Optimal leverage analysis
The Toll Holdings Limited is an Australian company whose operations are majorly in transport on roads, sea, rail and air. The company, in its operations, requires to be financing at all times. Sometimes the profits the company makes are not enough to finance all its projects. It, therefore, calls upon the company to think of a better way to finance its projects. One of the ways of financing the projects is through taking of debts. These debts are supposed to be scrutinized by both the company and the lender. Some debts might have some negative implications on the company and, therefore, require informed decision. Therefore, the financiers have developed ways and means of trying to evaluate the riskiness of financing such a company.
In the valuation of the business to see how best to evaluate the sources of finances, there are a number of parties involved. These parties are the stakeholders of the company. Stakeholders of any company are those people that are interested in the operations of the business. According to the stakeholder’s theory, the stakeholders of Toll Holdings Limited are the customers, shareholders, managers, suppliers among others. These have a direct contribution to the amount of finances required to operate a business. For example, to satisfy customers well, they require providing good travel services.
The owners of the business cannot run a business by themselves but must have to involve other people referred to as the agents. These agents are the ones who oversee the day to day operations of the organizations. According to the agent theory, the relationships between the agents and the principals must be enhanced at all times. Relationship between the two determines how effective the organization runs. How organization runs depends and also determines the amount of finances that is required by the firm. The principles are the financiers of the company and are the shareholders of the company. These sometimes run into a conflict in the management of the business and thus pose a risk to business operations. We, therefore, look at some of the ways that we can gauge the amount of such a risk.
Use of debt in financing is a good way of expanding business operations. The problem arises when the use of debts that are also known as leveraging becomes excessive. The interests on the debt may take the top line in taking large chunks of the company sales. Therefore, the company would end up having fewer funds left for marketing of products, research and developments and making other investments. Because borrowing of funds should always be under check. A company with huge debts becomes vulnerable in times of an economic downturn. When a corporation is struggling to pay regular interests, the investors are likely to lose confidence with the company and may end up bidding down the share price. To some extent, in the most, the company may become bankrupt.
For these reasons, many investors have developed some ways to help them analyze a business before financing it. These means help them understand the financial stand of the company before thinking on how they should invest in it. The trade-off consideration is a major way of analyzing a business. Trade-off consideration is important because it takes into account the benefits and the costs or raising the required capital through equity or debts. One of the important reasons of the trade-off theory is to bring to the attention the fact that corporations are financed in two ways. A corporation is usually financed partly by equity and partly by debts. A firm is supposed to take into considerations the amount of debt to take in financing its projects. It should be recognized that the marginal benefit of a further increase in debts goes down as the debts increase while the marginal cost goes up.
A firm that is optimizing on the overall value would, therefore, lay its focus on this trade-off when deciding on the amount of equity and debt to use in financing. It is easier for somebody to think that a corporation may use more debts than do. The main reason they never are because of the risk of bankruptcy and at the same time the risk of volatility that is usually found in the credit markets. It usually occurs especially when a firm attempts to take very huge debts.
Therefore, to summarize on trade-off, it can be defined as the idea that a company may choose on how much equity finance and debt finance to use by trying to balance benefits and costs. In developing this theory, some considerations were made, that is the dead weight of the bankruptcy and the saving benefit of tax of debt. More often the agency costs are also included in the balance. The theory expounds that there is a benefit of financing with debt, which is the tax benefit of debt. There is also a disadvantage financing with debt that is the financial cost of distress.
Dividend imputation is a situation in which some or all the taxes paid out by a company might be attributed to the shareholders of the company in the form of tax credit in order to reduce the income tax that is payable in the event of income distribution. It, therefore, eliminates the disadvantages that are involved in distributing dividends to shareholders by requiring them to pay only the difference between their marginal rate and the corporate rate. The shareholders are exempted the disadvantage of paying the personal taxes directly that renders itself more expensive as opposing to imputed tax. In most cases, firms would pick the capital structure by making a trade-off of the benefits of the tax shield from debts against the cost of the financial distress. It should also be recognized that the value of a levered firm would equal to the value of the value of the firm without leverage plus that present value of the expected tax savings got from debt, being less the present value of the financial distress costs expected.
The present value of the expected financial distress costs depends on the possibility of financial distress. This probability would increase with the volatility and the cyclicality of the cash flow, revenue and the asset values of the firm. Another reason is the operating leverage and the amount of the liabilities of the firm in relation to its assets and cash flow. From this we note that, a firm with high leverage ratio, or have a low interest coverage ratio, therefore, has a higher bankruptcy probability. The trade-off theory is capable of explaining why firms choose debts that are too low in order to have an exploitation of the interest tax shield. It is due to the availability of the financial distress costs.
Trade-off is also capable of explaining the differences in the use of leverage across industries. Financial distress may differ across industries due to the asset type. It is because intangible assets lose more value in the event of bankruptcy. It is evident that the quantity of debt affects the level of default. Therefore, higher debts have a higher possibility of default and lower debts have low default possibility. As the debt level increases the level of default also increases. Therefore, firms should increase their leverage level to the optimum where the value of the firm ids maximized. At this maximum level, the interest tax shields marginal benefits that are a result of the increasing leverage are, therefore, perfectly offset by the marginal costs of the financial distress.
The above trade-off theory is a theory that is based on two individuals, the financier and the debtor. The agency theory can explain the two act as agencies and their relationship. The ideology is based, therefore, on the fact that an agency relation exists where one party acts on behalf of another party. Sometimes these parties may have different ideas and thus conflict in their thoughts. It would bring about the agent problem that is brought by the availability of a conflict between the involved parties.
These agencies would, therefore, be involved in the determination of some of the crucial decisions of the firm in a way likely to explain their total interest. It, therefore, means that they would be involved in the operations of the firm and how the firm makes decisions. In the process of making decisions, the agencies may end up having a conflict that may bring about a misunderstanding. In this case, the agencies are the Toll Holdings Limited and the shareholders. The understanding of the two agencies is, therefore, crucial to the business. The earnings per share of the Toll Holdings Limited were 11.8 cents with a net profit attributable to the owners of the company amounting to $84.5 million. This might be viewed as an improvement in the company. The rise in the earnings can be accorded to an increase in the amount of investments in the company.
In another theory, the stakeholders, theory, the argument is the same. The non-financial stakeholders of the firm include the customers, suppliers, employees and community surrounding the firm. The theory dictates that a financial distressed firm is most likely to be liquidated in the future. Therefore, the non-financial stakeholders may be hurt by the financial difficulties of the firm. It, therefore, means that they may be less interested in doing business with the in the event of a financial distress. Customers may require to be given a discount to purchase products of a distressed firm. The customers may also avoid purchasing altogether. The result of this is decreased revenues. Under this condition of financial distress, the long-run reputation value of the firm may decline and become less than those of the short-run in order to avoid bankruptcy.
The result of this is the Toll Holdings Limited reducing the quality of the services to the customers in order to cut the costs of operations. When the quality is not easily eminent to the customers, the result is customers avoiding travelling with the company. It would therefore bring a negative impact on the firm's revenue and profit. The suppliers to the firm would also be affected in a different way. They may avoid doing business with distressed Toll Holdings Limited or may charge higher costs for their supplies. The result of this is a rise in the firm cost of operations. The suppliers would not provide favorable credit terms and this affects the operations of the firm. The firm's working capital requirement increases.
In additional, the predatory marketing theory of the product is brought about through importation of the product with low price than the existing product in the market. This contributes to lowering the rate in the market as well as affecting the financial status of the firm. The Toll Holding Limited has to introduce new tactics to deal with the market situation concerning the predation of the market has made the firms level of service offering to give less return. This has resulted to unfair competition hence low performance.
A higher levered firm is less attractive to the employees. The reason behind is that the firm is more likely to be liquidated, more likely to lay off workers or at the same time offer employees constricted chances of advancement. A high debt ratio is costly for firms that that try to attract talent. Therefore, Toll Holdings Limited should try to evaluate its leverage ratio in order to avoid employees shunning off the opportunity. Very high levered firms may be vulnerable to predators in the same line of operations. A low levered rival would initiate price competition by reducing prices, and the high levered firm would be unable to counter the reduction in prices due to its high operation costs. This makes the firm stand at a disadvantage to its rival firm.
References
Baker, H. K., & Martin, G. S. (2011). Capital structure & corporate financing decisions : theory, evidence, and practice. New Jersey: John Wiley & Sons.
Cheng-Few Lee, . L. (2010). Handbook of quantitative finance and risk management. New York : Springer.
D. van der Wijst, . v. ( 2013). Finance: A Quantitative Introduction. Cambridge: Cambridge University Press.
John B. Shoven, . W. (2012). Debt, Taxes, and Corporate Restructuring . Washington D.C: Brookings Institution Press.
