Equity and debt
Introduction
Walt Disney is a company that deals in the distribution and sales of Toys and children clothes and accessories. The company intends to finance its investment by use of short term financing opportunities by utilizing short term maturities since they can be refinanced easily in a few years at much lower rates. Walt Disney needs to raise this amount of money through the sale of long-term bonds to prospective investors. This move intends to keep the firm’s cost of capital within the two percentage points below the recommended level. Walt Disney also thought of financing of investment on debt capital as opposed to equity capital i.e. to save the cost of equity capital. These adds to approximately 4 to 4.5% of its regular cost of capital on savings.
The use of financial leverage, in these case Bonds free flow of cash for the firms generating more than enough cash required to fund extra NPV opportunities, reducing their perk consumption and the value destroying positive growth. The managers increases the free cash flow by ensuring there is utmost efficiency in the firms overall operations. Failure means the managers will opt for outside board members, takeover bids or substitution of the existing strategies. The debt holders also controls the diffuse free ridding stock holders hence it reduces the Equity Agency costs.
The signalling Theory MM assumes that the investors and interested parties including the managers have similar information. Where most of the information are mutual, stockholders also assumes that firms will issue new stock where Bonds are overvalued and issued. Where undervalued stocks are issued it indicates lower FCF, unwillingness to commit to increased debt financing service. Leverage-decreasing events indicates overvalued stock and vice versa which is supported by empirical data.
The signalling theory attributes in pecking order hypothesis companies will most likely choose from the following arrangement of funding sources to maintain overall financial stability. The first choice is retained earnings, extra cash debt issuance, and stock issuance. Profitable companies use less debt because they can source funds easily internally(equity) These contradicts off theory that suggests high debts because of low rates of defaulters and the need for tax incentives.
The trade-off theory of capital structure favours the issue of bonds as done by Walt Disney since it has more of a tax benefit than the issue of dividends to equity holders (Modigliani and Miller, 1958).This enables the firm to meet its objective of maximizing returns by replacing equity with debt. On the other side of the divide, bankers as well as other financial analysts seem to be in favour of the employment of debt as a tool to ensure increased profitability and hence increasing the value of institutions that are running on debt. The first advantage of debts that makes them so attractive as opposed to equity funding of companies is the fact that the burden of debt is significantly reduced when the business has been operating on debts.
Target Corp is a company that deals in clothing, electronics among other sports equipment. It’s a cash flow from investment activities dropped by 31% in the year 2013 from the year 2012. The management of Target Corp decided to adopt new strategies and increase its investment in long term projects.
The capital structure theory was researched and developed by Modigliani and miller. The two professors came up with the capital structure theories that concluded that in perfect markets, the capital structure of a company mattered not so significantly and the choice a company makes regarding its financial operations and financing its activities. The value of a firm is significantly determined by its ability to generate enough income and increase its earning power and also subject to the risk of its future prospects and the underlying assets, and that its immediate value is entirely independent of its choice of selection in investment and the distribution of dividends.
The management of Target Corp had considered using debt capital obtained from bonds floated in the public. These is in relation to cutting down the cost of capital which according Target Corp would be much higher if they opted to finance the investment using bonds floated in the public than through the shareholders equity capital which are not exempted from taxation and which have long term interest repayment period. These decisions are made by the managers as in the case of Target Corp whose management decisions fall under the capital structure theories of Modigliani and miller model trade-off theory, agency theory, and signalling theory. The effect of the debt borrowed by Target Corp on its capital structure depends on its impact on WACC feedback to FCF. With no taxes, (MM proposition 1) Target Corp value will be independent of its own capital structure. The irrelevance proposition of MM Capital structure assumes a situation of no taxes and no bankruptcy costs, the average weighted cost of capital remains constant even with changes in the company’s capital structure. The capital structure does not affect the company’s stocks since there are no changes or benefits from positive increases in debts therefore irrelevant. Capital can only be viewed as irrelevant under very tight and restrictive assumptions as MM theory concludes.
Where taxes are applicable in the MM Proportion 1, the total value of the unlevered company is equal to its earnings before taxes and interest which eventually adds up as the cost of equity. The value of unlevered company is equal to the company of unlevered firm with its additional taxes capitalized eventually at the cost of its debt. (Burgess, 2006).
Trade-off theory points at the optimal capital structure being attained at the point where its marginal distress costs exceed its marginal tax advantage from the additional debt in the MM model. These costs are only applicable at high levels of debt, otherwise the WACC of many capital structures are mostly unaffected. Target Corp intends to save between 4-4.5% of its cost of capital, by replacing the shareholders equity by the debt capital.
Debts can reduce relatively the Equity Agency problem of managers using company finances to fund non essential expenses (such as perks, irregular acquisitions or investment in retarded projects) or invest in low risk due to the undiversified interest in company problem which is common in large companies with diffuse owners or stock holders where management owns very little in the company’s shareholding. (Modigliani and Miller, 1958, Myers, 1984).
References
Burgess, K. (2006). Pressure building for public companies to adopt private equity tactics. Some institutional investors are questioning whether companies should put up more resistance to approaches from buy-out firms and use some of their typical methods to create value. Financial Times-London Edition.
Modigliani, F., and Miller, M. (1958).The cost of capital, corporation finance and the theory of investment.The American economic review, 48(3), 261-297.
Myers, C. (1984) The Capital Structure Puzzle, The Journal of Finance. 39 (3)
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