Abstract
Capital structure is a really important concept in the realm of financial management. Capital structure theory requires the management to search for the alternative sources of funds in an attempt to finance the various business operations and growth phenomenon. There are two main sources of capital around which the companies structure their capital financing, being debt and equity. This academic essay is an attempt on the part of the writer to discuss the phenomenon of capital structuring in detail. In lieu of this, the theory of capital structure is investigated in detail with an analysis of Modigliani and Miller model of capital structure. Next, the writer will do an in depth analysis of capital structure practicing of the Coca Cola company, a public limited corporation.
Introduction
Business is an activity that cannot be operated in isolation. With the passage of time, the usual notion of business has changed a lot. The modern day notion of business is that they exist to create certain stuff in the wake of earning a profit and hence, for the creation of this stuff, organizations are needed. In the business world, perhaps, the most important idiom that is of significant concern within business operations, asks for realization of the fact that there is nothing like a free lunch in life and one needs to pay for every luxury cum necessity in life.
This assertion is most aptly suited to the phenomenon of profit making in business. Profits in business are not realized for free, as first one need to invest in business. Investment in the corporate world is then followed by the activity of profit or loss. Henceforth, this investment in businesses is known as business capital, and the process is altogether labelled as business financing. It is no myth to state that this is the most crucial part of any business setup, as it requires the management to utilize all their exceptional decision making skills to decide how to build the capital structure of any business, in wake of risk minimization and profit maximization.
This academic essay is an attempt on the part of the writer to discuss the phenomenon of capital structuring in detail. In lieu of this, the theory of capital structure is investigated in detail with an analysis of Modigliani and Miller model of capital structure. Next, the writer will do an in depth analysis of capital structure practicing of the Coca Cola, a public limited company.
Capital Structure
Capital structure is a topic in financial management that is of utmost importance as the foundations of any business rests with the careful planning of this concept. Simply putting the idea, capital structure can be defined as a term that requires the management to search for the alternative sources of funds in an attempt to finance the various business operations and growth phenomenon . However, defining the term through the technical lens of financial management explains the concept as a proportionate relationship between debt and equity. The financial structure of a corporate entity is the amalgamation of various different means of financing business operations. As far as the documentation of the concept is concerned, the capital structure of any company is listed on the left hand side of the balance sheet, liabilities plus equity portion represents the capital structure.
As has already deliberated, there are two main sources of capital around which the companies structure their capital financing, being debt and equity. Generally, it is perceived that an economy which is characterized with stable trends is better off with more of debt financing, however, the reverse is witnessed if the economy is be faced with volatility or recessionary circumstances. Generally, the risks that an enterprise faces can be categorized under two subheadings namely, business risks and financial risks.
Business risk can be classified as a risk that is inherent in selling a product ranging from a legal issue to suppliers risk, etc. These have implications in the form of reduction of sales, thus affecting business. The financial risks, on the other hand, are related with the payment issues of the bills . A business that is characterized with more of business risk, the management is reluctant to finance that entity with debt, avoiding long term purchase decisions. It is important to note that a debt financed corporation is more exposed to business risks. Hence, the owners are more obliged to equity investments, rather than the counterpart. It is because of this reason that companies want to have a low debt to equity ratio, thus avoiding their respective business risks.
Among the many theories put forward on the concept of capital structure financing, the idea put forward by Modigliani and Miller is most pronounced one. Devised in 1950, the MM approach advocates the capital structure irrelevancy . The theory is of the view that valuation of a company is independent of its capital structure. The market value of the company is independent of the fact that whether the firm is highly leveraged, alternatively has low debt component in the balance sheet. Instead, the market value of a company is dependent upon the operating profit generated from the business. Summing it up, MM approach, applicable under certain assumptions, indicate that the value of a leveraged and unleveraged firm are same if the operating profits and future growth prospects of the companies are same. This theory of capital structure was successful in fetching a lot of scholarly attention, being the nova in the field; it was the first unanimous accepted theory of capital structure. However, the theory was also received by various critics, each having the view that the theory is applicable only under the set and prescribed assumption, limiting the generality of the proposition.
It is a note worthy fact to mention that there are hundreds and thousands of papers that have investigated the applicability of the capital structure theories. In lieu of this, it is asserted that the MM approach to capital structure has its foundations based on unrealistic assumptions. The capital paradigm of any company is influenced by the tax deductibility of interest on debt. There are significant costs associated with financial distress. In short, the approach does not aptly describe the financing process of the businesses but resulted in initiating a discussion on why financing is important in business. The study of these approaches poses certain important implications for managers. Keeping in view of time value of money concept, the managers must consider the tax advantage of debt. Managers must also consider the costs associated with financial distress as well as information asymmetry. Finally, managers must be opportunistic, taking advantage of stock and bond markets, and making financial decisions that seek to enhance their companies’ credit ratings, and investors’ perceptions.
Keeping in view of the implications of the capital structure, there is a need to develop optimal capital structure. An optimal capital structure is one where a balance is maintained between debt to equity pattern while, maximizing the cost of firm’s capital. This concept is central to studies in finance and accounting, as it works towards the desire of establishing a right mix of equity and debt. Every firm, in the corporate world, is perhaps, looking for the optimal capital structure and strives hard to maintain this balance.
Capital Structure theory: The Case for Coca Cola Company
Coca Cola Company is an American based multinational beverage corporation, dealing in the manufacturing, retailing, and marketing of the non alcoholic beverage concentrates and syrup. The year of 1919 marked the listing of this corporate entity as a public limited company . Henceforth, owing to this success rate of the company, it will be really interesting to study the capital structure of such a successful public limited company.
The industry that is in the business of producing non alcoholic drinks is characterised as a beverage industry, production varying greatly on the type of beverage being made. The snapshot of the soft drinks industry statistics is a proof of the fact that the consumption of the drinks has seen a downward trend owing to the global concerns about health, obesity and nutrition. The total US beverage volume has decreased from 60% to 35%, thus, showing a reduced industry trend .
It will not be wrong to say that coca cola is a profitable entity, as is evident from the figures of operating, gross and net profit margins. In 2013, the net profit margin and the gross profit figures for the company are 28.4% and 61.2%, respectively, which is higher than the industry averages. Analyzing the capital structure of the company is instrumental in identifying the type of financing coca cola pursue; either debt only, equity only, or a combination of both.
The figures in the above table present a realistic outlook of the company’s debt and equity position. Comparing the debt to total equity ratio of the company with that of industry averages, points towards an increasing trend for coca cola, pretty obvious from the figure of 75.44%, ensuring that company is on the right track as the figure is on a downward trend year after year . It is also interesting to note that company is on a better position to pay off its debt, as compared to the industry competitors, the main indicator being the quick ratio of 1.13, with interest coverage ratio of 1.75. Both the debt to equity and to capital ratio for the company has significantly decreased over the span of seven years, indicating a healthy sign that the company is depending less on debt activities in comparison to equity structures.
The capital structure for the company consists of net borrowings, dividend payments, share issuances and share repurchases. $40.88 is the recent calculated stock price, with bonds generating a return of 3.03%. Debt financing is used by coca cola as a means to lower the cost of capital, but this debt is established at manageable levels, thus, increasing shareholder’s equity returns, consequently, leaving company at the mercy of vulnerable interest rate scenarios. The capital structure of the company consists of debt and equity, with their respective shares at 54.2% and 45.8% .
Conclusion
The foundation of financial management rests with a comprehensive understanding of the concept of capital structure. It represents a proportionate relationship between debt and equity. The financial structure of a corporate entity is the amalgamation of various different means of financing business operations. There are two main sources of capital around which the companies structure their capital financing, being debt and equity. Looking at the capital structure formation of the Coca Cola Company, it is revealed that the company’s capital structure consists of 54.2% debt and 45.8% equity. The statistics for the company predict a stable financing trend for Coca Cola.
References
Admin. (2013). Annual Report Coca Cola. Retrieved June 21, 2015, from http://assets.coca-colacompany.com: http://assets.coca-colacompany.com/d0/c1/7afc6e6949c8adf1168a3328b2ad/2013-annual-report-on-form-10-k.pdf
Admin. (2015). Coca-Cola Co. Retrieved June 21, 2015, from http://quicktake.morningstar.com: http://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=ko
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