Introduction
Tingyi Holding Corporation is the Chinese company that deals in the production and distribution of instant noodles, baked products, and beverages. The company also produces soft drink under its brand name of Master Kong. The company is the largest manufacturer of instant noodles in China.
Tingyi Holding Corporation was established in 191 by the Wei Brothers of Taiwan. The company got listed in 1996. The soft drink brand of the company, Master Kong, was declared to be the second most recognized brand in China.
The company started producing instant noodles in 1992 under the brand name of Master Kong and expanded its operations to enter into the bakery and beverages segment by 1996. From 2008 to 2010, the company was named as one of the 50 best listed companies in Asia by Forbes, due to its solid financial structure and efficient management and entrepreneurial skills.
In 2012, the company announced their completion of strategic beverage alliance with the PepsiCo Inc., the world's second largest food, and beverage producers. In accordance with the alliance, Tingyi became the franchiser of PepsiCo bottling in China. The company began manufacturing, selling, and distributing the PepsiCo carbonated soft drinks and Gatorade brands. Moreover, both the companies also co-branded their juice brands under the brand name of Tropicana. Branding and marketing responsibilities of these brands remained with PepsiCo.
The alliance of the company with PepsiCo created a long-term value for the shareholders of the company and its local bottling partners. After the alliance, the company played a vital role in growth and development of beverage industry in China by introducing new innovative products and improving efficiency by reducing costs. The company is the wholly owned subsidiary of Ting Hsin International Group. It is headquartered in Tianjin, China and listed on Hong Kong Stock Exchange.
Modigliani and Miller Theory on Capital Structure
Modigliani and Miller presented a capital theory in 1950 that advocated a theory of irrelevant capital structure. The theory suggested that capital structure does not play any role in the valuation of a firm. In other words, whether a firm has low debt, or it is highly leveraged, it does not make any difference to the market value of the firm.
The capital structure can be defined as the means through which company finances its assets and operations. The operations of a company can be financed either by equity or by debts or by the combination of both the components. Any approach taken by the company, where the low debt or high leverage, has its own merits and demerits. Many theories have been presented in the past to develop a relation between the market value of a company and its financial leverage. Among many other theories, the theory of Modigliani and Miller also represents a distinguishing view.
The theory suggests that market value of the firm is impacted by its future growth plans and capital structure, or financing decisions have no bearing on market value. If future growth prospects of the company are higher, its market value would be higher and in turn, its stock prices will move up. On the other hand, if the future growth prospects of the company are not higher, the investors would not be attracted, and the value of the shares would decline.
The theory is based on the following assumptions:
The cost of buying and selling securities and bankruptcy cost is nil.
The cost of financing is same for companies and individual investors.
EBIT of the company is not affected by the debt financing.
There are no implications of taxes
There is no information gathering cost and the information available to the investors is same as that available to the corporations.
There are two propositions of Modigliani and Miller approach without taxes. The first proposition is that, given the assumption of no taxes, the value of a company will not be affected by the capital structure. It shows that equity shareholders and debt holders will be given the same priority in the company and profits of a company will be shared equally among them. Popescu and Sorin state that, in substance, the theory suggests that future expected cash flows are divided equally between investors and the company’s value remain unchanged by this share-out. Pan (2012) says that without the effect of tax, the value of the unlevered firm (VL) and the value of the levered firm (VU) in the capital structure will be same. It can be written as follows:
VL = VU
The first proposition with the effect of tax suggests that since the interest payment is excluded from tax payments, a firm that has more debts are more valuable. They called it as a tax shield effect. Alifani and Nughoro stated that current system of tax excludes interest from tax payments due to which tax paid by firms having debt structure is lower as compared to the firm that has no debt in their capital structure . Pan (2013) said that value of levered firm, in this case, would be equal to the value of unleveraged firm plus product of tax ratio and value of debt:
VL = VU + TcD
The second proposition is that financial leverage of a company is directly proportionate to the cost of equity. The shareholders will attribute a higher risk with the increase in debt component. Hence, the shareholders will demand a higher return, and the cost of equity will be increased.
Although the theory stands on the assumption that there are no taxes, this is not factual in the real world. The theory states that interest paid on debts is tax deductible. But the case with dividend payment is different. Hence, due to tax benefits, the actual cost of debt is less than the nominal cost. By applying the tax propositions, the Trade of the theory of Leverage suggests that debt requirements of a company can be capitalized if the cost of bankruptcy is greater than the value of tax benefits.
Thus, the trade of theory considers tax savings and deduces that a change in debt-equity ratio of the company has a direct effect on WACC (weighted average capital cost). In other words, a higher value of debt will result in a decline of WACC.
(Figure 1 above: MM Theory with Tax effect)
(Figure 2 above: MM Theory without Tax effect)
The theory of Modigliani and Miller has been criticized by many authors. For instance, Breuer & Gurtler (2008) argued that first proposition of the theory did not take into account the imperfections of the market. Similarly, the second proposition was argued by the Breuer and Gurtler on the grounds that different countries have different tax laws and regulations due to which market conditions are not identical. They stated that the entire proposition would lose its worth if the country changes its tax laws at any point .
Current Capital Structure of Tingyi Holding Corporation
Tingyi Holding Corporation has a policy to continuously review and monitors the adequacy of its capital structure by optimizing its equity and debts balances and making necessary changes to its capital structure in accordance with the changes in economy and market conditions. The company achieves its capital adequacy objectives by share repurchase programs, dividend payments, and issuance of new debts. While taking necessary steps, the company considers the market rates, future capital expenditures, and opportunities for investments. The primary objective of the company in relation to capital adequacy is to minimize the debt balances to nil balance.
In 2015, Tingyi Holding Corporation maintained a healthy and stable capital structure by applying effective control over its trade debtors, trade payables, inventories, and cash and bank balances. The total assets and liabilities of the company on fiscal year end December 31st, 2015 were$8481.5 and $4587.24 million respectively, decreasing by $724.55 million and $523.14 million respectively as compared to the year-end 2014 . However, the debt ratio of the company still decreased by 1.42 points and reached 54.09% in 2015.
The net long-term debts of the company included interest-bearing notes which decreased by $179 million and reached $2449.56 million in 2015.These borrowings are mainly used by the company for capital expenditures on developing production facilities and financing working capital. The majority of the company's long-term borrowings are denominated in foreign currencies, i.e. 79%. Remaining 21% were represented in Renminbi. The total debts of the company were constituted of 54% of long-term debts while remaining 46% were short-term borrowings. It shows that the long-term borrowings of the company have increased in 2015, since in 2014, the total long-term debts of the company were 47% of the total debts. It is also important to note that because of the changing trends of interest rates in US dollars, the company has revised its financing strategy and has increased its onshore financing while decreasing the foreign currency debts. By following the current strategy, the company plans to increase its borrowings in local currency over time.
Moreover, the company also issued interest-bearing notes of RMB 1 billion. These notes carried interest at 4.375% per annum and will expire on August 2018. These interest-bearing notes were unsecured and are issued for the purpose of refinancing existing debts of the company. It indicates that there is a high probability that the debts of the company will increase further in near future.
Capital Structure Analysis
Theoretical Share Value
Calculation of Theoretical share value per share of target company [Based on Modigliani and Miller theory]:
ROE before tax of low or no debt company =
Unleveraged Firm value =
Effective tax rate of target company =
Leveraged Firm value =
MV of equity of target company =
Theoretical share value per share of target company =
Share price analysis of Tingyi Holding Corporation reveals that average year-end price of the company was $11.06, as compared to the calculated share price of 32.54. The primary reason behind low share price of the company was the decline in its expected earnings at the year end. The net income of the company was $188 million for the third quarter of 2015. However, it declined significantly, and the loss of $86 million was reported by the company in its final quarter.
Return on Equity
The company selected for low or no long-term debt comparison is Monster Beverages. Monster Beverages is US based company that manufactures soft drinks, fruit drinks and energy drinks.
Return on equity evaluates the ability of the company to generate profits by utilizing the shareholders’ investment in the company. It shows the profit generated by using each dollar of investment. The return on equity of Monster Beverages is calculated as follows:
Return on equity of Tingyi Holding Corporation was 0.12 in 2015, as compared to 0.18 of Monster Beverages. The firm with low debt has a high return on equity as compared to firms with high leverage. The analysis ignores other factors including the composition of equity and economic conditions faced by companies. Comparing the company’s leverage with industry averages makes further evaluation of this fact below.
Industry Analysis
Weighted Average Debt to Equity Ratio
The debt to equity ratio is a financial leverage ratio that determines the percentage of capital that is financed by the creditors and investors. A Higher ratio shows that the company is financed more by creditors as compared to the shareholders equity. The debt to equity ratio of Tingyi Corporation was 0.53, 0.56, and 0.54 for 2013, 2014 and 2015 respectively. Three companies were selected to calculate the weighted average debt to equity ratio for the industry – PepsiCo, Coca-Cola Inc., and Nestle Inc. The weighted average debt to equity ratio of 2015 for the industry was 0.648 which was higher as compared to Tingyi’s 0.54 in 2015.
Whether the capital structure is optimal or not varies from industry to industry and depends on upon many factors. In the past few years, the search for an optimal capital structure that can maximize the firm’s value and shareholders wealth has gained a considerable attention globally . However, there could be no single theory that can take into account every factor and circumstances that are required to be included to explain the optimal capital structure.
The tradeoff theory states that it is in the hands of the company to choose how much debt financing should be used to balance the cost and benefits of debt and equity financing. The primary assumption of the theory is that companies achieve optimal capital structure if they are financed partly with debt and partly with equity financing. The analysis of the company for five years reveals that the company has financed its operations with the mix of debt and equity, with the debt financing having a high weightage in each of the year. From 2011 to 2015, the leverage of the company was at average of 0.54 points, except in 2014 where the leverage was increased to 0.56, mainly due to the increase in off shore financing. It indicates that the company has constantly been using trade off theory capital structure in order to obtain the advantage of debt financing and the tax benefits of debts. However, it is important to note that the marginal benefits of debt financing declines as its marginal cost increases. The company should therefore keep its focus on the tradeoff while deciding the ratio of debt and equity to be used. It can be seen that the trade of made by the company in past five years has resulted in the decline of WACC which indicates that the tradeoff of debt and equity applied by the company had been successful in reducing the cost of capital. Finally, when the company reduced its leverage from 0.56 in 2014 to 0.54 in 2015, its WACC reached 0.12 points which is the lowest cost of capital achieved by the company in recent past. Hence, it can be concluded that the company reached its optimal capital structure in 2015, where its cost of capital was lowest.
Miller and Modigliani’s theory assumes perfect conditions in which there are no taxes, bankruptcy cost, asymmetric information, and the difference in risks. The theory suggested that under these given conditions, financial leverage of the company is irrelevant in deciding the shareholders wealth maximization, and there is no optimal capital structure. Myers (2001) explains the Miller and Modigliani theory by stating that “debt has a prior claim on the firm's assets and earnings, so the cost of debt is always less than the cost of equity." He further said if the leverage is increased by using the cheap debts, it increases the cost of capital since the equity becomes expensive and outweighs the benefits of debt financing . When the leverage was low in 2015, its market value was high. Given the theory, it can be said that the debt to equity ratio of Tingyi Holding Corporation would not affect the value of the company. The analysis reveals that value of the company in 2015 was $2,336,556.6 million when its debt to equity ratio was 0.54, and the value of the company was 2,457,398 million in 2014 when it had the debt to equity ratio of 0.56. It indicates that when the leverage of the company was high in 2014, its market value was low and statistics that debt to equity ratio holds no connection with the value of the company and it was the future growth prospects of the company that had an impact on its value.
The market value of the firm can also be analyzed using the famous trade-off theory which states that optimal capital can be reached by balancing the gains and losses of debts. It suggests that the capital structure of every company is unique and changes in debt level should be dictated by the difference in a current and optimal level of debts. As compared to Miller and Modigliani theory, trade of theory justifies that gearing affects the value of the firm and gearing should, therefore, be moderate. Given this framework, it could be said that company's financing decisions to increase its debt financing and the borrowing of Riminbi 1 billion in 2015 had an impact on the value of the firm, and it declined as compared to the value in 2014.
The overall analysis suggests that although Miller and Modigliani's theory provides a deep insight into the capital structures of the firms, the gearing level does have an impact on the capital structure of the firm, as discussed under the tradeoff theory above. The comparison of the company’s debt to equity ratio with the industry average reveals that gearing of the company (0.54) is better than the overall industry average of 0.648, and the company’s decision to use trade off theory capital structure proved to be successful for reducing its cost of capital. Moreover, the possible reasons behind the better gearing ratio and high firm value could be the company’s alliance with the PepsiCo and the company’s strategy to decrease its offshore financing in response to the increasing interest rates, as discussed earlier in this paper. However, although the current capital structure of the company can be regarded as optimal, the plans of the company to increase debt financing can have a considerable impact on the shareholders wealth and can impact the value of the company.
List of
References
Alifani, G. & Nugroho, A., 2013. Proving Modigliani and Miller theories of capital structure: The research on Indonesian cigarette companies. International Journal of Economic Sciences, 2(3), pp.1-20.
Anon., 2015. Annual Report: Tingyi Holding Corporation. Tianjin.
Baker, K. & Martin, G., 2011. Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. John Wiley & Sons: Hoboken.
Breuer, W. & Gürtler, M., 2008. 50 years after MM: recent developments in corporate finance. Journal of Business economics, (6).
Myers, S.C., 2001. Capital Structure. The Journal of Economic Perspectives, 15(2), pp.81-102.
