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Working Capital: Benefits of the Money Market

March 14, 2010 Leave a comment

In the Beginning: The Balance Sheet

It all starts, when a couple of entities decide to pool their resources together to generate more resources. They do so by creating a company; and they inject it with their pooled resources [known as equity] along with some long-term debt; the combination of equity and long-term debt consitutes the company’s capital strucutre. The company then converts this capital “into assets [and operates it] to earn economic returns by fulfilling customer needs” (Groth and Anderson, 1997).

Thus, we have established that a company has assets financed through equity and long-term debt. The company’s assets are made up of current assets [which are more liquid: in the sense that they can be converted into cash more readily] and fixed assets [which are more illiquid assets: such as factories]. Like wise,  part of the longer-term debt will be short-term (or current liabilities), to enable day to day financing operations. Therefore, we conclude that current and fixed assets are financed with current liabilities, long-term debt and equity; which are the constitutes of the balance sheet. This is captured in the below formula:

Current Assets + Fixed Assets = Current Liabilities + Long-term Debt + Equity   (equation 1)

Working Capital: What Is That?

In a nutshell, “working capital is the [difference] between current assets and current liabilities” (Pass and Pike, 1987). Current liabilities represents the debts or obligations that must be paid by the company within the duration of one year; whereas, current assets are those assets that will be converted into cash within one year. Therefore, working capital represents the supposed excess cash on hand “to continue business operations” (Needles and Powers, 2004, p.259). The importance of this quantity is that it gages a company’s liquidity; the availability of cash to continue operations and meeting debt obligations.

Ideal World View: Working Capital

In an ideal world, the management of a company would be able to identify all the debt obligations it shall incur in the upcoming year. By knowing such information, management would match the current liabilities with the same amount of current assets; effectively having a net working capital of zero. Referring back to (equation 1) from the previous section, since current assets and current liabilities are equal, they can be dropped from the equation. Therefore, in an ideal world, fixed assets (which have a longer nature of usability) would be financed by long-term debt and equity. So we notice that, there is a matching of the “maturity dates of the assets with the liabilities” (Pass and Pike, 1987). This ideal world view is best captured in the below diagram:


Real World View: Working Capital & Money Markets

Though the ideal world view conceptually makes sense, it is flawed for two reasons. The first of which is that it is very hard to predict with certainty the debt obligations for the upcoming year. The second, and more important issue, is that “current assets cannot be expected to drop to zero … [as] long-term rising level of sales will result in some permanent investment in current assets” (Ross et al., 2008, p.755). This permanent investment in current assets comes partially in the form of accounts receivables, inventories, accruals, etc. Therefore, the real world view diagram will look something like:

A company will want to maintain a working capital such that it would minimize the sum of the carrying and shortage costs; it would do so by “minimizing the amount of funds tied up in current assets” (Filbeck and Krueger, 2005). Why a company would do so, is because short-term debt is much cheaper than long-term debt &/or equity, especially since working capital is financed by their of the latter two.  But if a company wants to maintain a set working capital, its must be able to predict accurately future inflow/outflows of transactions (cash); which as previously discussed, not possible. Thus a company might have, at anytime, a bit more or less cash relative to the optimal capital structures, running costs up; as depicted in the below diagram:

(Pass and Pike, 1987)

That’s were the role of the Money Market (MM) comes in. If a company has excess cash, it would invest it in the MM. Likewise, if it requires additional money, it would obtain it from the MM; which is short-term in nature, meaning cheaper than long-term debt or equity. In that regards, the more developed the MM of a given country, the easier it is for companies to obtain short-term finances, and maintain a working capital that would result in the least amount of costs.

~ Youssef Aboul-Naja

Capital Structure: Optimal Composition

March 7, 2010 Leave a comment

The Bigger Picture:

To start our discussion on how do companies decide on their composition of capital structure, it would be beneficial to take a step backwards, and glance at the bigger picture; prior to jumping into the details. Any company is brought into existence to increase the wealth of its owners; the shareholders. The company does so by generating economic returns through the process of taking “financial capital and [converting it] into assets…[to fulfill] customer needs” (Groth and Anderson, 1997). The financial capital utilized by the company, which becomes its assets, comes from shareholders’ funds (equity) and debt. It is the different percentage claims of the financiers (shareholders and debtors) that make up the capital structure of a company.

As companies are established to increase shareholder’s wealth, managers want to put in place a capital structure to achieve just that. Thus an “efficient mixture of capital reduces the price of capital … [and in doing so] increases net economic returns which, ultimately, increases firm value” (Groth and Anderson, 1997).

But reducing the price of capital is not the only task a company faces as it increase the wealth of its shareholders. A company face other variables such as:

-> Government taxes on the revenue it generates
-> Indirect bankruptcy claim costs, rendered through “higher interest rates” (Ross et al., 2008, p. 463), should the company default on its debts.
So, in selecting a capital structure, taxes and bankruptcy claims must also be taken into consideration; along with reduction of capital costs. Given such qualitative framework, the following questions arise: Is there an optimal capital structure for companies? Is a company’s capital structure a result of its operating context, or underlying principles?
In Principle:

Each company does have an optimal capital structure; and such structure is a result of underlying principles.

As stated briefly, four parties have claims over a company’s earnings: the shareholders (equity), the bondholders (which shall represent the debt portion), the government (taxes), and bankruptcy claims (indirect costs). As companies cannot influence directly the claims of the latter two [taxes and bankruptcy claims], it must do so by optimizing the debt-to-equity mix. “Stockholders choose the debt level to maximize the value of their equity taking into account the cost of default” (Harris and Raviv, 1990).

Modigliani-Miller (1958) have proved that the “value of [a] firm is completely independent of [its] capital structure” in the absence of taxes and bankruptcy costs. It was later demonstrated that “high leverage capital structures” (Miller, 1988) reduce corporate income taxes, as accounting principles require interest expense to be subtracted from earnings prior to tax calculation. With higher leverage [debt] capital structure, more money ‘in theory’ finds its way to shareholders/bondholders; since less of it goes to taxes. But one side effect of increased leverage is the increased risk of bankruptcy. Thus as a company’s leverage increases, so does its bankruptcy claims costs; which is reflected through increased interest rates on debts. With the increase of bankruptcy claims due to higher leverage, less money finds its way to shareholders/bondholders.

So in principal, the optimal capital structure of a company is when the tax shelter gains minus the bankruptcy claims costs is maximized. This should bring about the most wealth to the shareholder’s of the company. Effectively, “the use of the right amount of debt lowers the companies weighted cost of capital” (Groth and Anderson, 1997).

In Reality:

Though the above explanation of how to decide on an optimal capital structure makes perfect sense, it is all academia. “No equation exists to determine the optimal capital structure for a company” (Groth and Anderson, 1997). The actual market environment is much more complex to capture in mathematical formulas. Some factors that make it difficult to arrive to an optimal capital structure include (the list is not exhaustive):

-> “Investors’ receptivity to debt” (Milken, 2009): This is mainly influenced by the current market conditions.
-> A culture’s acceptability of debt: Culture plays a big role in “influences our values, which in turn affects our attitudes, and then behavior” (Chui et al., 2002).
-> Country factors: “Aggarwal (1981) [analyzed the] 500 largest European firms” (Chui et al., 2002) and concluded that country factors play a role when companies decide on their capital structure.
-> Free cash flow problem: Whereby if a company generates a lot of cash flows from the optimal capital structure, it would “waste it rather than pay it out to investors” (Myers, 1993) considering that a conflict of interest would be present between management and shareholders.
-> Deviation from industry norm issues: If a company structures its capital in a way where it deviates substantially from its industry norm, it might be frowned upon by lenders, making it difficult for the company to attain debt-financing.

Closing Notes:
Given the complexities of capturing all the variables that effect the optimal capital structure formula, then the capital structure composition is left to an educated guess at best: industry standards, operating context of the firm, stakeholder’s preference, etc. But as companies experiment with various capital structures, they would be inching ever closer or further to the optimal point. One statement that rings true, regardless of capital structure composition, is “it doesn’t matter whether a company is big or small. Capital structure matters. It always has and always will” (Milken, 2009).
~ Youssef Aboul-Naja