Corporate finance strategy involves identifying the possible strategies and methodologies that help in maximizing the shareholder's value and the market value of the organization. It is the area of finance which involves dealing with monetary decisions. A number of decisions can be included under this, ranging from whether a project should be undertaken or not, or the interest rate at which capital should be borrowed if required. But broadly speaking there are three decisions which comprise the corporate finance strategy. These are the financial decisions, investment decisions and the dividend policy.
Financial Decisions
The financial decisions involve deal with deciding the capital structure of the firm, the sources of the fund for a particular project to be undertaken by the company. Capital may be raised through equity or debt. Each of the two methods has its own merits and demerits and it becomes imperative on the management to decide which method it should be going ahead with. The performance of the company can change significantly by changing its capital structure. For example, EPS, which is considered to be a performance indicator of a company, can be significantly improved by borrowing more. It conceals the debt of the firm as its value depends on the profit after tax and the number of outstanding shares. Thus, the capital structure over here may show the company in good light, which may not be the case in actual reality. Thus the value of a firm can significantly change by bringing about changes in its capital structure which in turn affects the shareholder's wealth.
Investment Decisions
The investment decisions of the firm deal with the question as to whether the shareholders should be given a share of the company's profit in the form of dividends or the profits should be held back and put into an investment. The decision involves profitable usage of the company's fund in the long term. A number of parameters like the net present value, internal rate of return etc. are used to decide whether one should go ahead with a project or not. Since, it is not possible to determine the future cash flows from a particular project with complete accuracy; the decision involves a lot of risk.
Dividend Policy
These decisions determine the division of income between payments to the shareholders in the form of dividends and retained for re - investment in the organization. Although both dividends and retained earnings are desirable, their objectives are conflicting. Greater the dividend, greater will be the earnings for an investor, but reduced retained earnings which in turn decreases the capital available with the company for investment or expansion purpose.
The discipline of corporate finance can be divided into long term and short term decisions. The short term decisions are concerned with the balancing of current assets and current liabilities, by managing cash, inventories and short term borrowing and lending. Capital structure plays an important role both in the long term and the short term. The long term decisions on the other hand include the three decisions mentioned above which include the investment, financial and dividend decision.
Capital Structure
The capital structure of a firm is concerned with the proportion of debt and equity to finance the company's operations. It is applicable for the long term as well as short term scenario, as it decides how the mix of long term debt and short term debt mix looks like. In addition to these, it also involves the following:
If a project is to be financed through equity, whether it should be through primary issue or rights issue?
What is the extent to which the company's internal funds should be used for financing a project vis-à-vis the external funds which can be raised?
The financing pattern decision is a significant managerial decision as it influences the shareholder's wealth. Capital structure is dynamic in nature, it changes continuously. It changes from the time of the company's inception to its expanding process. The change in the debt-equity mix will affect the cost of capital of a firm. The cost of capital of a firm is the threshold level below which the company will not accept a project. As the cost of capital of a firm increases, it becomes increasingly difficult for the firm to accept projects which will give them return lesser their threshold levels.
The capital structure policy and the dividend policy are interrelated. The dividend policy affects the profits which can be retained for reinvestment. This in turn affects the capital structure. Thus, the capital structure of a firm has a huge bearing on the net profit, dividend payout ratio, cost of capital and the earnings per share.
According to the irrelevance theory provided by Modigliani and Miller, the market value of the firm depends only on the income stream generated by its assets. The value of the firm, according to their theory, should not be affected by the financial structure or by what will be done with the profits - returned as dividends or retained for reinvestment. In a perfect capital market, the irrelevance model is absolutely valid, but in an imperfect market differing views prevail. There is no, till this point of time, universally accepted model which explains as to whether, the value of a firm is affected by changes in capital structure.
Determinants of Capital Structure
Several studies shed light on specific characteristics of a firm that determines the leverage ratio. There are a number of characteristics like fixed assets, tax shields, size, profitability, uniqueness of the product etc. that affect the leverage of a firm in a positive manner or in a negative manner. The factors which have been included in this study are explained below.
Size
According to Rajan and Zingales claim, "Larger firms tend to be more diversified and fail less often, so size may be an inverse proxy for the probability of bankruptcy. If so size should have a positive effect on leverage. However size can also be the proxy for the information that outside investors have, which should increase their preference for equity to debt". The empirical studies do not provide any clear picture in this regard. Some studies show a positive relation between size and leverage and some show negative. The natural logarithm of sales is used to proxy for study in this study.
Profitability
According to the trade-off theory, more profitable companies should have higher leverage because they have more income to shield from taxes. However according to the pecking order theory, wherein firms prefer internal financing over external, profitable companies should have lower leverage as they will have lower need of external financing. In this study, profitability is proxied by return on assets.
Asset Tangibility
Tangible assets can be used as collateral; therefore higher tangibility lowers the risk of a creditor and increases the value of assets in case of bankruptcy. Thus a positive relation between tangibility and leverage is predicted. In this study tangibility is defined as Net Fixed Assets by Total Assets. There are some empirical evidences which show a negative relationship and others show positive relationship between tangibility and leverage.
Tax
According to the trade-off theory, the company with higher tax rate should use more debt and therefore should have higher leverage, as it has more income to shield from taxes. The variable which will represent tax in this study is the difference between earnings before taxes and earnings after taxes scaled by earnings before taxes.
Non Debt Tax Shields
Non Debt Tax Shields are items apart from interest expenses that contribute to the decrease in tax payments. According to Angelo - Masulis: "Decreases in investment related tax shields which reduce the real value of tax shields, will result in the firm increasing the amount of debt employed." So the relation between non - debt tax shields and leverage should be negative. Depreciation divided by total assets is used as a proxy for Non Debt Tax Shields.
Volatility
Volatility may be understood as the risk of the firm or the probability of bankruptcy. Thus, volatility and leverage are negatively related. The volatility is represented by the standard deviation of return on assets.
Growth
A negative relationship between growth and leverage if predicted because (according to Myers) a investment with high debt effectively transfers wealth from stockholders to debt holders. The compounded annual growth rate in sales will serve as a proxy for growth in this study.
Uniqueness of Product
Higher the debt, higher is the risk of liquidation of the firm. The core of the debate here is the trade-off between the benefits of leverage, in terms of payout discipline of managers and the cost imposed on customers, who are harmed by the firm getting liquidated and exiting the market. The concern is more in case of firms which produce durable goods wherein customers want after sales service. The concern for viability, by the consumers is pronounced when the firm's product is highly differentiated from its competitors. This is because, if the products were similar, then consumer can get the after sale service from the competitor which would not have been possible otherwise. Thus, there is a negative relation, expected, between the leverage and uniqueness of the product.
The above expected relations of the variables can be summarized in the table below.
Variable
Measure
Expected Relation
Size
Natural logarithm of sales (
Positive
Profitability
Return on Assets (
Positive / Negative
Asset Tangibility
NFAT(
Positive
Tax
Positive
Non Debt Tax Shields
Negative
Growth
CAGR in Sales
Negative
Volatility
Negative
Uniqueness of the product
Research & Development Expense
Negative
Table : Determinants of Capital Structure
Data, Sample Period and Variables - Considered for present study
The sample period for the present analysis is from 2006-07 to 2010-11. The stocks considered for this analysis are of the companies listed in the London Stock Exchange constituting FTSE 100. The data for the study has been obtained from the website of London Stock Exchange. The variables used in the study are enumerated in Table 2.
Variable
Explanation of Variable
TBTA
Total Debt to Total Assets
TBCE
Total Debt to Capital Employed
ROA
Earnings Before Interest & Taxes to Total Assets
SIZE
Natural Logarithm of Total Assets
TAX
Tax Paid to PBT
NDTS
Depreciation to Total Assets
VOL1
Coefficient of Variation of Return on Total Assets
VOL2
Coefficient of Variation of Return on Sales
NFATA
Net Fixed Assets to Total Assets
GROWTH
CAGR of Total Assets between
Table : Variables and their Definition
Findings and Analysis of Results
The final number of companies considered for the analysis is 69. This is due to the paucity of data available for all companies for the given time period from London Stock Exchange Website.
Variable
Mean
Standard Deviation
Skewness
Range
Minimum
Maximum
Count
TBTA
0.640313
0.220525654
-0.62115
0.973325
0.010726
0.9840514
69
TBCE
0.87778
0.4030025
1.455255
2.831865
0.010842
2.8427069
69
ROA
0.09436
0.08651742
1.645033
0.564378
-0.081072
0.4833059
69
SIZE
9.468501
1.954771397
0.82234
7.541921
6.850137
14.392058
69
TAX
0.233105
0.198974286
1.059718
1.919599
-0.613538
1.3060606
69
VOL1
0.059002
2.660688785
-5.05875
22.09974
-17.84664
4.2531072
69
VOL2
0.035846
2.6016512
-3.901
21.65705
-15.12108
6.5359621
69
NFATA
0.203244
0.215027964
0.932727
0.810314
0
0.8103138
69
GROWTH
0.102083
0.098076727
0.556606
0.504273
-0.125767
0.3785063
69
Table : Descriptive Statistics of Variables
The variables have been averaged over the period of five years, the sample period of 2006-07 to 2010-11. Stepwise regression is used to find out the significance of each variable over the debt ratio using EViews software.
The equations for regression are:
LEVERAGE (TBTA) = β1GROWTH + β2NFATA + β3NPM + β4ROA + β5SIZE + β6TAX + β7VOL1 + β8VOL2
And
LEVERAGE (TBCE) = β1GROWTH + β2NFATA + β3NPM + β4ROA + β5SIZE + β6TAX + β7VOL1 + β8VOL2
Figure 1 shows the results of the stepwise regression when run to determine the significance of variables over the measure of capital structure, TBTA and Figure 2 shows for TBCE. The figures depict the details of the method used, forward or backward stepping regression to determine the end results.
Asset Structure as determinant of Capital Structure
According to the agency theory, firms with larger fixed assets tend to borrow more by keeping the fixed assets as collateral. Thus the value of the assets increases in case of bankruptcy. Therefore a positive relation is expected between NFATA and Leverage which is the case in the scenario when TBTA is the dependent variable, but not when TBCE is the dependent variable.
Taxation vs. Capital Structure
As per the trade-off theory, the companies with higher tax should borrow more so as to have greater tax shields. But the results contradict the theory as the variable TAX is not significant in both the cases, TBTA & TBCE.
Effect of Return of Assets on Leverage
According to the pecking order theory, the profitable firms should not be borrowing more. But the results show otherwise by indicating a positive relationship between return on assets (ROA) and leverage (TBTA, TBCE).
The results of stepwise regression are shown below.
Constant
GROWTH
NFATA
NPM
ROA
SIZE
TAX
VOL1
VOL2
R2
Adj. R2
TBTA
0.47
*
-0.301
*
-1.012
0.034
*
0.018
*
0.55
0.52
TBCE
1.005
*
*
*
-1.351
*
*
*
*
0.08
0.07
'*' indicates the insignificance of that variable
Figure : Stepwise Regression TBTA
Figure : Stepwise Regression TBCE
Conclusion
The study makes an attempt to know the factors that affect the capital structure of the firms which constitute the FTSE 100. In contradiction to the pecking order theory, the leverage is found to be positively related to profitability. That is the firms borrow for their expansion rather than using their internal funds. The tangibility of the assets is found to be positively related to the leverage. In contrast to the trade-off theory, the tax is negatively related to leverage. Moreover, the factor of size also has a positive effect on the leverage which indicates that larger firms tend to borrow more.
