Capital Structure and Its Significance in Business Operations

This document explores the importance of capital structure in business operations and the balance between debt and equity financing. It discusses various capital structure theories and analyzes the capital structures of Royal Dutch Shell Plc and British Petroleum Plc. The findings highlight the impact of debt financing on the organizations' capital cost and value.

Finance

Executive Summary
The capital structure consists of equity and debt amount employed by an organization for
financing the assets and carrying out the business activities. It is very much important for an
organization to keep a balance between debt and equity in order to avoid any kind of financial
risks. Thus, an appropriate mixture of debt and equity is required for ensuring an efficient
capital structure. The capital structure is being determined and examined in relation to debt
and equity financing.
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Table of Contents
Executive Summary...............................................................................................................................1
Introduction...........................................................................................................................................3
Aim and Objectives...........................................................................................................................3
Significant Theories of Capital Structure and Underlying Rationale.....................................................3
Different capital structure theories.....................................................................................................4
Analysis of the Capital Structures Of Royal Dutch Shell Plc And British Petroleum Plc......................4
Conclusion.............................................................................................................................................6
References.............................................................................................................................................7
Appendix...............................................................................................................................................8
Appendix 1........................................................................................................................................8
Appendix 2........................................................................................................................................8
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Introduction
Capital structure is an important aspect which needs to be focused by each and every
organization. It assists to determine an appropriate balance between equity and debt
financing. The capital structure is considered to be imposing a significant impact on the
revenue, cost and risk of the organization (Hillier et al., 2016).
Aim and Objectives
Aim
The main aim of the research is to examine the capital structure dilemma and its significance
in business operations.
Objectives
The objectives of the study are as follows:
 To evaluate various capital structure theories
 To analyze conflict arguments against the theories of capital structure
 To examine various aspect to asses related changes in capital structure
Significant Theories of Capital Structure and Underlying Rationale
Capital structure theories play a significant role to determine a proper mixture of capital for
fulfilling the business requirements. The capital structure theories are stated below:
Net income approach:
Net income approach assists to determine an appropriate capital mixture. An organization can
be able to decrease WACC by improving the equity share prices of the organization in the
market with the assistance of debt. Thus, the organization is able to decrease the cost of funds
and increase its value with increasing loan financing in the capital structure (Holton, 2012).
Net operating income approach:
The approach is effective to determine other influence on the leverage value of the
organization. It states that an alteration in capital structure does not impose an impact on the
market value and capital cost of the organization.
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Conventional approach:
The approach states that the market value of the organization can be an increase or capital
cost can be decreased with including high debt financing. It states that debts can be raised at a
lower price in comparison to equity. An increased equity cost offset the advantage of cheap
debt (Martin and Baker, 2013).
Modigliani and Miller Approach:
The approach consists of two proposition developed by Merton Miler and Franco Modigilani.
Proposition I depict that the value of two identical organizations remains the same and does
not influence different financial resources. The firm's value is associated with future earnings
if the company does include any taxes. Proposition II depicts that financial leverage
influences the firm’s value and decreases WACC.
Different capital structure theories
Net income approach and net operating approach explains that capital cost can be decreased
by raising debt fiancé because it is low in comparison to equity. On the basis of the
assumptions included in the two theories, the increase in debt can be addressed but the
growth in financial risks for the equity shareholders cannot be addressed. Thus, arguments on
the theories depict that debt finance cannot be used constantly due to the risks associated with
it. An organization has to consider many factors such as the market price of the equity share,
financial risks, market value and interest rate on the debts in order to ensure proper capital
mix (Pettit, 2013).
Analysis of the Capital Structures Of Royal Dutch Shell Plc And British Petroleum Plc
British Petroleum Plc and Royal Dutch Shell Plc are the leading organizations in natural gas
extraction and petroleum field. Both organizations have to maintain their capital structure in
an appropriate manner.
Royal Dutch Shell Plc
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2013 2014 2015 2016 2017
0
20000
40000
60000
80000
100000
120000
140000
Total Stockholders' equity
Power (Total Stockholders'
equity)
Total debt (Short
term+Long term)
Linear (Total debt (Short
term+Long term))
Royal Dutch Shell Plc has focused on expanding its business activities by making alterations
in the capital structure. Net operating approach is followed to determine the capital structure.
The equity value is decreased in 2015 to £162876m from £180047m in 2015. The equity
value has increased after 2015 and in 2017 by 4.13% in comparison to the previous year. The
debt value of the organization has also increased (Royal Dutch Shell Plc, 2017).
British Petroleum (BP) Plc
2013 2014 2015 2016 2017
0
50000
100000
150000
200000
250000
Total Stockholders' equity
Polynomial (Total
Stockholders' equity)
Total debt (Short
term+Long term)
Exponential (Total debt
(Short term+Long term))
The equity value of British Petroleum PLC had decreased from £19302m in 2013 to
£95286m in 2016. The equity capital increased to £98491m after 2016 with a growth rate of
3.36%. In the last five years, there were positive trends seen in the value of debt capital. The
organization used debt financing in order to decrease the capital cost as per the net income
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capital structure theory which focuses on debt financing. The gearing ratio from the year
2013 to 2017 has depicted below (British Petroleum (BP) Plc, 2017).
The increment depicts the decrease in equity value and increases in debt funds. Net Income
Capital Structure theory was being followed by both organizations. The debt capital increased
and changes are addressed in the capital mixture, gearing ratio and interest coverage ratio
(Ramirez, 2017).
Conclusion
The capital structure has depicted to be imposing a significant impact on the market value
and profitability of the company. Different capital structure approaches play a significant role
in the adoption of proper capital structure. Both the organizations are focusing on the debt
capital to decrease the capital cost.
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References
Hillier, D., Ross, S., Westerfield, R., Jaffe, J. and Jordan, B. (2016). Corporate finance. 5th
ed. New York, N.Y.: McGraw-Hill Education.
Holton, R. (2012). Global Finance. 10th ed. Hoboken: Taylor & amp; Francis.
Martin, G. and Baker, H. (2013). Capital structure and corporate financing decisions. 3rd ed.
Hoboken, N.J.: Wiley.
Pettit, J. (2013). Strategic corporate finance. 5th ed. Hoboken, N.J.: Wiley.
Ramirez, E. (2017). Financial Management. 5th ed. Hauppauge: Nova Science Publishers,
Inc.
British Petroleum (BP) Plc (2017). Annual report | Investors | Home. [online] BP
global. Available at: https://www.bp.com/en/global/corporate/investors/results-
and-reporting/annual-report.html [Accessed 10 Mar. 2019].
Royal Dutch Shell Plc (2017). Royal Dutch Shell Plc - AnnualReports.com.
[online] Annualreports.com. Available at:
http://www.annualreports.com/Company/royal-dutch-shell-plc [Accessed 10
Mar. 2019].
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Appendix
Appendix 1
ROYAL DUTCH SHELL PLC
in Million 2013 2014 2015 2016 2017
Total Stockholders' equity 180047 171966 162876 186646 194356
% Change in Equity -4.49 -5.29 14.59 4.13
Short-term debt 7937 6694 4999 8361 10711
Long-term debt 31480 32144 47195 69256 59430
Total debt (Short term+Long term) 39417 38838 52194 77617 70141
% Change in Debt -1.47 34.39 48.71 -9.63
Gearing ratio (Debt/Equity) 0.20 0.22 0.32 0.44 0.38
Interest coverage ratio 60.14 38.26 3.06 3.79 7.42
Appendix 2
British Petroleum (BP) Plc
in Million 2013 2014 2015 2016 2017
Total Stockholders' equity 129302 111441 97216 95286 98491
% Change in Equity -13.81 -12.76 -1.99 3.36
Short-term debt 7340 6831 6898 6592 7701
Long-term debt 40317 45240 45567 51074 54873
Total debt (Short term+Long term) 47657 52071 52465 57666 62574
% Change in Debt 9.26 0.76 9.91 8.51
Gearing ratio (Debt/Equity) 0.32 0.41 0.48 0.54 0.56
Interest coverage ratio 33.03 2.88 -11.85 -3.36 4.29
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