This paper deals with the issues of financing mix. It explores the advantages and disadvantages of debt-equity financing mix in the success of a firm. The early portion of the paper deals with the advantages and disadvantages of debt financing. The next section deals with the effect of debt financing on the return on shareholders equities. It also includes discussion of optimal capital structure of a firm. The final portion of this paper highlights three chosen companies: The Kroger Company, Intercontinental Hotels Group, and Whirlpool.
I will try to evaluate the financing mix of the company based on the discussions of debt financing and optimal capital structure. Advantages and Disadvantages of Debt Financing In a book by Karl Seidman titled, “Economic Development Finance”, debt financing in general is the opposite of equity financing (Seidman, 2005, p. 26). Debt financing has the following advantages. First, it offers no strength of ownership. With debt, lenders have higher priority on their invested bonds than shareholders. Second, debts are now available at lesser rates from many lenders.
Finally, it offers greater availability (Seidman, p. 32), mainly streaming from the increasing number of lending firms around the world. When firms decide to incur debt to finance their business, finding lenders is not too hard. The obligatory mode of payment in terms of regular principal and interest, plus providing collaterals to debts increases the confidence of the lender to approve and issue debts to borrowing firms. Plus, interest rates come at affordable prices usually ranging from 8% to 12% or depending on prevailing rates (Seidman, 2005, p. 32).
There are four major disadvantages of debt financing. First, unlike equity, debt must be paid, and this causes firms to incur fixed costs, which Seidman referred as payment burdens (Seidman, 2005, p. 26). Second, most debts requires assets as collateral. Third, the flexibility of the firm’s operation may be hindered when lenders establish financial or other type of limitations. Finally, lenders may require personal assets as collateral (Seidman, 2005, p. 32). These negative impacts of debt financing increases the financial risk of the firm while offering greater sense of security to its lenders.
When a firm is affected by changes in business cycle, decreases in revenues and increases in costs likely occur. Obligatory payments to debts will surely hurt the borrowing firm. When firms are experiencing financial or operational problems, any asset paid to its lenders would have been utilized to support or expand operation to help the firm recover from losses, but because firms are obliged to pay debts, it leaves them no option but to pay. When firms pledged assets as collateral, lenders have the right to claim it as a payment regardless if it’s crucial to the operation of the firm or not.
Plus, giving right to the lender to set some limitations to the operation of the firm may possibly affect the overall operation of the firm. When lender’s set limitation in maintained balances, or any other operation of the firm, it will affect the productivity of the firm. The worst is this could possibly lead to bankruptcy. In general, when business is unfavorable to the borrowing firm, lender’s claim over the firm’s assets is a big threat. Debt Financing and its effect on the Cost of Equity “With Debt financing, the cost of equity, or the rate of return shareholders require also increases.”
Debt financing increases the volatility of the return on shareholders. Consequently, to cover up this volatility, shareholders and investors require higher rate of return on equity (Baker & Powell, 2005). This is one way of protecting the investors’ interest over his investment. There are major reasons the volatility of shareholder’s return on investment increases. First, equity-financed, and debt-financed firm both have an associated business risk affecting its operating earnings. The business risk alone is enough to affect the volatility of the earnings per share (EPS) and return on equity (ROE).
Second, when debt is incurred to finance a firm, another associated risk is added to the scene, and it’s known as “financial risk. ” The latter type of risk roots from incurred fixed cost as payments for principal and interest of debts, which is not in the case of equity-financed firm, and definitely the main reason why shareholders require higher rate of return. The relationship between interest on debts and taxes on earnings before interest and taxes (EBIT) also offer both attracting and undesirable feature with debt-financing.
Because taxes are computed after interest on debt is deducted from the earnings, it decreases the value of taxable earnings of the firm. This is called a “tax shield”. But tax shield can be availed if and only if the business has generated a net income greater than the interest on debt, otherwise, it would result to net loss. This only means that debt-financed business must reach EBIT higher than the fixed cost of debt to ensure shareholders can enjoy return on their equity.
Optimal Capital Structure of the Firm
A financing mix that maximizes the value of the firm is called an “optimal capital structure” (Baker & Powell, 2005). However, reality based, the effort for achieving this financing mix is still trivial, and research has yield mixed views. Some believe that optimal capital structure can be theoretically determined, but it’s uncertain to determine the precise percentage of debt that can maximize a firm’s market value. On the other hand, there are those who believe that the market value of the firm does not exist, because the market value of firm is independent of its financing mix (Baker & Powell, 2005).
In my own point of view, whether there is an optimal capital structure or not, the most important point is that the financing mix must be consistent with maximizing shareholder’s wealth, which Baker & Powell referred as the “premise of maximizing firm value”, (Baker & Powell, 2005). Let’s take note that in the real world where there are too many market imperfections exists such as taxes, depreciation, interest which could lead to financial distress. These all affects the value of the firm. If a firm is 100% equity financed, shareholders may only enjoy lower rates of return on their equities.
This is because equity financed firm yielding higher growth of earnings and profits prefer doing new investment than giving payouts to shareholders. In addition, these do not experience the burdens of interest and principal amounts on debts. But equity-financed firms do not enjoy tax shields like debt-financed firms do. If a firm is debt-equity finance, the ratio of debt to the overall capitalization of the business plays a very crucial role. When the ratio of debt is too high, the firm might experience financial distress in the end. For the purpose of illustration, we will just categorize debt ratio by these three levels: low, medium, high.
In a low debt-financed firm assuming earnings before interest and taxes (EBIT) is high, the return on equity on shareholders is definitely at its lowest. This is because the volatility of ROE and EPS is also at its lowest compared to the other two levels. This happens because the ratio of the EBIT to the cost of debt is also high. At the same time, the firm also enjoy lower tax shield, consequently increasing tax liability of the firm, also reducing the net profit after interest and taxes. In most case, 100% equity financed firm can outrun the rate of return on equity to shareholders of low debt-financed firm.
In a medium debt-financed firm assuming earnings before interest and taxes (EBIT) is high, the return on equity on shareholders is also at medial level. The volatility of ROE and EPS is also at medial level. Tax shield also decreasing the tax liability of the firm, and increasing the net profit after interest and taxes. At this level, debt-financed firm can outrun the EPS and ROE of 100% equity financed firm. In a high debt-financed firm assuming earnings before interest and taxes (EBIT) is high, the return on equity on shareholders is also at higher level compared to the other two.
The volatility of ROE and EPS is also at its highest. Higher tax shield is decreasing the tax liability of the firm, and increasing the net profit after interest and taxes. At this level, debt-financed firm can outrun the EPS and ROE of 100% equity financed firm, and the debt-financed firm at low and medium levels. However, when earnings before interest and taxes (EBIT) are low, high debt-financed firm might experience difficulty with meeting up the fixed cost of debt which is an obligation of the borrowing firm to the lender.
The lower levels may experience lower burden. Tax shields associated with debt financing have big effects on debt-financed firm. According to the “Trade off Theory”, tax shields and financial distress associated with debt-financing may provide a static trade-off which could help achieve an optimal capital structure (Baker & Powell, 2005). If we are to consider what the best capital structure is for a firm, we must always consider having an EBIT higher than the cost of debt so that we can enjoy the tax shield.
Otherwise, interest may just be enough to wipe out tax shield. Let us bear in mind that it is a requisite that a business must have net income to enjoy the tax shield. The Kroger Company Based on the concept of optimal capital structure, I think Kroger Company can continue operating at high level debt ratio. Kroger Company has utilized debt for capitalization as shown on their balance sheet for 3 years starting 2006-2008. It is apparent that during the 3 years of its operation, debt is greater than equity in their capitalization.
Looking at their income statement, their Earnings before interest and taxes for the 3 years were apparently higher than the interest on debts. The ratio of EBIT to interest in debt is relatively high enough showing the capability of the company to meet the cost of debts. However, I have observed that as the amount of debt increased within those years, the interest on debts reflecting in their income statement is decreasing. I think the company is enjoying lower interest on debts, and interest has seemed to reduce yearly, in contrast to increases in debt amount.
The consumer market of Kroger Company is stable, because it is offering the basic commodities that people needs. Intercontinental Hotels Group Based on the concept of optimal capital structure, I think Kroger is relying too much on debt. This is reflected on their balance sheets for the years 2005 to 2007. As the debt have increased by 4 times, the total stockholder’s equity have also reduced 3x. However, based on their income statement for the same years, EBIT is relatively high compared to the cost of debt. The firm is also enjoying lower interest rates on their debts.
But this will change when EBIT will decrease at its lowest. I believe its too much reliance on debt will bring financial distress to the firm in the future. And the fact, which hotel groups generally rely on travel and tourist industry, economic recession, will surely offer a big threat to Intercontinental hotels group reliance on debt. This is because, unlike on Kroger Company, tourist and other traveling groups relatively decreases especially when households around the world experience lower income. Whirlpool Company
The Whirlpool Company employs higher equity than debt to capitalize their business. This is shown on their balance sheet during the three years from 2006-2008. But it is also apparent that during the year 2008, they have increased their debt and reduced their equity. But I think the company must switch to lower debt ratio, and increase their equity by investing more shares. Observing their income statement, there was a successive reduction of its Earnings Before interest and Taxes starting 2006. The year 2008 was the lowest EBIT for the company.
But I believe the scarcity of funds have relatively high influence on its decision to increase debt. We can also observe how interest on debt has helped reduce their tax liability. But in general, there is a great danger associated with their reliance on debt. The company must work hard on increasing their EBIT, otherwise the company will no longer enjoy tax shields and may no longer able to meet the fixed cost obligation to their lenders. If EBIT will continue to decrease, the company will experience financial distress for sure within the next years.