Tax Liability a Preview of Capital Structure Essay

  • Length: 6 pages
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  • Subject: Business
  • Type: Essay
  • Paper: #45408700

Excerpt from Essay :

Tax Liability

A preview of capital structure issues

In regards to the overall business environment, capital structure has profound implications of the business, irrespective of its industry. For one, a firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $40 billion in equity and $160 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example is referred to as the firm's leverage. This leverage has implications on the entire firm. For example, leverage in many respects is a double edges sword. On one hand, leverage can amplify gains for firms. However, if used incorrectly, leverage can also amplify loses. As such, firms must be cognizant of its capital structure as complacency can hinder overall business performance. Debt and equity financing, can have a profound implications on the business overall. In particular, prevailing interest rates can better determine adequate means of debt or equity financing. Taking the prevailing interest rates today would suggest that debt financing may be ideal for more capital intensive businesses. For one, many companies can lock in fixed terms at todays very low rates. These rates are often outpaced by inflation. As such, companies may find a capital structure skewed heavily towards debt financing to be very advantageous. For one, the low interest rate environment makes debt financing very attractive relative to equity. Furthermore, macroeconomic considerations seem to preclude massive amounts of impending inflation. As such, companies can pay debtors back in heavily depreciated dollars. This too is advantageous to the firm as it can have access to very cheap, low cost forms of funding (Timmer, 2011). The overall macroeconomic environment therefore, does provide a foundation by which companies decide on their capital structure. In many companies equity financing is much more expensive relative to its debt counterpart. Debt, at current rates is very cheap. This cheap financing allows companies to purchase other companies, expand into international markets, purchase property, and otherwise expand the business. However, companies must be leery of how they use debt in regards to capital projects. In some instances, adverse economic situations can cause undue hardship on a corporation heavily levered with debt. Once this debt becomes due, it may be difficult for the firm to cover interest expense. As such companies must be mindful of their overall capital structure. Coca Cola is unique in that its product offering is highly differentiated in regards to its brand. Coca-Cola is ubiquitous around the world. Its brand is very powerful and easily recognizable. The brand is everywhere consumers are happy. This includes the Olympics, the World Cup, movies, restaurants, theme parks, universities, and much more. This brand image provides a buffer in regards to its capital structure. Consumers are often willing to pay more for Coke products relative to its peers in the industry simply due to the brand image. As such, Coke has the ability to manipulate its capital structure in a manner very unique for a company in its industry (Lyandres, 2007).

Business and financial risks related to capital structure

The possibility that a company will have lower than anticipated profits, or that it will experience a loss rather than a profit can be quite larger relative to prevailing macroeconomic factors. For instance, retail companies depend heavily on discretionary income of its customers. If consumers believe the future to be difficult, they may curtail spending until conditions improve. This pessimistic attitude towards consumptions can have adverse consequences for a firm that is heavily financed through debt. Business risk is influenced by numerous factors, including sales volume, per-unit price, input costs, competition, and overall economic climate and government regulations. As is the case with financial institution, regulation can hinder the ability of the firm to generate profits. Dodd Frank for example, was implemented shortly after the financial crisis. This regulation required banks to hold more capital in case of default. This capital has an opportunity cost as it is not being deployed in a profitable manner. As such, product pricing has changed. Banks have responded with increasing fees, charging for checking accounts and reducing staff. Coca-Cola is unique in that it sells a product that is ubiquitous. According to a recent annual report, the company sells roughly 1.6 billion 8 ounce servings a day. As such, it is a consumer staple within the world. Consumers are willing to pay $1 every so often to consumer a Coke product. This incremental profit quickly compounds as consumers drink more Coke products as time passes.

A company with a higher business risk should choose a capital structure that has a lower debt ratio to ensure that it can meet its financial obligations at all times. Investors in a company are exposed not only to business risk, but also to financial risk, liquidity risk, systematic risk, exchange-rate risk and country-specific risk. This is also the case for Coca-Cola. Much of its sales volume is done overseas. To calculate business risk, analysts use four simple ratios: contribution margin, operation leverage effect, financial leverage effect and total leverage effect. For more complex calculations, analysts can incorporate statistical methods.

Modigliani and Miller's [MM] capital-structure theory

The basic theorem states that, under a certain market price process, in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. According to the MM capital structure theory, it does not matter if the firm's capital is raised by issuing stock or selling debt. In addition, it does not matter what the firm's dividend policy is as the firms value is not be affected by this dividend policy.

Criticisms of the MM model and assumptions

To begin, Modigliani and Miller are often criticized for not having realistic assumptions regarding capital structure. As indicated above, their theorem assumes the absence of very common aspects of capital structure such as taxes and agency costs. These costs are very contentious are often taken into consideration when deciding on optimum capital structure of companies. In this model, both creators believe that a firm's capital structure does not matter. However, in the real world, events are often uncertain, and costs are very real. The market for example does posses some amounts of asymmetric information. Emotions are often come into play in regards to overall company valuations. As such, as indicated during the financial crises, prices can fall substantially. As prices fall so too does consumer confidence which ultimately affects the capital structure of business. As was the case of 2008, firms that were financed extensively with debt went bankrupt or perished altogether. These firms including Washington Mutual, Bear Stearns, Wachovia, Merrill Lynch, and Long-Term Capital Management all have heavy debt burdens. Their overall capital structure was skewed heavily towards the debt side of capital structure. Due primarily to the uncertain world in which business operates these companies' ultimately lost large amounts of money for their shareholders. As such, capital structure is indeed important and does affect the value of the firm. Instances such as these are very common throughout history. Therefore, the general criticism of the MM model is that it is not applicable in real world situations and is thus purely academic (Baker, 2002).

Capital structure evidence and implications

Unlike many of the assumptions posed in the MM theory. Capital structure does have implications on firm value. For one, dividend policy heavily effects firm value. As stated earlier, the MM theory doesn't take into account the emotional nature of the market. In many instances, investors are prone to make irrational decisions based primarily on emotions. Dividend policy is not such exception. In regards to firm value, with all things remaining equal, companies that pay higher dividends are often value higher than those who do not. Investors, see dividends, and in particular consistent dividends, as a sign of company strength. Dividends are also seen as stable and predicated which is desired from the investment community. As such, dividend policy does indeed affect firm value in regards to investor valuations.

In addition, high debt burdens, particularly in economic contractions, lowers firm values. The first example given was during the financial crisis. However, numerous examples exist. Companies with no debt are often valued higher that those with excessive amounts of debt financing. Again emotions enter into the valuation of companies as investors are fearful of the company's ability to repay creditors. Currently, JC Penny is undergoing such treatment. The company is undergoing a complete overhaul in regards to stores, and its assortments. Initially, this remodel was met with much fanfare. Investors clamors for the shares of the company, ultimately bidding the value of the company up. However, the company quickly eliminated its cash position, thus needing debt financing. This debt financing quickly escalated, while sales declined. Year over year, JC Penny same store sales declined 25%. As such considerations regarding the company's capital structure came into question. The value of…

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