What is the capital structure of a company?
A specific distribution of debt and equity makes up the finances of the company can be said as capital structure. It depends on the manner in which the firm finances its overall transaction and growth by applying various sources of funds (Giacomini, Ling and Naranjo, 2015). Present essay revolves around the views relating to capital structure present by DeAngelo according to whom capital structure is unstable and Binsbergen which explains the theories relating to the empirical model of Optimal Capital Structure. Detail discussions relating to theories provided in the journal have been explained in detail for providing an appropriate understanding. Further analysis on both of them has been presented so that a fair conclusion regarding the same can be made.
It has been studied by leading researchers that the capital structure of individual companies are stable for a longer period with organisations having high or low leverage trending . The same is present because an effort is made to maintain that high or low leverage trending for more than two decades (Brusov, Filatova and Orekhova, 2013). The leverage has been examined in the article relating to both over time and companies from different perspectives, and it has been assessed that the capital structure of an organisation is unstable.
Leverage Ratios: These ratios can be said as one of the various financial measures which assess the amount of capital which comes in the form of debt and the ability of the organisation to accomplish its financial obligations. Various other measures on the financial health of the company can be ascertained through it. The instability in leverage majorly refutes target-rebalancing model of the capital structure according to which managers have to maintain company’s closer to provided target ratio (Brisker and Wang, 2017). However, at the mean time our simulations relating to leverage dynamics in which management is having only weak incentives for the purpose of achieving the targeted leverage back. Thus it has been observed that these kind of models are consistent but with wide variation in leverage (DeAngelo and Roll, 2015). It has also been assessed that familiar capital structure assists the management in maintaining an investment-grade credit rating which fits this target-zone template.
Time series range and Standard Deviation of Book Leverage, Market Leverage and Net Debt ratios: Book leverage is the ratio of total debt to total asset and market leverage is the ratio of debt to sum comprising the market value of the market stock. Accordingly, the net-debt ratio is ascertained with following formula i.e. debt – cash / total assets. The target zone model posits that the financial distress enforces leading company for deleveraging in case exogenous shocks enforces leverage to a higher level (Arce, Cook and Kieschnick, 2015). The investigation also presented connection between operating and investment leverage dynamics. It has been assessed that relationship between leverage variation and funding policy stands out clearer in case investigations and it has been observed that conservatively leveraged organisations are defined as those who have no debt outstanding. Highly leveraged organisations are considered those firms which have Debts/Total Assets > .400.
Exploring the Optimal Capital Structure Model
Implications for theories of Capital Structure: However, it has been assessed that capital structure stability do sometimes arise but the leverage ratio of the non-financial organisation usually has varied over time (DeAngelo and Roll, 2016). Thus the instability is inconsistent with the fact that companies make an effort for keeping leverage close to particular target leveraging ratio. It has been assessed that departure from stability indicates an important relation between leverage instability and the funding of investment policy.
It has been agreed in the theoretical paper that a variety of benefits can be availed by application of debt which comprises tax benefit of interest deductibility, oversight and assessment of corporate managements through intermediaries and financial market. A specification has been made in the report that a cost is to be paid for using debt which includes expected loss related to bankruptcy and financial distress (Borochin and Yang, 2017). The existence of debt overhang which will enable the managers to approve positive NPV projects and cost regarding the conflict between creditors and managers as representatives of stockholders.
Marginal Benefit and Marginal Cost Curves of Debt: Marginal cost curve is ascertained by exogenous variation in marginal tax benefits of debts. Initially, the tax benefit is ascertained with the actual figure of debt available and further estimations are made for future years. The same is represented by a point which specifies the equilibrium intersection of marginal cost and benefit of debt functions (Lin and Flannery, 2013). Further, the movement in curve represents the shit in benefit, and thus the marginal cost of debt is estimated, and the same must be rationalised with the capital structure choice of organisation.
Cost and Tax Benefit of Debt: A variation in debt usage has been applied to different firms because the benefit function shifts but the cost function remains at one place only. It has been observed that marginal curve assess specifies the exact manner in which the benefit is shifting and to what extent (Devos, Rahman and Tsang, 2017). The value of an additional dollar of interest deduction is applied for evaluating the probability that firm will be profitable, and with same, it can be assessed that whether the increased interest would buy same the company of taxes equal to the marginal tax rate in the year of deduction. The benefit is assessed by observing the movement of the curve that as the tax rate falls the benefit of the dollar also reduces with the same and thus a critical statistical issue is to be dealt with in mapping out the cost and benefit from debt function.
Capital Structure Stability and Leverage Dynamics
Determining Optimal Capital Structure: Optimal capital structure can be ascertained after assessing the specific marginal benefit and marginal cost curves. Further, the marginal curve can be applied for evaluating the overall benefit of debt, the cost of debt and the net benefit of debt comprising optimal debt levels (Zhang, Wei and Ma, 2016). The vertical lines of below diagram present the actual debt usage and the dotted line from the intersection of both the curves represent the optimal level of company or organisation. Thus the following method can be applied for ascertaining the optimum structure of capital.
Figure 1: Marginal Benefit and Marginal Cost Curve of Debt
(Source: Danis, Rettl and Whited, 2014)
Capital Structure Instability: A variety of companies were assessed for ascertaining the facts relating to instability of capital structure which were three groups: the first one was 2751 companies with at least data of 20 years; the second one was constant composition of 157 companies whose data of the year 1995 to 2000 was available and third group was 24 Dow Jones Industrial Average companies (Albul, Jaffee and Tchistyi, 2015). The extent of stability available in cross- sectional distribution of leverage ratios has also been examined which is the tendency of companies with relatively high, medium or low leverage over time. Departure from Leverage stability usually presents the significance increase in leverage and dollar value of the remaining amount of debt. As the same is leverage ratios are typically associated with a major increase in company’s asset growth and capital expenditure and with material funding deficit and the fact, have been concluded after assessing prominent companies.
Downward profitability was faced by Kodak Company, and due to same, it abandoned its de facto policy regarding employment guarantee at high wages. Thus the company adopted a zero-debt capital structure and conservative leveraging enabled the company to deliver employment guarantee without affecting cash squeezing (Zeitun and Tian, 2014). The option was forced to choose rather pay creditors or to employees and further, they were not able to force for a longer period, and the company final intended to replace the policy and borrowed aggressively for reducing the eroding profit from declining photography business. Another such case is observed from banking companies as their leverage ratios are higher in comparison to non-financial companies that all increase the leverage as their operating policies transferred towards the greater provision of banking services. The above facts provide an appropriate understanding of the capital structure and the importance of assessing investment policy in order to affect the leverage dynamics and to consider payout policy and financial flexibility and other factors relating to the operating environment.
Payout Policy and Financial Flexibility
An attempt has been made by Binsbergen for explaining the methodology of ascertaining the optimum level of capital structure. A fact has been made available regarding the advantage of using debt which comprises tax benefit. But another side of that benefit has also been appropriately explained which is cost relating to the debt. The cost which is relating to debt comprises expected loss relating to distress and bankruptcy, and these enforce the managers for passing positive NPV project (Zhang, Wei and Ma, 2016). However, the cost relating to the potential conflicts the interest among creditors and managers which are part of stockholders. It has been observed that changes in corporate values are relating to debt-financing and cost of over levering is higher in comparison to under levering. The main emphasis is made on the cost and benefit relating to debt, and all the further decision are taken only after considering both the elements. Initially, the approach which is provided in the article emphasises on the tax benefit relating to interest on the debt and further all other benefits and cost of debts which influence the choice of debt has been analysed in detail.
Application of marginal benefit and marginal cost curve has been made for ascertaining the optimal amount of debt. It has been analysed that for an average firm the net benefit after considering all the relevant cost is equal to 4% of market value and on the other hand the gross benefits without considering the cost are approximately 8% of the firm value. The direct approach of cost and benefit of debt can be applied for facilitating the predictions relating to the optimum structure of capital (Borochin and Yang, 2017). The cost is assessed after ascertaining the financing choices as usually the option which is having higher debt cost does not opt. Moreover, after analysing the cost-benefit framework the optimal capital structure can be estimated by value adding and application of the model and addressing other issues relating to debt. Further, the present value of tax benefit is determined by adding interest deduction relating to another dollar, and the benefit is integrated for the purpose of determining the marginal benefit curve. The marginal benefit of debt is downward sloping reducing the level of interest deductions presenting the decreased value of each additional dollar of interest deduction.
Figure 2: Marginal tax benefit of a Debt Curve
(Source: Lin and Flannery, 2013)
Comparing DeAngelo and Binsbergen’s Theories
DeAngelo & Roll specifies that the capital structure of an organisation has been highly unstable over a period of time and on another hand, Binsbergenet has made an attempt at explaining the methodology for optimal capital structure. DeAngelo has provided a conventional idea that optimal structure is maintained in accordance with leverage targets and the same are determined by assessing the tax benefit of debt as well as the agency cost and financial distress i.e. cost relating to debt (Arce, Cook and Kieschnick, 2015). Thus it can be concluded that both the researchers have concluded on a single point that optimal capital structure for an organisation can be assessed only after ascertaining the cost and benefits relating to debt.
Further, the method provided by Binsbergenett for establishing optimal capital structure emphasises on the tax and cost benefit of debt for taking an appropriate decision relating to it. The specified analysis specifies the application of marginal tax benefit and ascertainment of tax benefit curve for evaluation of the optimum amount of debt for a specific firm. The various companies which have been assessed in the article specify that capital structure of almost all the firm changes after a certain period of time, and for evaluating the optimal capital structure it is necessary to evaluate cost and benefits relating to it in an appropriate manner. It can be concluded from the above discussion that as both the reports can be reconciled with each other as both of them emphasise on the cost and benefit analysis of debt for ascertaining the capital structure of an organisation and both the report can be reconciled with each other.
References
Albul, B., Jaffee, D.M. and Tchistyi, A., 2015. Contingent convertible bonds and capital structure decisions.
Arce, D.G., Cook, D.O. and Kieschnick, R.L., 2015. On the evolution of corporate capital structures. Journal of Evolutionary Economics, 25(3), pp.561-583.
Borochin, P. and Yang, J., 2017. Options, equity risks, and the value of capital structure adjustments. Journal of Corporate Finance, 42, pp.150-178.
Brisker, E.R. and Wang, W., 2017. CEO’s Inside Debt and Dynamics of Capital Structure. Financial Management.
Brusov, P.N., Filatova, T.V. and Orekhova, N.P., 2013. Absence of an optimal capital structure in the famous tradeoff theory!. Journal of Reviews on Global Economics, 2, pp.94-116.
Danis, A., Rettl, D.A. and Whited, T.M., 2014. Refinancing, profitability, and capital structure. Journal of Financial Economics, 114(3), pp.424-443.
DeAngelo, H. and Roll, R., 2015. How stable are corporate capital structures?. The Journal of Finance, 70(1), pp.373-418.
DeAngelo, H. and Roll, R., 2016. Capital Structure Instability. Journal of Applied Corporate Finance, 28(4), pp.38-52.
Devos, E., Rahman, S. and Tsang, D., 2017. Debt covenants and the speed of capital structure adjustment. Journal of Corporate Finance.
Giacomini, E., Ling, D.C. and Naranjo, A., 2015. Optimal Capital Structure and the Effects of Deviations from Target Leverage on REIT Return Performance. Real Estate Research Institute Journal.
Lin, L. and Flannery, M.J., 2013. Do personal taxes affect capital structure? Evidence from the 2003 tax cut. Journal of Financial Economics, 109(2), pp.549-565.
Zeitun, R. and Tian, G.G., 2014. Capital structure and corporate performance: evidence from Jordan.
Zhang, B., Wei, H. and Ma, L., 2016. Does Financial Reporting Quality Affect Optimal Capital Structure? Evidence from China. Frontiers of Business Research in China, 10(3), p.432.
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