A company capital structure regards the way a firm finances its assets. A firm can finance its businesses either by equity or debt, as well as a different combination of the two sources. A company capital structure can contain a lot of debt aspect or a lot of equity aspect, one of the two elements or an equal measure of both equity and debt. Each technique of financing a business has its own advantages and disadvantages; therefore, the business should do an evaluation and choose the best form of financing the business. Moreover, there are a number of capital structure theories attempting to relate the company’s leverage with the company’s market value. This papers aims at evaluating capital structure debate, issues, and theory, while demonstrating how choices of capital structure influence the risk profile and return on investment (ROI) of a selected publicly-held company.
Capital Structure Analysis
Capital structure refers to the manner in which business is financed. A firm can consider financing its business using debts, equity or a mixture of debt and equity at different ratios. The best way to finance a business is determined by the company’s leverage ratio. This is basically determined by the debt to equity ratio. Low debt cost increases return on equity relative to return on asset. However, debt can be very expensive that it lowers the return on equity below return on capital. This puts a business into higher risk, a situation that should be highly avoided. Capital structure affects credit risk. Credit risk is the likelihood that an entity will not manage to pay debts obligations at the right time. A company with low probability of default, low fixed commitments cost and small debt amount is considered to have minimal credit risk. The company capital structure risk can also be measured by use of leverage index. This is computed as ROE/ROA. A ratio of more than one demonstrates a favorable debt financing utilization (Welch, 2011).
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Business and Financial Risks Related to Capital Structure
The financial and business risk of a company highly depends on the adopted capital structure. According to Welch (2011), the employment of non-equity capital that include leasing, borrowing or any other contractual agreement develops a set financial commitment to a firm in form of rent, interest or other duties. This non-equity capital commitment to supplier, yield to financial risk. As leverage augment, the financial commitment rises and thus, the risk rises too. Actually according to Welch, an equal ration loss or gain on assets (ROA) results to a higher magnitude of equity capital (ROE) loss as compared to the gain. This defines the increasing risk principle. Similarly, if the return on invested capital (ROA) is higher than cost of employing non-equity capital there is leverage use gain in increased returns form to the business owner.
Modigliani and Miller’s [MM] capital-structure theory
The MM theory of capital structure was defined in 1950s. This theory advocates for irrelevancy theory of capital structure. It proposes that the firm’s valuation is irrelevant to the firm’s capital structure. Therefore, according to the theory, it does not matter whether a company has low component of debt or is highly leveraged in the mixed financing. This based on the theory contains no any contribution the firm’s value. The theory also states that the firm’s market value is influenced by its prospect of its future growth rather than the involved investment risk. According to MM, the company’s value is not dependent on the financing decision or the capital structure choice of a company. In case a firm contains high prospect of growth, the company has a higher market value and thus, the prices of its stock would be high. In this regard, the market value of a company can only be high if the investors can see attractive prospects of growth in the firm (Miller, 1988).
Criticisms of the MM Model and Assumptions
According to critics, the MM model is highly based on a number of assumptions which makes it hard to be tested. These assumptions include that there is no taxes involved, no costs of bankruptcy, no transaction costs, and no impact of debt on the earnings of a firm before taxes and interest. It also assumes equivalence in the costs of borrowing for both investors and companies and that there is symmetry information about the market which simply implies that both investors and firms contain the same information regarding the market.
These assumptions are considered by most critics of the theory as unrealistic. For instance, transaction cost is real in the real life. Actually a company in real situation has to pay the commission and fees when issuing warrants, bonds, stocks as well as other instruments. Moreover, all these transactions are time consuming and thus, they are not as easy as the MM theory want us to believe. In addition, the theory’s equal costs borrowing, which acts as a fundamental pillar for the theory is unrealistic especially where the borrowing rate is different between the firm and the investor, a situation that is very common in the actual world. According to the theory, investor and firm borrowing money and purchase the shares of the firm have the same end result. According to the theory, investors are leveraged in both cases, which imply that the investors have to assume the risk associated borrowed funds (Bhaird, 2010).
Estimating the Firm’s Optimal Capital Structure
Apple is an international technology company that is involved in selling, developing and designing personal computers, online services, computer software and consumer electronics. The company was established in 1976 by Steve jobs and two of his associates in America. The company’s headquarters are situated at Cupertino, California. The company is currently famous for manufacturing and selling a number of online services and tablets. Based on its financial statements Apple Company has been trading positively in the technology industry. The company has a mixed capital structure, such that it depends on both debts and equity to finance it business. According Morningstar (2015), the company relies more on equity as compared to debts. The debt to equity ratio of the company in the last two years: 2013 and 2014 were 0.14 and 0.26 respectively. This is a clear indication that the company depend more on equity as compared to debt. Moreover, the company has been depending on equity to finance its business all through until in 2013 when the company decided to employ a mixed capital structure. However, based on the above ratios, Apple still has a strong capital structure since it does not depend on debt to effect its operations. According to Welch (2011), firms that depend more heavily on debt to finance their business put their business into greater risks since this kind of financing is comparatively highly levered. Apple is able to avoid such high risks since it highly depend on equity to finance its business rather than debts.
The company’s leverage ratio for the last two years is 1.68 and 2.08 respectively. This is a value of more than 1 and it is a clear indication that the company has managed to keep its debts low and to make a considerable amount of profit. The company return on Asset for the last two years: 2013 and 2014 is 19.34% and 18.01% respectively, while return on equity is 30.64% and 33.61% respectively. The two ratios can be used to determine the company’s leverage index which is computed as ROE/ROA. The leverage index in this case is 1.58 and 1.87 respectively. This is a clear indication that the company has a favorable use of debt financing. Basically Apple Company has demonstrated that it has a strong capital structure. In addition, the company demonstrates a positive financial trend with a steady increase in its revenue, and net income (Morningstar, 2015). The company has as well been making profits since its establishment and thus, even when MM is used to determine its ability, the company will still show positive results.
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