The capital structure decision and the cost of capital

The Capital Structure Decision and the Cost of Capital

            Debt financing involves borrowing money by a company whether for its capital expenditures or working capital through selling bills, bonds or notes to institutional investors or individuals or getting a loan. This act makes the company a debtor to its lenders. The company pays its lenders principal and interest after the specified period. The interest is calculated with an agreed rate and the lender does not acquire a share in the company it has lend the money. The main institutions involved in debt financing are banks, Small Business Administration (SBA) and government agencies (Welsh, 1996).

There are various advantages for debt financing to borrowers. First, it gives the company that borrowed an opportunity to manage its business without interference from investors or other financial institutions that would like to become business partners. Since the lender has no stake in the business, the borrower can go ahead and make decisions in the business without interference from the outside. Secondly, the borrower will not split the profits with other people like investors. As long as the borrower pays the interest, the lender does not disturb him and he can go about with business comfortably. Thirdly, interest paid from the loan is tax deductible hence reducing the company’s overall tax burden. The amount saved can be injected into other viable projects to stir the company’s growth. Fourth, small businesses can apply for Small Business Loans that have a lower interest rate. This will enable them get money needed to fund their projects and they will pay at a lower rate than other customers will. The company can inject these savings into other profitable projects. Fifth, the reports prepared are not complex. This is very advantageous for a small business (Damodaran, 2005).

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The disadvantages for debt financing are first that if a business does not pay loans on time to the banks they will lower their credit rating making borrowing difficult in future. Secondly, commercial banks may require the lender to give some of their assets as collateral. This happens mostly for new businesses and means that the owner of the business will lose his personal assets incase the business goes under. Thirdly, the owners are exposing themselves to bankruptcy since the more debt used, the higher the likelihood of becoming bankrupt. Lastly, there is still the risk of losing personal property even when the business is incorporated. This is so because the lenders will still take personal property in case of default as long as it was the collateral (Welsh, 1996).

Use of debt financing increases the shareholders’ required rate of return. This is because shareholders know that the debt holders have prevalence over them in interest or principal payments. Incase of bankruptcy, legal costs are first paid, then the debt holders and the remaining amount is shared among the shareholders. To compensate themselves from such a loss, they ask for a high rate of return (Gold, 2006). If a company incurs more debt, there is a greater risk of bankruptcy and since the addition of more debt is risky, the shareholders will demand for a higher rate of return.

An optimal capital structure is a capital structure that has the minimum weighted average cost of capital therefore maximizing the company’s stock value but not its earnings per share. This kind of structure involves some percentage of debt and equity. Each company has its own capital structure. There are many methods of determining a company’s optimal structure, one of them being the use of CAPM (Damodaran, 2005).

            General Dynamics Corporation is a US defense conglomerate that came into existence because of mergers and divestments. In the world, it is ranked the fifth largest defense contractor and has four major business segments namely combat systems, information systems and technology, aero-space and marine systems. The companies making the marine systems are National Steel and Marine Systems, American Overseas Marine Corporation, Bath Iron Works and Electric Boat. The Combat systems are Dynamics Land Systems, which include Crusader Self-Propelled Howitzer and M1Series Abrams Main Battle Tank among others. General, General Dynamics Armament and Technical Products, Dynamics Robotic Systems, General Dynamics European Land Combat Systems and General Dynamics Ordnance and Tactical SystemsInformation systems and technology are General Dynamics C4, General Dynamics Advanced Information Systems among others and there is Gulfstream Aerospace in the segment of aerospace(Harvey, 1995).

            General Dynamics makes approximately $30 billion sales mostly military but National Steel, which builds ships, and Gulfstream sells to civilians. General Dynamics has acquired many companies in the 20^th and 21^st centuries. Its beta is 1.22.

            Sprint Nextel Corporation deals with wireless communications, which include walkie-talkie service and IP broadband access services. Sprint merged with Nextel in 2005 to form Sprint Nextel therefore enlarging its market. This merger was regarded to as a merger of equals and the shareholders agreed to the merger unanimously. The company is the third largest wireless network in the US with approximately 48.1 customers. Its beta is 1.04 (Gold, 2006).

            Dell Inc is based in Texas and deals with making and selling computers and its parts and offers computer related services. The company sells servers, personal computers, network switches, data storage devices, computer peripherals, software, printers, HDTVs, cameras, MP3 players and electronics made by other manufacturers. Dell has many customers around the world and 96,000 employees. Dell is more like family business and therefore has few shareholders. Its beta is 1.34.

             In light of the information above, General Dynamics should embark on a high debt equity ratio. Its beta is 1.22 meaning that the industry is quite volatile and to stay in business and make an impact they have to be well-funded (Gold, 2006). Since it involves purchase of heavy-duty materials to make ships and aero-space, it means that it will need a lot of capital. In most cases, getting that kind of capital from equity would be difficult unless the company had millions of shareholders. Since the company is a US defense conglomerate, it limits the shareholding to the government and other related corporate. This significantly reduces the choice of equity as a source of funds. In its case, it would be good for General Dynamics to borrow from the government.

The advantages are that first, it will give the company a low interest rate. It is also very efficient since the government is its major shareholder. Issuing shares to the public takes a lot of time and since many investors would like to understand the business before investing, it would mean some vital information on the countries defense would be leaked to outsiders who probably are enemies. It is also easier for the government to borrow from commercial banks because governments are considered stable therefore giving confidence to banks that they will pay. The same happens to individuals; people like buying government bills and bonds because the risk is low. This low risk translates to a low premium but the people usually prefer a lower risk and a lower return than a high risk and a high return (Harvey, 1995).

            Sprint should have a medium debt ratio. This means its debt-equity ratio should be close to 1.00. It should get slightly more money from lenders and the rest from shareholders. Since it is a merger between two companies, a substantial number of shareholders who can give the kind of capital required are present. Its beta is almost 1.00, which supports this kind of capital structure. Being a wireless network company that is profitable, many people are conversant with its services and would readily buy shares if they were floated. Because of its profitability, its existing investors would be willing to take-up right issues therefore lending money to the company. The company can borrow a little bit more from other institutions that have no stake. This is to reduce their tax burden since the interest paid is allowable.

Many financial institutions would readily offer the company a loan because of its profitability and asset base, which could be used as collateral. In addition, the fact that Sprint is quoted in the stock exchange motivates the company to be responsible so as not to lose its customers. The kind of industry Sprint is in is very competitive and involves a lot of technological advancement. Since the shareholders know this, it would be easy to call upon them to contribute more money so that the company can expand its operations therefore maintaining its competitive hedge in the industry. Leaning a little more on debt would be advantageous to the company since it does not have to incur floatation costs and there is a lot of paper work involved when making a public offer. Saving time is sometimes of essence especially in a dynamic industry such as the one Sprint is in.

            Dell optimal capital structure should be a low debt ratio; meaning that equity should be more than debt. This is because it is more of a family business and therefore has few shareholders. With such strong ties, every shareholder is closely involved in the running of the company. Since Dell is a volatile industry, which is indicated by its beta of 1.34, it would be good to borrow shareholders money because they understand the industry. Shareholders are paid dividend when the company makes profits (Gold, 2006). Incase of losses, the losses will be carried forward and they will not receive dividends that year. This means the company will be under no immediate pressure to pay, unlike when a company has a loan and must pay interest. The investors who come in and give equity capital could also give skills that could be useful to the business. Since the investor has a stake in the business, he will work very hard and do a lot of research to ensure that the company grows. It is therefore important that dell gets to bring in collaborates with good knowledge of the industry and resourceful. The other advantage is that equity investors would be willing to give funds in future, for the company’s growth. Though raising money through equity is time consuming with good planning, funds can be raised on time so that the company can continue competing effectively with the other companies. Equity financing makes an investor have a stake in the company. It therefore means that dell cannot make decisions without consulting with the shareholders this could lag the decision making process. Since the advantages outweigh the disadvantages, it would be good for Dell, to have a low debt ratio structure

 

 

 

 

 

 

 

 

 

 

 

References:

Biger, N.. Finance : A Conceptual Approach. Carlisle, UK:  Butterworths, 1981.

Damodaran, A., (2005). Finding the Right Financing Mix: The Capital Structure Decision. Retrieved August 2009, from: http://pages.stern.nyu.edu/~adamodar/pdfiles/cfovhds/capstr.pdf

Gold, J., (2006). “Reducing a Company’s Beta: A Novel Way to Increase Shareholders Value.” Journal of Applied Corporate Finance, Vol. 18, No. 4.

Harvey, C., (1995). The Capital Structure and Payout Policy.

Retrieved August 2009 from: http://www.duke.edu/~charvey/Classes/ba350/capstruc/capstruc.htm

Welsh, I., (1996). A Primer on Capital Structure. Los Angeles, LA: The John E. Anderson Graduate School of Management, University of California, 2009.