This essay will compare and evaluate the Capital Structure and the Cost of Capital of GlaxoSmithKline (GSK LN) PLC and AstraZeneca (AZN LN) PLC, and determine the composition of their Equity by using the firms' Debt to Equity Ratio, Weighted Average Cost of Capital and Capital Asset Pricing Model. GlaxoSmithKline (GSK LN) is a Multi-National Pharmaceutical Company that specialises in the development of advanced medication and other diverse societal health related products and services with the objective of pro-longing and increasing life expectancy. GlaxoSmithKline was ranked the 5th while AZN LN ranked 6th amongst the top Pharmaceutical Industry in 2011.
Capital Structure
"The study of Capital Structure attempts to explain the mix of securities and financing used by corporations to finance real investment" (Myers, 2001). The main source of finance used by GSK LN and AZN LN are debt and equity in their operations over a decade (10 years) (see the attached Financial Statement)
Equity Financing
GSK LN and AZN LN use Ordinary Shares, Retained Earnings and other equities as their main Source of Equity Financing. GSK LN Equity Finance over a decade ranges from £5,804,000 to £10,742,000 with the highest in 2007. Conversely, AZN LN had an equity ranging £6,670,506 to £15, 134,440 with the highest in 2011. It was observed that from 2002 - 2011 the average equity that formed the total finance of GSK LN and AZN LN were 27.46% and 46.09% respectively. The Equity Finance of both Companies increased from 2007 to 2011 which could be linked to the World Economic crisis that started in 2007. However, both companies are not financed by preference shares. (see the Financial Statements of the two Companies).
Debt Financing
The liabilities of both GSK LN and AZN LN include: Short and Long Term Borrowing, Interest and Account Payables with Share Capital. GSK LN has higher total liabilities than AZN LN with an average ratio of 72.54% in its equity compared to AZN LN which has an average of 53.91% total liabilities to its equity. The debt financing focuses on the long and short-term borrowings of the two companies as shown in appendix 2
Debt/Equity Ratio
"The debt/equity ratio determines a company's debt-paying ability" (Gibson, 2011). It supports creditors in determining how protected they are from insolvency. It is also referred to as the leverage.
Fig 1 and 2 compares the debt/equity ratio of GSK LN and AZN LN.
Fig 1. Debt-Equity Ratio
Fig 2. Leverage Ratio
It is observed from fig 1 and 2 that GSK LN is highly leveraged than AZN LN. Generally it is believed that leverage can increase a firm's expected earnings per share. This implies that the expected earnings of GSK LN are anticipated to be higher than that of AZN LN. Modigliani-Miller (1958) however argues that a firm's debt-equity ratio does not affect its market value in their first and second propositions on capital structure. This is confirmed by Fig 3, comparing the Earnings Per Share (EPS) of the two Companies. The EPS of AZN LN is higher than that of GSK LN over a decade with £4.5719 in 2011 compared to £1.046 for GSK LN in 2011. At the onset of the economic crisis in 2007, both companies recorded a decrease in EPS. However, AZN LN overcame the fall and its EPS increased gradually from 2008 to 2011 whilst GSK LN ESP increased from 2009 to 2011. The growth in the EPS of GSK LN can be attributed to the company's charge to resolve long-standing legal matters which impacted earnings in 2010.
Fig 3. EPS
Cost of Capital
The Cost of Capital for GSK LN and AZN LN is their cost of using funds from their Creditors and Shareholders. These are the Long Term sources of Funds, Equity and Debt Financing.
Cost of Equity
Cost of Equity is the cost of the firms raising additional funds by issuing shares. The cost of equity for GSK LN and AZN LN are compared over a decade using two models; the Capital Asset Pricing Model (CAPM) and the Gordon Growth Model (GGM) which is a simplified form of the Dividend valuation Model (DVM)
Capital Asset Pricing Model (CAPM)
The CAPM relates the rate of return of equity finance to its market risk measured by beta. Fig 4 describes the cost of equity of the two companies using CAPM.
Fig 4. Cost of Equity (CAPM)
The cost of both companies increased from 2007 to 2010 as more shares were issued to finance their operations during the financial crisis which affected the pharmaceutical industry as a whole. GSK LN recorded their highest with 11.93% in 2010 while AZN LN recorded 11.01% because the company issued a total of 1,409 million shares as at 31st December 2010 and a net share repurchased of $ 2,110 million in 2010 which was the reason for it highest cost of equity in 2010.
The Gordon Growth Model
The GGM assumes a constant growth rate in dividend of the companies. With different dividends over a decade, the average dividend is assumed to be the constant growth rate for the GGM to be applied. The cost of equity of AZN LN is higher over the period to GSK LN as shown in fig 5.
Fig 5. The Gordon Growth Model
The different assumptions underlying GGM and CAPM give different cost of equity to the AZN LN and GSK LN.
Cost of Debt
The Cost of Debt is the effective rate at which both GSK LN and AZN LN will pay their current debt. Fig 6 describes the cost of debt structure of both companies over a decade. Both Companies have a correlated cost of debt with the highest rates in 2006 and lowest rates in 2011. AZN LN as part of its re-financing programme issued further bonds in 2007 at the cost of $6.9 million which resulted in its highest cost of debt at 3.77% in 2007.
Fig 6. Cost of Debt.
Weighted Average Cost of Capital (WACC)
The WACC is the cost associated with the capital structure a firm uses. It is also the rate required by GSK LN and AZN LN to pay on the average all their shareholders to finance their assets. Fig 7 shows the WACC of both companies over the 10 year period.
Fig 7 WACC
Appendix 1 also describes detailed WACC valuation while Appendix 3 describes the capital structure of both companies associated with the WACC.
The WACC of AZN LN over the period is relatively higher than GSK LN.
CONCLUSION:
In conclusion, it is drawn from the analysis made that both Pharmaceutical Companies are of high standard and both are financed by Debt and Equity. GSK LN had higher debt and less equity while AZN LN had lower debt and higher equity. A stabilizing economy will have a positive impact on both AZN LN and GSK LN. The cost of debt and cost of equity of both companies decreased in 2011 indicating a positive prospects in the future operations of the companies. It is recommended for the two companies to invest in research and developments to develop cheaper sources of financing their operations.
References:
Jones, J, & Lumby, S. (2011) Corporate Finance; 8th Edition, Theory and Practice, South-Western Cengage Learning, Cengage Learning EMEA, Hampshire UK.
Berk, J. & DeMarzo, P (2011) Corporate Finance, 2nd Edition, Pearson Education, Prentice Hall, Boston USA.
Ryan, B. (2007), Corporate Finance & Valuation, Thomas Learning, London UK.
Myers, S. (2011) Capital Structure, The Journal of Economic Perspectives, Vol 15, No.2 pp 81 - 102. American Economic Association. Available online at http://www.jstor.org/stable/2696593 Accessed on 22/11/2012.
John, H (1999), Corporate Finance Manual: Determining Cost of Capital The Key to Form Value, Great Britain: Financial Times Prentice Hall.
AstraZeneca PLC, Full Year Results 2007. Available online at http://www.astrazeneca.com/cs/satellite. Accessed on 20/11/2012
AstraZeneca PLC, Full Year Results 2010. Available online at http://www.astrazeneca.com/cs/satellie. Accessed on 20/11/2012
GlaxoSmithKline PLC, Annual Report Review 2010. Available online at http://www.gsk.com/content/dam. Accessed on 20/11/2012
AstraZeneca PLC, Financial Statements. Available at Bloomberg Database. Accessed on 15/10/2012.
GlaxoSmithKline PLC, Financial Statements. Available at Bloomberg Database. Accessed on 15/10/2012.
Appendices
Appendix 1
WACC
Year
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
GSK LN
8.31%
8.24%
7.99%
8.65%
7.20%
7.93%
7.03%
7.21%
10.23%
7.51%
AZN LN
8.27%
8.92%
8.62%
8.66%
8.54%
9.17%
8.36%
8.19%
10.36%
8.22%
