Financial Management: Sources of Long-Term Finance, Financial Distress, and Optimum Capital Structure

This document provides a discussion on the basic sources of long-term financing, such as long-term debt and preferred stock. It also explains the concept of financial distress and its direct and indirect costs on a corporation. Additionally, it evaluates the optimum capital structure required to maximize shareholder's wealth. The subject is Financial Management, and the document type is a study material.

Part 1: Financial Management
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Contents
Introduction......................................................................................................................................3
Task 1: Discussion on Attributes of the Basic Sources of Long-Term Finance..............................3
Long-Term Debt..........................................................................................................................4
Preferred Stock.............................................................................................................................5
Common stock.............................................................................................................................6
Lease Financing...........................................................................................................................7
Angel Investor..............................................................................................................................8
Task 2: Explanation of Financial Distress and its Direct and Indirect Costs on Corporation.......10
Task 3: Evaluation of optimum capital structure to maximize the shareholder’s wealth..............13
Optimum Capital Structure........................................................................................................13
Capital Structure as per Modigliani and Miller.........................................................................13
Financing Decision with WACC Techniques............................................................................14
Mixture of equity and debt that will result in lowest WACC and maximum value of market
value of company.......................................................................................................................15
Conclusion.....................................................................................................................................18
References......................................................................................................................................20
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Introduction
The businesses need to manage their financial resources in an adequate manner for
promoting their long-term growth and development. This is because they require continuous
supply of funds for their capital expenses, working capital and other long-term use of these funds
for promotion of their growth and development activities. It is therefore important for the
financial manager of a business corporation to take financing decisions in an adequate manner
for ensuring that continuous supply of funds is available to create value for the shareholders. The
main objective of financial management within a corporation is to ensure that adequate sources
of funds are available to overcome the financing problems that can occur due to lack of adequate
funds to conduct the daily business activities. As such, it is highly important for a financial
manager to take adequate decisions that lead to maximizing the value of business through proper
planning and management of financial resources that leads to minimize the financial risk and
leads to increasing its profitability position. In this context, this report has been prepared for
providing a discussion relating to the basic sources of long-term financing such as long-term debt
or preferred stock and others. Also, it provides an explanation of the financial distress and the
direct and indirect costs related with it. This is followed by conducting an analysis of the
optimum capital structure required to be maintained by a corporation for maximizing
shareholders wealth.
Task 1: Discussion on Attributes of the Basic Sources of Long-Term Finance
Long-term financing sources for a business corporations is required to meet the capital
requirements for a long-term financial period. The capital expenses incurred by a company in
purchasing fixed assets such as plant, machinery, land and others are funded with the use of
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long-term sources of finance. In addition to this, the businesses also adopt the use of long-term
sources of financing for meeting their working capital requirements. The major sources of long-
term financing that are used by business besides equity and debt capital is discussed as follows:
Long-Term Debt
The long-term financing used by a business through debt sources can be mainly
categorized into loans and debentures. Debentures are long-term debt instrument that are utilized
by companies to borrow funds at a fixed rate of interest from general public. On the other hand,
term loans are provided by a financial institution such as bank having a fixed rate of interest and
that need to repay in installments. The major advantage and disadvantages associated with the
use of this long-term debt financing are discussed as follows:
Advantages
 Long-term debt financing is less costly method of gaining funds for businesses as interest
on debt in subjected to tax deductions and it is also regarded as having lesser financial
risk
 It enables the business in promoting long-term growth by acquiring assets that require
major funds such as purchasing land or building or investing in research and development
activities supporting the business expansion
 The bondholders or creditors does not have ant stake in business and thus do not interfere
in business activities (Rossi and Matteo, 2016).
Disadvantages
 There exist a financial risk of not able to meet the interest obligations on these sources of
finance in a timely manner
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 The financial manager is required to make provisions for repaying the debt obligations on
their maturity date to avoid the possibility of occurring of bankruptcy (Rigby, 2011)
Preferred Stock
Preference shares are issued by companies for raising long-term debt capital and possess
the combination of both equity and debt and thus are referred as hybrid instruments. The major
advantages and drawbacks that are associated with them are stated as follows:
Advantages
 The major benefit of using this type of funding option is that it is associated with lower
risk for the company as they are often cumulative and thus the dividends required to be
paid can be accrued on time and thus paid on a later date
 This type of long-term financing option for the company is also not associated with the
risk of providing ownership and the amount of dividend provided is fixed (Werner and
Stoner, 2010)
Disadvantages
 The businesses are required to pay higher dividends and are required to pay dividends at
this rate only till the maturity of the stock. The increase in the market interest rates can
lead to rising of the price of preferred stock and thus increasing the dividend obligations
for the company
 There is no significant tax advantages associated with the use of this type of financing
option
 The rate of dividend is considerably higher as compared with the rates of interest on
bonds and loans (Rigby, 2011)
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Common stock
These stocks are the ownership rights and are issued by the companies in the open market
and are taken by the general public at a predefined price. The people who invest money become
the shareholder and thus receive ownership rights within a company. The major advantages and
drawbacks are discussed as follows:
Advantages
 This type of financing option provides the company the significant advantage of
acquiring large sources of funds for supporting business expansion and growth
 It can be regarded as a permanent source of capital and the shareholders become the
owners and thus diversifying risk
 The company is not legally liable to pay dividends to the shareholders and thus at the
time of occurrence of any type of uncertainty it can significantly reduce the amount of
dividend to be paid
Disadvantages
 The businesses are required to provide a right of ownership to the shareholders and thus
diluting their power of control
 It is considered as a risky investment option due to associated uncertainty in the amount
of dividends required to be paid
 It is associated with higher costs as dividends to be provided is not associated with any
type of deduction of taxes (Megginson and Smart, 2008)
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Lease Financing
Lease financing can be defined as the contract that is developed between the owner and
user of an asset for a specific period of time. This type of financing can be used by a business
corporation for purchasing the assets and thus sourcing its fixed assets. Its significant advantages
and drawbacks can be stated as follows:
Advantages
 It enables businesses to gain the tax benefits as the depreciation realized over an asset can
be claimed as an expense in the financial records and thereby achieving the benefits of
taxes
 It helps in avoiding the ownership risk and helps in reducing the financial leverage and
thus providing opportunities to businesses for borrowing money
Disadvantages
 The long-term lease agreement is regarded as a financial burden on the business due to
paying of higher fixed expenses for the several years as rental payments
 The higher expenses incurred by the company on the leased assets can significantly result
in decreasing the net income and thus achieving reduced returns for the equity
shareholders (Megginson and Smart, 2008 )
Angel Investor
Angel investor is an individual providing capital for starting up a business in the form of
convertible debt or ownership of equity. These types of investors are mainly involved in
providing support to the start-ups at the initial phase and promoting their growth and
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development. The significant advantages and drawbacks that are associated with the use of this
type of financing method can be stated as follows:
Advantages
 The use of this type of financing option is considered as less risky in comparison to the
method of financing by debt. This is because use of long-term capital form angel
investors does not required to be paid back unlike the funds that are derived with the use
of loans. The angel investors have knowledge of the nature of business and adopt a long-
term view on the business and thus are interested in having a long-term stake on the
business performance.
 There are no monthly interests obligations on the businesses such as that required to be
met in case of bank loans credit cards. The angels are interested in long-term business
performance as they are interested in the share of profits.
Disadvantages
 The major disadvantage is that use of this type of financing option can result in loss of
control of ownership as angel investors are interested in nature of business operations as
they are entitled to receive the share of profits
 This type of financing option is also associated with complying with more complicated
legal rules and regulations that can be time-consuming and tedious for businesses
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Task 2: Explanation of Financial Distress and its Direct and Indirect Costs on Corporation
The financial distress condition of a company is the situation when it is having problems
in making payments to the creditors. This can be largely due to the inability of a company to
create revenue and thus it does not possess enough funds to meet its financial obligations. This
can be due to higher fixed costs, illiquid assets or decline in the revenue due to economic
fluctuations. The prolonged condition of financial distress within a company can lead to
accumulation of higher amount of debt which cannot be repaid and thus leading to bankruptcy.
The higher the amount of debt a company use for financing its operational activities the higher is
the risk of facing the situation of financial distress (Allen, Franklin and Carletti, 2010). The
accumulation of debt under the condition of financial distress can eventually occur due to the
reduced ability of the company to secure financing. This is because the significant decline faced
by it in its market value and reduced sales that can ultimately impact its profitability position.
The condition of financial distress faced by a company can be identified by examination of its
financial statements over a period of time by the investors and others. For example, negative
cash flows and net profits realized by a company is eventually an indicator of the condition of
financial distress. This could occur due to difference present between the cash payments and
receivables, higher interest payments and reduction in the working capital (Farooq and Nazir,
2012). There are different costs that a company has to face due to condition of financial distress
and these can be clarified as below:
Direct Costs
The bankruptcy costs are a direct cost related with the condition of financial distress. This
is because the higher the debt present on a company there is significantly increased risk of not
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being able to meet the financial obligations that are owned to the creditors. The condition of
having higher debt obligations as compared to the net income represents a situation of financial
distress and as such a highly leveraged firm has the more probability to be declared as bankrupt.
The bankruptcy costs include legal fees, financial losses occurred due to sale of assets and the
loss of competent employee base. The company should consider the expected cost of bankruptcy
by multiplying its probability with the expected cost of the bankruptcy at the time of increasing
debt obligations on it. In addition to this, the auditor fees or management fees can be regarded as
other direct costs that are significantly associated with the condition of financial distress (Bilal
and Tufail, 2013).
Indirect Costs
The condition of financial distress can also significantly result in the business companies
to reduce the expenses incurred on research and development activities, marketing research and
other investments for saving cash to conduct the daily operations. This can restrict the business
expansion and growth and eventually hamper its sustainable development due to lack of
innovation and inability to meet the changing customer needs and requirements. Thus, loss of
customer base can be regarded as one of the major indirect cost that is related with the financial
distress condition. The financial distress condition can result in negatively impacting the
reputation of a firm and thus can face the loss of customers. Also, it can also influence its trade
credit terms from the suppliers and also lead to increasing the cost of capital (Farooq and Nazir,
2012).
Also, there are significant costs associated with the conflict that can occur between the
self-interests of the creditors, managers and the owners. The investors also does not prefer to
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invest within the company that is engaged in risky investment and rather prefer to invest within a
company that a stable financial position. Thus, it can lead to restricting the flow of money within
the company which can negatively impact the plans of its business growth and expansion. This
can thus have an impact on the ability of the company to create wealth for its shareholders.
Method for Reduction in the Cost of Debt
The businesses can significantly reduce the cost of debt to overcome the possibility of
occurrence of occurrence of the condition of financial distress with the use of refinancing
method. The higher interest payments on the loans can be brought down by a company with the
option of refinancing. The reduction on the interest rates as compared to that at the time of
money borrowed by businesses can provide them the benefit of using the option of refinancing.
The refinancing the loan to a lower interest rate can cause a reduction in the amount of monthly
payments. Also, it provides the opportunity to borrow more money and thus the additional cash
can be used to support the plan of business growth and expansion. However, it is important to
assess the cost of refinancing by the business managers to ensure that it is proving to be a
feasible option to reduce the cost of debt. It provides an effective way for reducing the debt to
capital ratio by reducing the debt payments and thus restructuring the debt proportion in the
capital structure of a firm (Bilal and Tufail, 2013).
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Task 3: Evaluation of optimum capital structure to maximize the shareholder’s wealth
Optimum Capital Structure
Optimum capital structure refers to the right mix of main sources of finance in order to
reduce the cost of capital and increase of shareholder’s wealth. In professional way, optimum
capital structure defines as the best proportion of sources of finance such as debt, common stock
and preferred stock so that overall cost of capital got reduce to minimum level and market value
of company increases to maximum level (Baker and Powell, 2010). It is upon the management
discretion to choose from the available financing option so that maximum value can be delivered
to the shareholders through increasing earnings after tax and improving the market value of
company shares. According to finance theory, debt financing provides lowest cost of capital due
to tax deductible factor but too much debt creates the financial risk within the company and also
creates a sense of uncertainty in the minds of shareholders. If debt financing is used more than
the permissible limit then it will lower the return on equity which is not good for the equity
shareholders. So it is important for the management to find the optimal point where the marginal
benefits obtained from the debt financing is equal to the marginal cost (Hatfield, Cheng and
Davidson, 2011).
Capital Structure as per Modigliani and Miller
According to Modigliani and Miller capital structure of the company linked closely to the
value deliver to the shareholders. As per the capital structure theory given by Modigliani and
Miller, when there are no taxes, no bankruptcy cost, asymmetric information and agency in the
given efficient market, the value of company is not affected by any proportion of capital
structure. But in real world it is not possible as all the given factors are present in efficient capital
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market and it impacts the value of company at any chosen proportion of capital structure.
Modigliani and Miller have provided two propositions to explain impact on capital structure on
the value of firm in different situation (Arnold, 2013). Proposition I states that value of entity is
not impacted by the change in the capital structure. It is because Proposition I assumed that there
is no tax factor that impacts the firm but in real world it is not possible. As per Proposition I
value of firm is critically dependent upon the expected future earnings and has no link with
proportion of capital kept by the company. On the other hand, Proposition II takes in account the
applicability of taxes on the company and provides that financial leverage increases value of firm
and also helps in reducing the WACC (Moles and Kidwekk, 2011). It means change in
proportion of capital will definitely impact the firm value. It is also true that too much leverage
capital will increase risk and investors will take least interest in such firms as it lowers the
overall return they receive. So, optimum capital structure is highly important to maximize the
shareholders value (Ferdous, 2019).
Financing Decision with WACC Techniques
WACC refers to weighted average cost of capital and it provides cost that company bears
on financing the capital with different sources. WACC measures the average cost of capital that
company pays on debt and equity capital. Through use of WACC one can make various
financing decisions such as capital budgeting decisions and selection of most economical source
of capital that increase value of shareholders.
Formula of WACC:
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Mixture of equity and debt that will result in lowest WACC and maximum value of market
value of company
Optimum capital structure is nothing but only the appropriate mixture of debt and equity
capital. Debt capital has lower cost of capital to tax benefit but it also lower the market value of
the company. So, it is important to choose appropriate mix where there is not too much debt and
too much equity but there should have balanced proportion of each capital. This balance
proportion can only be possible when various capital proportions have been put to test to figure
out the WACC and market value of company. Then only, an appropriate equation of capital can
be framed that will result in maximum market value and lowest WACC. Also, it is not always
possible that lowest WACC will result in maximum market value of company. In such cases it is
better to choose such proportion where overall return earned by the shareholders is maximum as
it will helps in increasing company market value and also allows to build strong relationship with
shareholders.
In order to determine the optimum capital mix with regards to maximization of
shareholder’s wealth it is required to minimize the weighted average cost of capital and
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maximize the market value of equity capital. When the cost of capital (WACC) is lowest, the
present value of future cash flows generated by the company will be highest and it helps to
increase the market value of company. It can be better understood through the below example
with detailed explanation (Schauten and Spronk, 2010).
Hypothetical Example: In the below example, it is assumed that Firm A is planning to make the
choice from the available alternative of proportion of capitals (Debt and Equity). For this
purpose, capital structure of the company will be evaluated at 0%, 10%, 20%, 30%, 40% and
50% proportion of debt or leverage capital as the part of total capital. There will various inputs
and outputs depending upon the requirements. The main outputs to evaluate the most optimum
capital structure will market value of the firm, WACC and book value of the firm.
Statement of selection of optimal capital structure
Debt/Leverage % 0% 10% 20% 30% 40% 50%
Earnings before
interest and tax
$
184,800
$
184,800
$
184,800
$
184,800
$
184,800
$
184,800
Less: Interest
expenses
$
-
$
7,079
$
14,972
$
24,893
$
36,960
$
51,827
Profit before taxes
$
184,800
$
177,722
$
169,828
$
159,907
$
147,840
$
132,973
Taxes @ 30%
$
55,440
$
53,316
$
50,948
$
47,972
$
44,352
$
39,892
Profit after taxes
$
129,360
$
124,405
$
118,879
$
111,935
$
103,488
$
93,081
Cost of Equity (Ke) 12.00% 12.50% 13.00% 13.50% 15.00% 17.00%
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Cost of Debt (Kd) 9.00% 9.75% 10.00% 10.50% 12.00% 14.00%
Book Value of Debt
$
-
$
100,000
$
200,000
$
300,000
$
400,000
$
500,000
Book Value of
Equity
$
1,000,000
$
900,000
$
800,000
$
700,000
$
600,000
$
500,000
Book Value of the
Firm
$
1,000,000
$
1,000,000
$
1,000,000
$
1,000,000
$
1,000,000
$
1,000,000
Market Value of
Debt
$
-
$
72,600
$
149,722
$
237,078
$
308,000
$
370,192
Market Value of
Equity
$
1,092,000
$
1,008,616
$
928,010
$
843,844
$
700,700
$
555,242
Market Value of
the Firm
$
1,092,000
$
1,081,216
$
1,077,732
$
1,080,922
$
1,008,700
$
925,434
Weighted portion of
Equity capital
(Market Value) 100.00% 93.29% 86.11% 78.07% 69.47% 60.00%
Weighted portion of
Debt capital (Market
Value) 0.00% 6.71% 13.89% 21.93% 30.53% 40.00%
Weighted portion of
Equity capital (Book
Value) 100.00% 90.00% 80.00% 70.00% 60.00% 50.00%
Weighted portion of 0.00% 10.00% 20.00% 30.00% 40.00% 50.00%
16

Debt capital (Book
Value)
Shares outstanding
in market 10000 9700 9100 8600 8000 7600
Stock Price
$
109.20
$
103.98
$
101.98
$
98.12
$
87.59
$
73.06
WACC 12.00% 12.32% 12.58% 12.84% 14.08% 15.80%
(Zimmerman and Yahya-Zadeh, 2011)
The above example clearly reflects when debt capital is 0% the value of firm is highest
and it has lowest WACC. It is just an example and actual values can be different that will
provide different results. So, it can be said that mere the consideration that cost of debt is lowest
will not provide the criteria that debt capital must be in highest proportion.
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Conclusion
It can be stated from the overall discussion conducted within the report that business
requires continuous supply of funds for meeting its capital expenses, maintaining working capital
and promoting their long-term growth and development. The best sources of long-term finance
that can be used by a company are long-term debt, preferred stock, and common stock, lease
financing and internal accruals. Also, the condition of financial distress that can occur due to
higher leverage within a company is associated with direct cost of bankruptcy an indirect cost of
loss in customers and lack of innovation. The cost of debt can be reduced by a company with the
use of method of refinance that helps in restructuring of debt proportion within the capital
structure. The optimal capital structure having an effective mix of debt and equity resources is
essential to maximize shareholders wealth and creating higher value for them.
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