Strategy and Finance: Factors, Measures, and Optimal Capital Structure

This article discusses the factors that influence the capital structure of a company, measuring capital structure ratio, advantages of equity financing, and optimal capital structure. It also provides insights into the subject with Desklib's study material.

Running head: STRATEGY AND FINANCE
Strategy and finance
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1STRATEGY AND FINANCE
Table of Contents
Factors that influence the capital structure of the company.......................................................3
Measuring capital structure ratio................................................................................................4
Advantages of equity financing.................................................................................................7
Optimal capital structure............................................................................................................7
Using preference share as capital...............................................................................................8
Reference..................................................................................................................................10

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Next is the UK based retailer that was established in the year 2982 and offers
designed, exciting, excellent quality, beautiful footwear, clothing and accessories and various
home related products. The company mainly distributes its products through 3 major
channels – Next international retail that have more than 200 main franchise stores, Next
Directory that is its home shopping sector having more than 4.5 million customers all over
from UK and overseas and Next retail that is the chain of more than 540 stores in Eire and
UK. Main financial objective of the company is to provide long term returns to the
shareholders through combination of sustainable earning growth per share and payment of the
cash dividends (Fischer 2016). The company believes that the objective can be achieved
through the following strategies – developing and improving the ranges of products, the
success for which will be measured through sales performances, increasing the profitable
Next Directory consumers and their spending in UK as well as through international sales in
online and focussing on the customer satisfaction and services in directory stores as well as
retail stores (Nextplc.co.uk 2018).
Capital structure is the part of financial structure and it refers to the percentage of
various long term financing sources. Capital structure is concerned with the way a firm
decides to segregate the cash flows in broad components – fixed component that is kept for
meeting the debt capital obligations and the residual component that belongs to the equity
shareholders. Generally, the capital structure has 2 components – the debt component and the
equity component. Each component of the capital structure has its own cost to the company
(Namvar and Phillips 2013). Various decisions associated with asset financing are crucial for
each business and the finance manager always finds it tough to decide about the optimum
capital structure or the proportion of debt and equity that will be most beneficial to the
company. However, there shall be appropriate mix of equity and debt to finance the assets of
the company. Generally, the capital structure is designed keeping in mind the shareholder’s
interest. Therefore, rather than collecting total fund from shareholders, a part of long term
capital can be borrowed in form of bond or debentures though paying fixed annual charges.
Though these charges are expenses to the company, this financing method is applied for
protecting the shareholder’s interest in better way (Kurt and Hulland 2013).
Need to have a proper capital structure are as follows –
It maximizes the firm’s market value that means if a firm has its capital structure
properly designed the total value of ownership interests and claims will be maximised.

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It maximizes the market price of the company’s share through increasing the EPS of
ordinary shareholders. It will also help in increasing the dividend payment to the shareholders
(Konstantelos and Strbac 2015).
It enhances the company’s ability to search for new investing opportunities that will
improve its wealth generating capacity. With appropriate gearing the company can also
increase the confidence level of debt suppliers.
It increases the growth and investment rate of the company through increasing the
opportunity of the firm in engaging into future investment that will generate more wealth
(Midrigan and Xu 2014).
Usually the firms use 2 sources for fund – equity and debt. As the new company is not
able to collect more funds through borrowing it has to depend on equity. However, after
establishing the credit worthiness in the market its structure of capital starts getting complex.
A typical complex pattern of capital structure may include – (i) long term debentures and
equity or, (ii) preference shares and equity shares or, (iii) long term debentures, preference
shares and equity (Stanyer 2014).
Factors that influence the capital structure of the company
Primary factors that have an impact on the decision of capital structure are as follows
–

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Business risk is basic risk related to the operation of the company. If the business
risks become higher, the optimal debt component and debt ratio of the company will be
lower. If the company has lower risk, it will have stable stream of revenue. If the operating
risk of the business is less, then the financial risk of the company states that the company is
in a position to utilise more debt capital. On the contrary, if operating risk of the company is
high then the company will be associated with more risk if it raises further debt (Gitman,
Juchau and Flanagan 2015).
Tax rate and tax exposures of the company play another important role in deciding
about the capital structure. Debt payments are deductible expenses under tax. Therefore, if
the tax rate of the company is high then using the debt finance will give higher deduction
from tax. Further, the tax rate has an impact on the debt cost of the company. If tax rate is
high then debt cost reduces. The reason behind this is that the interest deduction from profit
on debt capital considers it as the part of expenses (Fatica, Hemmelgarn and Nicodème
2013).
Management style and company’s size and strategy also plays important role in
deciding the capital structure of the company. Management’s style can be conservative or
aggressive. If the approach of the management is more conservative it will be less inclined to
use the debt for increasing the profit. On the contrary, if the management’s approach is
aggressive it will try to grow quickly through using the significant amount of the debt for the
company’s growth. In the same way, the company with growth strategies are more inclined to
debt as compared to equity (Philippon 2015).
Measuring capital structure ratio
The following measures can be taken to measure the capital structure of the company
–
Debt to equity ratio –
Debt as well as equity of the company is shown in the liability side of the balance
sheet. If the company uses more portion of debt as compared to the equity then the financial
assets will have high leverage ratio and the company will therefore have an aggressive nature
of capital structure. On the contrary, the company that finances its assets with more
proportion of equity will have conservation structure of capital or low leverage ratio. The

5STRATEGY AND FINANCE
goal of the management is to find optimal mix for equity and debt (Weber, Alfen and Staub-
Bisang 2016).
Debt to equity ratio of the company for the last 2 years is as follow –
Ratio Formula 2017 2016
Debt to equity ratio Total liabilities / Total equity 3.71 6.47
It can be observed from the above that the debt of the company is significantly high as
compared to its equity. For the year 2016 the debt equity ratio of the company was 6.47.
Though in the year 2017 the company was able to improve the ratio and reduced it from 6.47
to 3.71 it is still considerable high. Generally, the high debt to equity ratio signifies that the
company is not able to create sufficient cash to pay off the debt obligations. However, lower
ratio of debt to equity also signifies that the company is not taking any advantage of enhanced
profits that may be brought by the financial leverage. Further, it notifies that the company has
practice of aggressive leverage that is associated with high level of risks (Turner 2017). It
may lead the company to volatile earning situation owing to additional expenses of interest.
High debt ratio further has the following associated risks –
It reduces the ownership value. Equity and liabilities represents respective claims that
the owners and creditors have on the assets of the company. High debt to equity ratio
decreases the owner’s value in the business stake as the asset’s proportion. Further, if the
small business has high debt to equity ratio and if the company goes into liquidation, larger
portion of proceeds from liquidation has to be distributed to the creditors as compared to the
amount that will be left for the shareholders (Gitman, Juchau and Flanagan 2015).
It will increase the business risk and the risk that the business will not be able to pay
off the obligations which in turn will increase the debt to equity ratio. Reasonable amount of
debt can assist the company to grow its business but if the debt proportion becomes too high
it will overburden the company with high payment of interest and the creditors may take the
assets of the company which in turn will lead the company to bankruptcy (Wossen, Berger
and Di Falco 2015).
It will create trouble while the company will try to obtain additional finance.
Generally banks require low debt to equity ratio when they lend new credit. The reason
behind this is that the high debt to equity ratio decreases the chances that the amount will be

6STRATEGY AND FINANCE
repaid to the bank. Taking this fact in consideration the bank may refuse to offer additional
finance or may provide the amount with unfavourable conditions (Mac an Bhaird 2013).
It may lead to violation of debt covenants. Often the loan agreements include
covenants that are the stipulation that will require not to do or to do certain things like
maintaining adequate level of financial ratio. If the debt to equity ratio exceeds certain limit
the bank may call for immediate repayment.
Interest coverage ratio –
This measures the ability of the company to meet the interest payments. It is
calculated through dividing the earnings before interest and taxes for the period by the
interest expenses of that period. it measure the number of times that the company can make
payment of interest on its outstanding debt with the available EBIT. Further, it determines the
efficiency of the company with regard to the interest payment. If the interest coverage is low
it signifies that the debt burden of the company is high and the company is highly associated
with bankruptcy risk. Further, it signifies that the company has fewer amounts of earnings
available for meeting the payment of interest and therefore, the business is more vulnerable to
increase of the interest rate. However, if the interest coverage ratio of the company is 1.5 or
less than that, the ability of the company to meet its interest obligation may be questionable.
Further, the interest coverage ratio of less than 1 signifies that the business is not able to
generate sufficient cash to meet its interest obligation. On the contrary the higher ratio
signifies that the financial health of the company is better and it is able to meet its interest
obligations efficiently. It further signifies that the company is too safe and neglecting the
opportunities for magnifying the earnings through leverages.
Ratio Formula 2017 2016
Interest coverage ratio EBIT / Interest expenses 21.90 27.44
It can be identified from the above that the interest coverage ratio of the company for
the year 2016 is 27.44 and for the year 2017 is 21.90. Both the year’s ratio is signifying that
the company is efficient in paying off their interest obligation. However, as the interest
coverage ratio of the company for both the years are very high it is signifying that the
company must be losing opportunities for magnifying the earnings through leverages.

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However, if the company is required to raise further funds for the business operation
it shall raise through equity instead of debt or mix of debt and equity. The reason behind this
is that debt equity ratio of the company is significantly high that is 3.71. Therefore, further
borrowing will lead the company to unstable position which in turn may lead the company to
liquidation.
Advantages of equity financing
Debt to equity ratio reveals what percentage of financing is provided by debt and what
percentage is provided by equity. Main advantage associated with equity financing as
compared to debt financing is that no obligation is there for repayment of money obtained
through equity financing. Various other advantages associated with equity financing are as
follows –
Main advantage is no repayment required. Under equity financing the company is not
bound to make repayment. Rather the shareholders get return through share of profit or loss.
If the investor wishes to exit from the company he can simply sell his shares to anyone else
and the company will not be liable to make the repayment. On the contrary, the company is
bound to repay the debt, whenever required. Further, as the investors share both profits as
well as loss, it protects the company during economic downturn.
Another advantage is good credit rating. Involvement of various investors or high
level of equity base improved the company’s credit rating. It gives an impression that venture
backed by various investor and the company has sufficient funds for compensating the
debtors if things go wrong.
It also provides better corporate governance. The public listed companies are bound to
maintain spotless records, hold directors meeting and general body meeting regularly, audit
the accounts and comply with other standard practices. It enhances the corporate governance
quality and improved professionalisms.
It also facilitates easy exit. Raising fund through equity through listing itself in stock
exchange makes it easier for the promoter to offload the holdings and quit the company
without shutting down the business. In the same way the investor can recoup his investment
as per his wish unlike the fixed debt terms

8STRATEGY AND FINANCE
Optimal capital structure
An optimum capital structure is the financial measurement at which the company uses
the best mix of debt and equity for the expansions and operations of the company. The
optimal capital structure ensures lower cost of the capital which in turn makes the company
less dependent on the creditors and ability to finance the major operations through equity. To
determine the optimal capital structure following considerations are –
1st consideration is the advantage of corporate tax. The finance manager may take the
opportunity of utilising financial leverage through the corporate tax. Debt financing is less
costly as compared to equity as the debt financing is deductible expenses under tax. As the
equity involves high cost, it can be avoided while raising funds. However, the shareholders
will be the ultimate beneficiary through trading on equity.
2nd consideration is avoidance of the high risk capital structure. If debt portion is
higher than the equity portion it will expose the company to leverage risk which in turn will
reduce the price of the share in the open market. In other words, the capital structure that is
highly geared is always considered as risky. Therefore, the finance manager under such
circumstances shall not raise further fund through borrowing.
3rd consideration is associated with advantage of the financial leverage. If return from
the investment is high as compared to the fixed cost of the fund, the finance manager shall
opt for raising the fund. However, there is always some cost involved with finance but the
shareholders will be benefitted at the end.
4th consideration is the debt-equity mix advantages. The finance manager may avail
the benefits from including the equity-debt mix in his capital structure planning. Once
optimum capital structure is achieved, the finance manager will be free from the financial
hazards. Therefore, the utmost objective of the finance manager is to check whether proper
debt equity mix utilization has been achieved or not (Baker and Wurgler 2015).
However, the debt equity ratio of 0.40 or 40% of debt and 60% of equity is considered
as optimal capital structure. It can be found from the above debt to equity ratio that the
company has significantly high debt to equity ratio and shall not go for further debt
borrowing and shall go for equity finance if further finance is required (Jõeveer 2013).

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Using preference share as capital
Preference shares are the shares that carry some priority or special rights. 1st the
dividend is payable at fixed rate on these shares before payment of any dividend on equity
shares. 2nd at the occasion of winding up of company the capital is repaid to the preference
shareholders before payment of any equity capital. Further the preference shares do not carry
any voting rights (Baghai, Servaes and Tamayo 2014). However, the preference share holders
may claim for voting rights if the company does not pay any dividend for 2 years or more
than that on cumulative preference shares and 3 years or more than that on non-cumulative
preference shares (Graham, Leary and Roberts 2015). Various advantages of preference
shares are as follows – (i) it has no dividend payment obligation that is the company is not
bound for paying dividend on the preference shares if the profits for the particular year are
not sufficient. (ii) The preference share holders can sell their shares very easily if they want
to sell their shares. (ii) As the preference shares do not carry any voting rights the company
can raise the capital without the dilution in the control. Equity shareholders will retain
exclusive control on the company (iii) trading on the equity is another advantage. Dividend
rate on the preference share is fixed. Thus, with the increase in earnings, the company will
provide benefits of trading on the equity to the equity shareholders. (iii) No charge on the
assets that is the preference share does not create any charge or mortgage on the assets; The
Company can keep the fixed assets with itself to raise the loans in future (Robb and Robinson
2014).
However, the preference shares are associated with some disadvantages too. These are
– (i) it has limited appeal. Bold investors do not prefer to invest in preference shares.
Conservative and cautious investors prefer the government and debentures securities.
Therefore, to attract sufficient investors, the company may need to offer higher dividend rate
on the preference share. (ii) Low return is another issue associated with preference shares.
When the company’s earnings are high, then the fixed dividend on the preference shares
seems unattractive (Rampini and Viswanathan 2013). Generally the preference shareholders
do not have any right to participate in company’s prosperity.
Therefore, from the above analysis it is concluded that the among all the options like
debt, equity or preference shares then company shall opt for equity for additional fund if
given a chance.

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