Proper D/E ratio differs from one industry to another
Capital budgeting process refers to committing funds in long-term projects which are expected to generate financial benefits in the future. Financial investments are funded using capital raised through owner’s equity and borrowing. A mix of equity and debt funding of an investment is known as capital structure. Several factors should be considered before choosing an effective capital structure for a company. The study focuses on identifying the factors that determine the Alstria Office REIT-AG’s capital structure.
Alstria Office REIT-AG is a listed company operating in the Germany’s financial services industry. The company operates in the real-estate market specializing in the development of office properties. The Alstria Office REIT-AG uses a market niche in the Germany property market to create value. The medium size company was founded in 2006. Alstria Office REIT-AG relies on issuances of shares and borrowing to finance its investments. As mentioned earlier, several factors influence the company’s capital structure.
Alstria Office REIT-AG uses the following factors to determine the most appropriate capital structure;
- Cash Flow Position: Refers to the ability of a company to generate enough cash to run its operations. Not all companies that make a profit can generate enough cash flow to make payments. Debt should be used when a company can generate enough cash flow (Sekar, et al., 2014).
- Return on Investment: When return on investment is more compared to interest rates incurred from debt, then Alstria Office REIT-AG should consider increasing debt in its capital structure. Alstria Office REIT-AG should prefer an equity funding when its return on investment is less compared to the interest rates incurred on debts (Baker & Martin, 2011).
- Cost of Debt: Refers to the cost insured by a company to obtained debt funds. Alstria Office REIT-AG should go for more debts than equity funds when the interest rate associated with debt is low. However, when the debt’s interest rate is high, Alstria Office REIT-AG should avoid debts (Weert, 2011).
- Tax rate: The interest paid on debt is lower when the tax rates are high because payable interest is deducted from the company’s income before tax calculation. On the other hand, interest paid on debt is high under a low tax rate, and therefore a company should prefer more equity in its capital structure (Miglo, 2016).
- Cost of Equity: Investors expect wealth maximization from their investment. Increase in expected earnings in determining by calculating the earning per share (EPS). Debt should be part of the capital structure if it contributed to the increase of EPS. However, debt should be excluded from the capital structure when it contributes to the reduction of EPS (Bierman & Smidt, 2014).
- Floatation Costs: Refers to the costs associated with issuing debentures or shares. Floatation costs include legal fees and advertisement cost. Floatation cost cannot be ignored when determining the most suitable capital structure for a company. A company incurs several legal formalities besides the costs before making an entrant into the capital market. Compared to loans and advances, debentures or shares requires more floatation cost and formalities. Therefore, Alstria Office REIT-AG should consider legal formalities and floatation cost when choosing a capital structure (Pettit, 2011).
- Associated Risk: Business operations are affected by financial risks. Financial risks refer to a company’s inability to meet its financial costs. When the financial risks are low, Alstria Office REIT-AG should raise capital by issuing debt securities. On the other hand, when the financial risks are high, Alstria Office REIT-AG should highly depend on its equity (Baker & Martin, 2011).
- Flexibility: A company is restricted from borrowing when its debt level is above the limit. Therefore, a company should maintain its borrowing flexibility to handle unforeseen situations in the future (Ghosh, 2011).
- Control: The control of a company lies with its owners because they are the ones who make a crucial decision in the country. Compared to equity shareholder, holders of debentures have no control over the company while preference shareholders enjoy limited rights. Therefore Alstria Office REIT-AG’s shareholders should employee more debts in the capital structure to continue their control over the company. It is easier for another group to gain control of the company by buying many shares when equity shares are issued for purchase. On the other hand, if the current shareholders want to give away some degree of control, then equity shares should be issued out (Johnson, 2014).
- Regulatory Framework: The issuance of debentures and shares should be done per the Federal Financial Services Supervisory Authority (FFSSA) guidelines. A company seeking to take loans should adhere to the monetary regulations and policies. Companies prefer the issuance of shares and debentures when they can easily meet the FFSSA guidelines compared to the monetary policies. On the other hand, a company should go for loans when the fiscal policies are flexible compared to FFSSA guidelines (Baker & Martin, 2011).
- Conditions in the Stock market: The capital structure is affected by boom conditions on the stock market. When seeking additional capital, investors should consider market conditions. For instance, during a depression, business is slow in the market. Therefore investors should avoid taking additional risks. In such conditions, Alstria Office REIT-AG should issue borrowed securities because they are less risky. During the boom period when business is flourishing, investors should take risks. Therefore, the company should prefer issuance of equity share and earn more dividend (Baker & Martin, 2011).
Proper D/E ratio differs from one industry to another. Some industries rely more on debts while other prefer equity. A business like Alstria Office REIT-AG that operate in the financial sector relies more on borrowing compared to issuance of equity. As such, an SME business requires more borrowing to facilitate its business operations. Studies have shown that firms in the financial service industry have higher D/E ratio (Horton, 2018).
The financial industry comprises of several companies based on service provided such as credit services, banking, asset management, insurance, and brokerage firms. On average, Germany’s financial service industry has a D/E ratio of 90.89. A real-estate company like Alstria Office REIT-AG depend on borrowing to operate. Therefore, the business should have a higher D/E ratio (Horton, 2018).
An organization should ensure that the D/E ratio supports its business strategy. Capital structure affects an organization’s cost of capital and operating cash flows. Having debt in a company’s capital structure increases intrinsic value (Bierman & Smidt, 2014). For instance, a mature organization with predictable cash flow should use more debt in its investment opportunities. On the other hand, a company faced with financial uncertainty should reduce its debt level and develop a flexible capital structure to sustain its investment plan. Instead of going for debts, a highly uncertain company should seek mergers and acquisitions and a way to raise more capital for investment (Horton, 2018).
Lastly, before choosing a specific capital structure, a company should understand its future investment requirements and revenue. After developing a sustainable business strategy, the next step is to determine a capital structure that supports the plan. At any given time, a chosen capital structure should support an organization’s business strategy (Sekar, et al., 2014).
Conclusion
Before investing, Alstria Office REIT-AG should develop with a suitable and sustainable capital structure plan. Alstria Office REIT-AG should consider factors such as market conditions, its cash flow position, risks associated with borrowing, and the costs of borrowing when balancing between equity and debt in its capital structure. As a stable organization, Alstria Office REIT-AG has a predictable cash flow and should use more debt in its investment opportunities. However, when faced with financial uncertainty Alstria Office REIT-AG should reduce its debt level and develop a flexible capital structure to sustain its investment plan.
References
Baker, H. K., & Martin, G. S. (2011). Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. New York: John Wiley & Sons.
Baker, K. H., & Martin, G. S. (2011). Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. New Jersey: John Wiley & Sons.
Bierman, H., & Smidt, S. (2014). Advanced Capital Budgeting: Refinements in the Economic Analysis of Investment Projects. New York: Routledge.
Ghosh, A. (2011). Capital Structure and Firm Performance. London, UK: Transaction Publishers.
Horton, M. (2018). What is the average debt/equity ratio of companies in the financial services sector? Retrieved 09 15, 2019, from https://www.investopedia.com/ask/answers/032315/what-average-debtequity-ratio-companies-financial-services-sector.asp
Johnson, R. S. (2014). Equity Markets and Portfolio Analysis. New York: John Wiley & Sons.
Miglo, A. (2016). Capital Structure in the Modern World. London,UK: Palgrave Macmillan.
Pettit, J. (2011). Strategic Corporate Finance: Applications in Valuation and Capital Structure. New York: John Wiley & Sons.
Sekar, M., Gowri, M., & Ramya, G. (2014). A Study on Capital Structure and Leverage of Tata Motors Limited: Its Role and Future Prospects. Procedia Economics and Finance, 11, 445-458.
Weert, F. d. (2011). Bank and Insurance Capital Management. New York: John Wiley & Sons.
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