Introduction 3
Capital Structure Issues 3
Business and Finance risks related to capital structure 4
Modigliani and Miller’s [MM] capital-structure theory . 5
Criticisms of the MM model and assumptions . 5
Capital-structure evidence and implications . 6
Estimating the firm’s optimal capital-structure .. 8
Conclusion .. 10
Introduction
Capital structure management is crucial in enhancing business sustainability. In that respect, as a business environment change, organizations seek to manage their balance between debt and equity application. In that respect, this analysis seeks to demonstrate the effects of capital structure on a business risk and returns. To achieve the objective, the analysis uses the case of Wall-Mart to analyze its capital structure and recommend a suitable structure while noting its possible effect on the Company’s ROI.
Analysis
- A preview of capital structure issues
Capital structure is a company’s percentage of capital at work by type. In that respect, there are two types of capital including debt and equity. The two types has drawbacks and benefits hence part of corporate stewardship and management is seeking to establish the optimal capital structure by considering rewards and risks for shareholders. (Sagner, 2010)
Equity capital is the money that is owned and put up by shareholders and includes the contributed capital that is initially invested by investors in exchange for shares or ownership. The other type of equity capital is the retained earnings representing the profits that have been retained / kept by the company for purposes of funding expansion, acquisitions and growth. The cost of the equity capital is the return that a business must earn in order to attract investors. (Baker & Marti, 2011)
On the other hand, debt capital is the money that is borrowed for business use. In includes debts like long-term bonds and short-term commercial papers. Cost of debt capital depends on the company’s ratings that determine the cost at which it can borrow. Thus, the current fluctuations in borrowing rates owing to uncertain economic conditions presents a risk for businesses like Wall-mart that has a highly leveraged capital structure. (Sagner, 2010)
The mix of the two capital forms for business also depends on its business circumstances with a flourishing business and economy favoring debt financing while volatile business and economy entails high risk for debt financing. In that view, the volatile business environment that faces global economy presents a challenge for businesses in respect to capital structuring as they seek to manage related risks. (Baker & Marti, 2011)
- Business and financial risks related to capital-structure
An organization’s capital structure is guided by its operating environment and business strategies. In addition, the structure also defines the risks that the business could face depending on its suitability. (Baker & Marti, 2011) Such risks associated with the structure can be summarized as follows.
- High cost of debt is a challenged that is associated with highly leveraged businesses. Thus, the use of long-term debts that are subject interest rate fluctuations subjects a business to high costs.
- Liquidity problems that could result if the business had challenges in meeting its obligations when they are due. Wall Mart could face such a challenge owing to its significant current liabilities.
- Bankruptcy is also a risk for a business that is highly leveraged in case of poor performance. That is because performance may fail to support debt payments subjecting a business to bankruptcy. (Sagner, 2010)
- Modigliani and Miller’s [MM] capital-structure theory
The MM theory comprises of four distinct results with the first proposition stating that debt equity ratio has no effect on market value of the firm under certain conditions. The second proposition is that the company’s leverage does not affect the weighted average cost of capital. The third proposition is that the company’s value is not dependent on its dividend policy. Finally, the fourth proposition establishes the indifference of equity holders about a company’s financial policy. (Sheridan, 2002)
The MM advocate irrelevance of capital structure theory and their approach is similar to the net operating income approach. Thus, their view is that a firm’s value is not dependent on whether it is highly or low leveraged. Further, they view the value of the firm to be dependent on the future growth and the business risk rather than on its capital structure. In that view, the theory would consider Wall Mart’s value to be independent of its capital structure regardless of its leverage level and dividend policy. (Sheridan, 2002)
However, Modigliani and Miller do consider other conditions for a trade-off theory. The theory assumes that the company has benefits in leveraging its capital structure up till when an optimal structure is achieved. It also recognizes that there are tax benefits for interest payments as the interest that is paid on debt is tax deductible. In addition, issuing bonds also reduces tax liability for the company. However, it states that dividend payment does not have tax benefits. Thus, the original MM capital theory and the trade-off theory of leverage differ on the trade-off theory’s view of potential benefits to a company for debt capital. (Sheridan, 2002)
- Criticisms of the MM model and assumptions
The MM Model is based on a number of assumptions listed as follows.
- No taxes.
- Homogeneous expectations.
- Perfect capital markets with no transaction costs thus borrowing and lending are at the risk-free rate.
- Riskless debt with all interest rates being risk-free.
- All cash flows are perpetuities as all bonds are perpetuities and all firms expect zero growths. (Sheridan, 2002)
Critics
Contrary to the theory’s assumptions, the real world involves transaction costs, taxes and bankruptcy costs as well as differences in lending and borrowings rates. Further, markets are marked by information asymmetries as well as effects of debts on the company’s earnings. (Sheridan, 2002)
Thus, the MM theory is not applicable to the real world situation. However, the trade-off leverage theory is more applicable as it considers that a business could benefits by increasing its leverage to the optimal point where further leverage does not have benefits in increased ROI. (Sheridan, 2002)
- Capital-structure evidence and implications
Wall mart’s capital structure can be summarized by ratios that have been calculated based on its debt, equity and total capital for the period beginning 2009 to 2013 as follows.
Source: (Wall-Mart, 2013)
In view of the company’s liabilities, equity and total capital, the capital structure can be described as experiencing fluctuation over the period from 2009. That is shown by the increase in the four ratios in 2010, 2011 and 2012 followed by a decrease in 2013. Finally, the ratios increased in 2014 showing the fluctuation in the use of debt relative to equity and total capital. The values and ratios also show that the company applied relatively more debt than equity for its capital structure hence being highly leveraged. (Wall-Mart, 2013)
- Estimating the firm’s optimal capital-structure
In view of Wall Mart’s capital structure and its trend over the analyzed period, consideration of various aspects of the business operations is necessary for decision on the optimal capital structure. Those aspects are considered as follows.
- Business risk
Owing to increasing competition in the retail industry within which Wall Mart operates, there is high risk to growth and performance that is only cushioned by the company’s well-established brand in the market. In addition, the fluctuation in economic conditions presents possible business risks that may not favor heavy borrowing. (Sagner, 2010)
- Tax position
The company’s operations are subject to tax depending on the region of operation. In that respect, it can benefits from tax savings on interest payment. Thus, although Wall mart could reduce its leverage level, it can balance between equity and debt to continue enjoying the savings on tax. (Wall-Mart, 2013)
- Managerial conservativeness
In view of the company’s borrowing in the years 2012 and 2013, some borrowing forms like the secured borrowings are guided by conservative and strict covenants with set debt limits. (Wall-Mart, 2013)
- Growth opportunities
The company operates in a highly competitive market that is saturated. In that view, Wall Mart does not have a great prospect for growth as it has already expanded to various markets and segments. In addition, the fluctuation of the company’s income for the years 2011, 2012 and 2013 shows a limited growth prospect. In that view, the prospect cannot support high debt level capital structure. (Wall-Mart, 2013)
In that view, the company should choose a capital structure that avoids excessive debt. That can be achieved by applying a balanced capital structure with equal debt and equity capital. That would mean the company reducing its debt level that is relatively high given the considered aspects and risks. (Sagner, 2010)
Regarding the structure’s effect on the company’s ROI, it is notable that decreasing the debt level would result to lowering tax savings. In that respect, the company’s WACC would increase in line with the MM theory that states that an increase in leverage would reduce WAA and vice versa. Thus, lowering Wall Mart’s leverage by reducing the level of debt would reduce ROI. However, that would be suitable as a means of managing related risks in the face of limited prospects and market fluctuations. (Sheridan, 2002)
Conclusion
The analysis has demonstrated that the company’s capital structure comprises of two forms of capital including equity and debt that have varying costs. In that respect, Wall mart’s capital structure has been identified to be highly leveraged with relatively high debt compared to equity. In addition, the analysis has identified that the MM theory is not practical in the real world under its assumptions. However, the theory’s version of leverage trade-off applies even to Wall-Mart’s structure. Finally, the analysis of the company’s situation has resulted to a recommendation of lowering the leverage to have a capital structure that is balanced. However, the approach reduces ROI but is an appropriate risk management strategy.
References
Baker, K & Marti, G. (2011). Capital Structure and Corporate Financing Decisions: Theory,
Evidence, and Practice. New Jersey: Wiley.
Sagner, J. (2010). Essentials of Working Capital Management. New Jersey: Wiley.
Sheridan, T. (2002). The Modigliani and Miller Theorem and the Financial Markets’
Integration. Financial Management. 31, 101-115.
Wall-Mart. (2013). Annual Report. Retrieved from,
http://cdn.corporate.walmart.com/66/e5/9ff9a87445949173fde56316ac5f/2014-annual-report.pdf
