Capital structure analysis and financial implications

Introduction

Corporate finance focuses on financial decisions made by financial managers. Financial decisions is broadly categorized into two: financing decisions and investment decisions (Renzetti, 2001). Investment decisions determines the composition of assets held by a firm while financing decisions focuses on the optimal mix of debts and equity (capital structure). An optimal capital structure can be defined as a combination of equity and debt that maximizes shareholders’ wealth or value of a firm. The value of a firm “is the present value of expected future cash flows to be generated by the assets, discounted at the company’s weighted average cost of capital (WACC). Generally, the determination of optimal capital structure is a complex decision process involving calculations of various debt-equity ratio. In this paper, the capital structure of Afterpay Touch Group Limited (ATP), FlexiGroup Limited (FXL), and Zip Co Limited (Z1P) will be calculated, theories of optimal capital structure will be discussed and optimal capital structure of ATP will be determined. 

Calculation of Capital Structure

Capital structure is described by the relationship between debt and total capital in terms of debt ratio. The formula for calculating debt ratio is as follows:

Debt ratio = Long Term Debt / Total capital 

Total Capital = Debt Equity

Tables 1, 2, and 3 shows the capital structure of ATP, FXL, and Zip Co. All these firms are in the computer service industry. ATP uses less long term debt finance compared to Z1P and FXL (As of 2019, the debt ratio of ATP is 7%, while Z1P and FXL is 61% and 89%, respectively). 

Optimal Capital Structure Theories

There are four capital structure theories that have been developed to date: 1) the trade-off theory, 2) the pecking order theory, 3) the signaling theory, and 4) the managerial opportunism theory (Graham & Leary, )  Each theory describes a firm’s optimal capital structure as discussed below.

Trade-off Theory

This theory suggests that managers should choose a mix of debt and equity that achieves a balance between the tax advantages of the debt and the various costs of using financial leverage. Costs of debt include agency costs, bankruptcy costs, and loss of future financing flexibility. A firm is allowed to deduct interest expenses form gross income when determining taxable income. So, debt reduces taxes. On the other hand, when a firm uses equity, they are not allowed to deduct dividends from gross income to determine taxable income. The tax benefit from interest payments is calculated as follows: Tax benefit = Tax rate * Interest Payments. 

Bankruptcy costs is a function of the cost of going bankrupt and the probability of bankruptcy. Firms with volatile earnings and high cash flows have a higher probabilities of bankruptcy at any given level of debt for any given level of earnings. Direct costs of bankruptcy include deadweight and legal costs while indirect costs are costs that arise because investors perceive a firm to be in trouble. Other things being equal, the greater the indirect bankruptcy cost, the less debt the firm can afford to use for any given level of debt.

Agency costs arises whenever a business hires a third party to carry out the operations of the business. It usually arises because the interests of the principal may deviate from that of an agent. Generally, in any business, the interests of the stakeholders are different from that of the lenders. Lenders are interested in getting their money back while shareholders are interested in maximizing their wealth. This theory states that if a firm has a greater agency problems, they should avoid using debt at all costs. 

Debt is also associated with loss of financing flexibility. A firm that has borrowed to its capacity losses the flexibility of financing future projects with debt. Other factors remaining constant, the more uncertain a firm is about its future financing requirements and projects, the less debt the firm will use for financing current projects. 

Pecking Order Theory

This theory was developed in 1984 by Myers and Majluf and assumes that there is no optimal capital structure. It specifies the order in which funds should be raised. Retained earnings is usually first, followed by debt then convertible debt and preference shares and lastly, new issues of equity. Generally, this theory is most applicable to firms which the value of growth opportunities is low compared to the value of assets. 

Signaling Theory

This theory suggests that managers know more about their company’s future investment opportunities that investors do. If a manager thinks that investors have undervalued his firm, he will tend to communicate the correct value to the market. He can send a costly signal like issuing debt. Investors will then react to the increased debt by increasing the share price hence raising the value of the firm. 

The Managerial Opportunism Theory

This is the latest theory to explain the optimal debt / equity mix. The theory states that

companies try to issue shares when share prices are high and issue debt when share prices are low. It means a firms capital structure is based on the issuance of shares especially when prices are high. Overall, the price of shares influences a manger’s decision to either issue equity or debt. 

Optimal Capital Structure for ATP

Based on trade-off theory, there are four steps to be followed when determining the optimal capital structure of a firm. The steps are listed below:

Estimating cost of equity at different levels of debt

Estimating cost of debt at different levels debt

Estimating cost of capital at different levels of debt

Determining firm value

Cost of Equity

Estimating the cost of equity is the first step in determining the optimal capital structure of firm. In the case of ATP, cost of equity at different levels of debt was determined using Capital Asset Pricing Model (CAPM). The formula for this model is as follows:

Table 4 shows the estimated cost of equity at an interval of 10%, up to 90% debt based on the above calculations. Column one shows the percentage of long-term debt financing at an interval of 10%. The second column shows the debt/ equity ratio for each level of debt. The third column shows the leverage beta. In column four, the cost of equity for each level of debt is indicated. . 

Cost of Debt

After estimating the cost of equity, one needs to estimate the cost of debt. The formula for calculating cost of debt is 

Cost of debt (After-tax) = Before-tax cost of debt (1 – adjusted tax rate)

Maximum Tax Benefit = EBIT × Tax Rate

Adjusted tax rate = Maximum Tax Benefit / Interest Expenses.

Table 5 shows the estimated cost of debt at each level of debt. The Ratings Table is shown in Appendix A. The cost of debt (after-tax) is shown in the last row of the table 

Estimating Cost of Capital

The third step is estimating the cost of capital. The cost of capital at different level of debt was determined using weighted Average Cost of Capital (WACC). The formula for WACC is as follows:

WACC = Cost of Equity (E/(D E)) Cost of Debt (D/(D E))

Where:

D = Market Value of Debt

E= Market Value of Equity

Table 6 shows ATP cost of capital schedule and firm Value. Column 3 shows the cost of equity which were determined in the first step. In column 5, the cost of debt is indicated (it was calculated in step 2). In column 7 and 8, the cost of capital and the value of the firm is determined, respectively. 

Determining Firm Value

The last step is determining the value of a firm. The value of ATP at each level of debt is estimated using the following formula: