of finance are categorised on the basis of control and ownership, time period, as well as source and generation of funds. With regard to time period, sources of finance are categorized into short term, medium term, as well as log term.
Long-term sources of business finance implies capital requirements for a time period that exceeds five years. Some in case a firm wishes to fund its capital expenditure in such fixed assets as machinery, plant, buildings, or land, then long term financing is the way to go. A firm may also finance its working capital using long term sources since this form of capital remains with the firm permanently. On the other hand, medium term finance refers to the type of finance available to a firm for a period between 3 and 5 years. A firm may require medium term financing for two key reasons. First, in case it lacks long the firm has no access to long-term capital. Secondly a firm may opt for medium term financing in the event that it makes such deferred revenue expenditures as advertisements and needs to be written off within a period of between 3 and 5 years.
A newly formed private company will find it harder to attract diversified forms of medium and ling term financing in comparison with a well established company that has been in operation for more than 20 years. This is because the older company has already established a name for itself, not to mention that it will most likely have developed long-term working relationship with financial institutions, the public, and equity investors (Gulati & Singh 2014). On the other hand, the newly established company is trying to build a name. One of the easier options for medium term financing is to reinvest profits made. In this way, the company assumes a self financing approach to capital (Metrick 2007). Thus, ploughing back of capital enables the company to expand its operations, modernise and replace its obsolete assets, as well as fulfil special or permanent working capital requirements.
Alternatively, the newly established company may seek loans medium and long term finances from commercial banks and other financial institutions. Alternatively, the company can raise finances by inviting employees, shareholders as well as the general public to deposit their savings with the corporation. This will enable the company to fulfil its shorter-term and medium-term financial requirements using such public deposits.
Another form of medium-term finance available to newly established firm is invoice finance (Akwetey 2011). In this case, the company approaches a financial institution such as a bank with an invoice for payment that is due in future and it is then granted funds against such an invoice. This method of financing is enables the firm to finances its operations using internal means. However, there is the risk of facing constrained cash flows because the firm is already in debt even before it has received a payment.
Private companies that have been in business for over 20 years may also turn to franchising in a bid to raise extra capital for growth. Franchising enables the firm to expanding its existing business with less capital than what it would have ordinarily required (Burns 2014). The franchising arrangement is such that the franchisor receives funds from the franchisee in exchange for business rights under the trade name of the franchisor. While the franchisor incur certain costs such as establishment costs support services, and marketing costs, these are often recovered through regular payments made by the franchisee. The business may also borrow from banks in the form of short-term and medium-term lending. Medium term loans are often offered for between three and ten years, while short term lending does not exceed three years. The business must ensure that such financing goes to its operational costs or restocking because it needs to be repaid within a short duration of time.
Long-term debt encompasses financial obligations and loans incurred by a firm, and which last over 12 months. A firm may incur a long-term debt with a view to obtaining immediate cash to finance its operations (Kaumann 2009). For a start up firm, it needs significant funds to finance research, purchase equipment, and for promotion and advertising. On the other hand, short-term debt refers to the debt incurred by a firm, usually payable within 12 months. Gearing is a measure of firm’s debt relative to its equity capital, in the form of a percentage. It is an indication of a firm’s financial leverage and it a measure of the level to which a firm’s operations are financed by lenders relative to shareholders. A high gearing ratio reveals that a firm has a high percentage of debt to equity, and vice versa (Brealy et al. 2008). Firms with high gearing ratio are viewed as being riskier in comparison with firms with low gearing. This is because the firm has financed most of its operations with money from lenders who are obviously not owners of the business. This is regarded as riskier since creditors have to be paid whether or not the business makes a profit, or generates an income, for that matter.
A high gearing ratio is thus a measure if the financial the greater financial risk to which the firm is exposed to, because excessive debt could result in financial difficulties (Atrill, McLaney & Harvey 2014). On a positive note, a high gearing ratio is a sign that the firm has a high level of leverage, in that it is paying for its operations using debt. In case of an economic downturn, such a firm might encounter difficulties in repaying its dent on schedule, and could face bankruptcy. Under such circumstances, a firm may not survive with a high gearing ratio. A high gearing ratio is also a source of concern for lenders since it is a sign that their money loaned out may not be repaid, after all (Atrill et al. 2014).
At face value more equity than debt is desirable for a corporation. Debt eats into the profit margins of a company. One would imagine then, that a company is best advised to avoid debt. However, not all debt is bad for the company. In fact, debt could be a good thing for a company for two reasons, especially if it is used to finance business operations. To begin with, government encourages corporations to use debt as a financing tool by permitting them to deduct the ensuing interest on borrowed money from its income taxes (Fisher Investments, Teufel & Azelton, 2009). This has proven to be a very enticing move for corporations. In this way, the company gets to expand its operations on borrowed money. In addition, debt can be a cheaper option to financing in comparison with equity. This hinges on the fact that equity carries more risks in comparison with debt. Based on the fact that a corporation bears no legal obligation to pay dividends to its ordinary shareholders, it follows that those common shareholders desire a certain rate of return on their investment in the company. On the other hand, the firm bears a legal obligation to pay its debt. Therefore, an investor views debt as being far less risky than equity. Furthermore, in the event that a company goes bankrupt, shareholders who provided equity funding to the firm lose their investment first (Pyles 2013). Besides, a firm normally ties up a big portion of its return on equity in the form of stock appreciation.
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