Bamburi Cement Ltd. (Bamburi Cement) is a Kenya based cement production company. Bamburi Cement, through its subsidiaries is primarily engaged in the manufacture and sale of cement and cement related products, which include the Portland cement, Portland pozzolana cement and Portland limestone cement. The company´s products are marketed under various brand names which include Power Plus Cement, Nguvu Cement, Supaset, Multi Purpose and Plasta Plus. Bamburi Cement also owns and manages a world class nature and environmental park that was developed from the rehabilitation quarries. The company has its operations in Kenya and Uganda. The company is headquartered at Nairobi, Kenya.
In this study, Bamburi Cement has used the total debt-to-assets (or debt-to-capital employed) as a measure of its capital structure. Total debt includes interest bearing long-term and short-term debt. Assets include fixed assets and those current assets that are financed by debt.
This paper is divided into several sections namely; Definition of Capital Structure; Rajan and Zingales (1995) argue that the definition of capital structure would depend on the objective of the analysis. For example, for agency-problem related studies, capital structure maybe measured by total debt-to-firm value ratio., Relevance of Capital Structure; The prevailing argument, originally developed by Modigliani and Miller (1958), is that an optimal capital structure exists which balances the risk of bankruptcy with the tax savings of debt. Once established, this capital structure should provide greater returns to stockholders than they would receive from an all-equity firm.
Evaluation of the Capital Structure of Bamburi Cement Company; Bamburi's debt-asset ratio of 22.9% and capitalization ratio of 24.2% shows that it is less dependent on leverage, i.e., money borrowed from and/or owed to others. As seen elsewhere in this paper Bamburi Cement operates in a highly dynamic environment and their choice of capital structure measure resonates well with what modern thinking is, about, finding the right or best financing mix. Firms in industries characterized as exhibiting high levels of dynamism are more successful if they had relatively low levels of debt.
One of the dramatic changes created by the expanding global economy is the increase in the rate of change within industries. And as more industries experience greater levels of change, the use of debt-centered governance will prove less effective in the near future.
The other areas covered include; determinant factors of Capital Structure, Limitations in improving Capital Structure and How to improve Capital Structure.
INTRODUCTION
Bamburi Cement Ltd. was founded in 1951 by Felix Mandl - a director of Cementia Holding A.G. Zurich. Cementia later went into partnership with Blue Circle PLC (UK). In 1989, Lafarge, the world's largest building materials group, acquired Cementia, and thus became an equal shareholder with Blue Circle. Lafarge bought Blue Circle in 2001 to become the largest building materials company in the world and Bamburi Cement Limited principle shareholder.
It's first plant Mombasa started production in 1954 with annual capacity of 140,000 tonnes of cement. Today the Mombasa based plant has the capacity to produce of 1.1 million tonnes.
In 1998, a new one million tonne per annum clinker grinding plant was added just outside Nairobi, increasing the total production capacity to 2.1 million tonnes. With the new plant, Bamburi Cement has been able to improve it's service to Nairobi and upcountry markets, through speedier and more efficient packing turn around time, The rail sliding at the Nairobi plant has also facilitated sales to Western Kenya and Uganda.
Bamburi Cement is the largest cement manufacturing company in the region and it's Mombasa plant is the second largest cement plant in sub-Saharan Africa. It is also one of the largest manufacturing export earners in Kenya, exporting 28 per cent of its production in 1998 (29 per cent). Export markets include Reunion, Uganda and Mayotle. In the past, they have also included Mauritius, Sri Lanka, The Comoros, Madagascar, Seychelles and the Congo.
Bamburi is primarily engaged in the manufacture and sale of cement and cement related products. Bamburi also owns and manages a world class nature and environmental park developed from rehabilitated quarries.
Bamburi has financed its various expansion projects through debt over the last six years although its capital structure is a mix of debt and equity. However, there is a reduction in borrowings propping up the cash balances that are expected to fund expansionary capital expenditure.
Firms are free to choose whatever mix of debt and equity or capital structures they desire to finance their assets, subject to the willingness of investors to provide such funds. In some firms, such as Chrysler Corporation, debt accounts for more than 70 percent of the financing, while other firms, such as Microsoft, have little or no debt.
A firm's capital structure should attempt to determine what its optimal, or best, mix of financing should be. Determining the exact optimal capital structure is not a science, so after analyzing a number of factors, a firm establishes a target capital structure it believes is optimal, which is then used as a guide for raising funds in the future. This target might change over time as conditions vary, but at any given moment the firm's management has a specific capital structure in mind, and individual financing decisions should be consistent with this target.
1.1 Definition of Capital Structure
Capital structure could be defined in different ways. In the US, it is common to define capital structure in terms of long-term debt ratio. In a number of countries, particularly the emerging markets, companies employ both short-term and long-term debt for financing their assets, including current assets. It is also common for companies in developing countries to substitute short-term debt for long-term debt and roll over short-term debt. Hence, it is more appropriate and particularly in the context of developing economies, to define capital structure as total debt ratio. Rajan and Zingales (1995) argue that the definition of capital structure would depend on the objective of the analysis. For example, for agency-problem related studies, capital structure maybe measured by total debt-to-firm value ratio. Debt could be divided into its various components, and numerator and denominator could be measured in book value and market value terms. In this study, Bamburi Cement has used the total debt-to-assets (or debt-to-capital employed) as a measure of its capital structure. Total debt includes interest bearing long-term and short-term debt. Assets include fixed assets and those current assets that are financed by debt.
1.2 Relevance of Capital Structure
A capital structure that is appropriate is a decision that is critical for any kind of business organization. Such a decision is vital not only due to the impact it would have on the organization's ability to handle its competitive environment but also the need to maximize returns to the different organizational constituencies. There is a prevailing argument developed originally by Miller and Modiglian (1958), which states that there is the existence of an optimal capital structure that balances the tax savings of debt with the risk of bankruptcy. Once such a capital structure is established it is capable of providing bigger returns to the stakeholders than they would get from an all-equity organization.
Financial management researchers have not managed to find the optimal capital structure despite its theoretical appeal. The best practitioners and academics have managed to achieve are actually prescriptions that satisfy short-term goals. For example, recently in a Harvard Business Review article, readers were given the impression that using leverage is one of the ways to improve an organization's performance. This can be true is some circumstances although it does not consider either the long-term survival needs of an organization or the complexities of the competitive environment.
Using leverage either to achieve economic gain or discipline managers is sometimes considered the 'easy way out' although in most instances it could lead to the death of an organization. An indication of some flaw in the logic is the fact that no optimal capital structure has been found. The original query was incorrectly framed. Instead off: What is an optimal mix of debt and equity that will maximize shareholder wealth; it should have asked: Under what circumstances should leverage be used to maximize shareholder wealth? Why? Because equity and debt usually have profound long-term implications for corporate governance which exceed the exigencies of the moment by far.
To understand the issues in question requires one to look at the origins of the concept of using debt to control managers and then reconciling this kind of thinking with the need to survive in today's competitive environments.
They observed that ownership and control had become separated in larger corporations as a result of the dilution in equity positions. This situation provided an opening for professional managers, as those in control, to act in their own best interest. Today, the central issue for agency theory is how to resolve the conflict between owners and managers over the control of corporate resources through the use of contracts which seek to allocate decision rights and incentives.
In the 1990s, one defining characteristics of business was the adapting of prescriptions from agency theory to look at managerial extremes of 1970s and 1980s. Means and Berle came up with the classic agency theory concept (1932). They noticed that control and ownership had been separated in bigger corporations due to dilution in equity positions. The situation offered an opening for the professional managers, as those in control, to act in their own best interests.
Managers have various incentive to help them follow growth-oriented strategic options. The bigger the organization, the greater the political and economic power of its top management team and the greater its capability to assemble the necessary resources to effectively deal with its social and competitive environment. Larger organizations are also seen as being in a position of sustaining their freedom from the discipline of capital markets. Generally, we can say that growth does actually lead to an increase of the shareholder's wealth. However, it is feared that most of the activities associated with increasing the size of organizations are motivated by opportunities for self-interest of management and not by the desire to maximize wealth of the shareholders.
Debt creation is the contractual device that agency theory suggests to realize transfer of wealth from an organization to its investors. Debt offers a means of bonding manager's promises to pay out future cash flows. It is also a means to control opportunistic behavior by dipping the available cash flow for flexible spending. It is thus clear that the attention of top managers is to pay attention to the activities that are necessary to make sure that debt payments are made. Companies that fail to make principal and interest payment may be confirmed involvement and could thus be dissolved. Using debt as a punitive tool makes survival in the short-term the main issue for all concerned.
Agency theory has also some significant implications for the relationship between debt-holders and stockholders. Stockholders are usually attracted to the return over and above the amount that is needed to repay debt. The main interest of debt-holders is the debt payment which is specified in the contract. Stockholders are occasionally seen as having an interest in pursuing business activities that are riskier than what debt-holders would desire. When this happens, debt-holders might charge higher prices for debt capital and also institute greater control measures to stop the top managers from investing capital in undertakings that are riskier.
Agency theory does not however the necessity for managers to make choices beyond a stockholder's wealth-maximizing perspective nor does it consider competitive environments. This may appear to be a serious omission for two reasons. Firstly, equity and debt represent constituencies that are different which have their own competing and often goals that are mutually exclusive. Secondly, as the debt level increases, the structure of corporate governance could change from one of internal control to one of external control. For those firms that adopt debt as a control mechanism, lenders become the key constituents in their corporate governance structure. This could have an impact that is significant on both the ability of the organization to deal with its competitive environment effectively and also on managerial discretion.
A characteristic distinguishing the strategic management discipline is its emphasis on the competitive environment of the firm. In order to survive and succeed, an organization has to find a match or fit between its internal management systems and the demands of its competitive environment. The organizational structure and the management system for any given organization is usually a product of the set of specific environmental contingencies it is facing.
Strategic management recognizes also the fact that the organization has multiple objectives and constituencies, and also accepts that it might not be possible to achieve all the objectives or maximize returns of all the constituencies. More importantly. strategy is usually concerned about the long term survival of the firm within its competitive environment. This normally requires a model of the firm that is more complex than that envisioned by either economics or finance. Such disciplines assume away cognitive limits in their assumption of efficient markets and complete information. On the other hand, strategic management accepts the argument that managers are limited in their ability of gathering and processing information. We can therefore say that choosing capital structure more a matter of searching for alternatives in an uncertain and complex environment and less a matter of alternatives that are predefined.
Across the industries there are significant differences in the environmental characteristics impacting organizations. The most relevant among the characteristics is environmental dynamism which is defined as the rate of environmental change and the instability of that change. Environmental dynamism is usually as a result of different forces operating at one time. They include an increase in the number and size of organizations within a certain industry, increase in the rate of technological variation plus its diffusion throughout that industry.
For all involved parties (including stockholders, debt-holders, top managers and others), as environmental dynamism increases it results in an increase in actors increased inability to assess both the present and the future state of the environment accurately. This limits their ability to establish the potential impact of decision-making on future and current business activities and determining feasible alternative that organizations should pursue. This means that the effect of increasing environmental dynamism levels is reduction of access to knowledge required in making critical decision. This as a result reduces the predictability and stability of relations among organizations and their constituents within a certain industry. It is thus a logical inference that varying degrees of environmental dynamism could have a differential influence on similar activities occuring between industries. This means that since the degree of environmental dynamism varies across industries, it would be reasonable to expect significant differences in adaptive capabilities that are required for survival and that such differences should have implications on performance.
Table 1 below can verify this. It is a table showing a rank ordering of industries based on their extent of measured environmental dynamism. The industries located towards the top of this table are those characterized as having high dynamism level. This means that the rate of change plus the degree of uncertainty about future states makes decision-making hard. Conversely, the firms in the industries found towards the bottom of the table are in relatively benign environments.
Table 1
From the perspective of a firm. a higher cost of debt capital could cause a decrease in its attractiveness to different stakeholder while greater external control by debt-holder could interfere with the ability of the firm to navigate within its competitive environment effectively. This would indicate that firms need to engage in business activities that are riskier since the firm has to respond to changing competitive pressures, using debt financing would be an impediment that would subject managers to both the constraints and discipline of capital markets.
This data was used to study the economic performance of more than 700 firms across 31 industries. These results are shown in Figure 1 below. The findings were that firms in industries characterized as showing high dynamism levels were more successful if they had comparatively low debt levels. This means that debt was related negatively to profit in these industries. The relationship between innovation and debt was also examined and the findings were similar. In environments that are more dynamic, debt-holders are less likely to appreciate the need of investing in long-term projects that have pay-offs that are questionable.
Figure 1
The relationship between economic performance and debt across types of environment
The results displayed in Figure 1 provide guidance also for investors and practitioners on how to approach the question of capital structure. The firms in industries toward the top of this table should choose equity over debt in financing projects whose outcomes are uncertain. Those firms in industries toward the bottom of the table should consider increasing debt to increase returns to investors. There are practical examples of this from the 1990s. Coke, located in an industry toward the bottom of the table, did increase its debt in 1998. This resulted in a considerable increase in shareholder wealth and returned excess cash flow to investors. In contrast, Kodak, located in an industry toward the top of the table, has struggled through most of the 1990s with excess debt relative to other firms in its industry. As a result, investors have forced the firm to cut back on essential research and development, and inhibited the firms expansion into emerging high tech industries.
This study is a serious test to the traditional capital structure literature. One of the dramatic changes created by the expanding global economy is the increase in the rate of change within industries. As more industries encounter greater levels of change, the use of debt-centered governance will prove less effective in the near future.
The first duty of managers is to guarantee the long-term survival of the organization within its competitive environment. In a world devoted to quick fixes, and short-term thinking edited by sound bites, it is difficult to take time to think through serious challenges. As environments become more competitive, those who make the time to reach appropriate decisions will be the ones left standing.
Bamburi cement operates in an environment that is highly dynamic and their choice of capital structure measure resonates well with what modern thinking is, about, finding the best or right financing mix. Firms in industries characterized as exhibiting high levels of dynamism are more successful if they had relatively low levels of debt.
1.3 Evaluation of the Capital Structure of Bamburi Cement Company
In this study, Bamburi Cement has used the total debt-to-assets (or debt-to-capital employed) as a measure of its capital structure. Total debt includes interest bearing long-term and short-term debt. Assets include fixed assets and those current assets that are financed by debt.
Period
Year 6-2009
Year 5-2008
Year 4-2007
Year 3-2006
Year 2-2005
Year 1-2004
Sources of Funds:
Kes 'millions'
Share capital & Reserves
20,941
16,602
15,075
13,736
11,281
10,485
Long Term Debt
6,227
6,170
2,422
2,319
2,230
2,348
27,168
22,772
17,497
16,055
13,511
12,833
Weight of Sources of Funds:
Share capital & Reserves (we)
0.7579
0.71522
0.85454
0.84878
0.82725
0.8077
Long Term Debt (wd)
0.24206
0.28477
0.14545
0.15121
0.17274
0.1922
Dividends per share
11.00
6.00
6.00
5.50
5.30
6.12
Market price per share
156.00
165.00
196.00
215.00
140.00
95.00
Cost of Sources of Funds
Cost of Share capital (ke)
7.05128
3.6363
3.0612
2.5581
3.7857
6.4421
Interest rate, i
9.5
9.5
9.5
9.5
9.5
9.5
Corporation tax, t
0.3
0.3
0.3
0.3
0.3
0.3
Long Term Debt (kd),
i(1-t)
6.65
6.65
6.65
6.65
6.65
6.65
Growth in Equity (G)
25.82
8.90
9.31
21.89
8.27
(10.43)
Ke+G
32.87
12.54
12.37
24.45
12.06
(3.99)
kewe
25.34
9.14
10.66
20.92
10.07
(3.26)
kdwd
1.5242
1.8017
0.9205
0.9605
1.0975
1.2167
Weighted Cost of Capital, WACC
(%)
Ko= kewe+ kdwd
26.8609
10.9446
11.5800
21.8802
11.1662
-2.0448
Net profit
Kes 'millions'
6,970
3,412
3,810
2,799
2,155
1,901
Total Assets Kes '000'
27,168
22,772
17,497
16,055
13,511
12,833
Return On Investment
(ROI %)
25.655
14.9833
21.7751
17.4338
15.9499
14.8133
1.5 Determinant factors of Capital Structure
Factors Determining Capital Structure
Trading on Equity- The word "equity" denotes the ownership of the business. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to supplementary profits that equity shareholders make because of issuance of debentures and preference shares. It is based on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general rate of company's earnings, equity shareholders are at advantage which means a company should go for a well thought-out blend of preference shares, equity shares as well as debentures. Trading on equity becomes more significant when expectations of shareholders are soaring.
Degree of control- In a business, it is the directors who are so called elected representatives of equity shareholders. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Preference shareholders have reasonably less voting rights while debenture holders have no voting rights. If the company's management policies are such that they want to preserve their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares.
Flexibility of financial plan- In an enterprise, the capital structure should be such that there is both contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which provides inflexibility to plans. Therefore, in order to make the capital structure viable, the company should go for issue of debentures and other loans.
Choice of investors- The company's policy commonly is to have different categories of investors for securities. Therefore, a capital structure ought to give adequate choice to all kind of investors to invest. Adventurous and bold investors generally go for equity shares and loans and debentures are generally raised keeping into mind conscious investors.
Capital market condition- In the lifetime of the company, the market price of the shares has got an important influence. During the depression period, the company's capital structure generally consists of debentures and loans. While in period of inflation and boons , the company's capital should consist of share capital generally equity shares.
Period of financing- When company wants to raise finance for short period, it goes for loans from banks and other institutions; while for long interval it goes for issue of debentures and shares.
Cost of financing- In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that debentures at the time of profit earning of company ascertain to be a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits.
Stability of sales- An established business which has a growing market and high sales turnover, the company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and company is in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If company is having unstable sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such cases.
Sizes of a company- Small size business firms capital structure generally consists of loans from banks and retained profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. The bigger the size, the wider is total capitalization.
1.6 Limitations in improving Capital Structure
Four problems that tend to increase as leverage escalates: (1) a growing risk of bankruptcy; (2) lack of access to the capital markets during times of tight credit; (3) the need for management to concentrate on finances and raising additional capital at the expense of focusing on operations; (4) higher costs for whatever additional debt and preferred stock capital the company is able to raise. Aside from the unpleasantness involved, it is noted that each of these factors also entails tangible monetary costs.
1.7 How to improve Capital Structure
Effective capital structure management can he achieved through consistent use of the following strategies.
strategy 1. organize for effective capital structure management
The essential building blocks for effective capital structure management include obtaining and providing education, establishing the team, and defining the organization's attitude toward risk.
Education ensures that the board of directors and senior leaders are on the same page about the benefits and importance of effective capital structure management to the organization's competitive financial performance.
strategy 2. determine the appropriate level of debt capacity
Debt capacity, the amount of debt an organization is capable of supporting within a particular credit rating profile, establishes the parameters of the debt portion of the capital structure. The figure must expand each year if the organization wants to remain strategically and financially competitive.
strategy 3. determine the optimal mix of debt-to-equity financing and traditional-to-nontraditional financing
Once an organization determines its debt capacity, it knows how much it can borrow in the debt markets and how much capital will need to come from other sources, both traditional and nontraditional. Targets for the appropriate debt to equity ratio are based on debt capacity, rating agency benchmarks, and tolerance for risk.
strategy 4. select and achieve the "right" relationship between fixed-rate debt and variable-rate debt
Every organization has a different "right mix" of fixed-rate to variable-rate debt. The mix is dependent on the organization's bond ratings, availability of bond insurance, amount of free cash, investment policy and the board's attitude toward risk, and changing interest rates.
strategy 5. diversify variable-rate debt and avoid exposure to any one form of risk
Variable-rate debt comes with certain risks, including basis risk, put risk, bank risk, credit risk, and failed auction risk. A diversified variable-rate debt portfolio can mitigate these risks and lower the organization's overall cost of capital.
strategy 6. pursue a level debt structure with the longest possible final maturity
The average life of an organization's overall debt and its amortization and maturity structure have a significant impact on current and predicted cash flow and debt capacity. The lowest net present value of any payment structure is generally the longest amortization obtainable in the capital markets and permitted by tax law.
strategy 7. monitor and continuously adjust the debt portfolio
To maintain maximum flexibility, lowest possible interest costs, and acceptable levels of risk, organizations must proactively and regularly adjust their portfolios as changes occur in the market and in the portfolios themselves. The importance of effective and efficient capital structure management to an organization's long-term competitive strategic financial performance cannot be overemphasized. Use of the above capital structure management strategies will increasingly reward organizations with the know-how and muscle to achieve a strategic financial competitive advantage.
