Corporate Finance Essay


Most corporate financing decisions in practice reduce to a choice between debt and equity. The finance manager wishing to fund a new project, but reluctant to cut dividends or to make a rights issue, which leads to the decision of borrowing options. The issue with regards to shareholder objectives being met by the management in making financing decisions has come to become a major issue of recent times. This relates to understanding the concept of the agency problem. It deals with the separation of ownership and control of an organisation within a financial context. The financial manager can raise long-term funds internally, from the company’s cash flow, or externally, via the capital market, the market for funds of more than a year to maturity. This exists to channel finance from persons and organisations with temporary cash surpluses to those with, or expecting to have, cash deficits, i.e. the shareholders.

The agency problem on a firm’s capital structure decisions

Potential conflict arises where ownership is separated from management. The ownership of larger companies is widely spread, while the day-to-day control of an organisation’s business interests rests in the hands of a few managers who usually have a relatively small proportion of the total shares issued. This can give rise to the problem of managerial incentives. Examples of this include pursuing more perquisites (splendid offices and company cars, etc.) and adopting low-risk survival strategies and satisficing behaviour. This conflict has been explored by Jensen and Meckling (1976), who developed a theory of the firm under agency arrangements. Managers are, in effect, agents for the shareholders and are required to act in their best interest. However, they have operational control of the business and the shareholders receive little information on whether the managers are acting in their best interest. According to Jensen and Meckling (1976), if a wholly-owned firm is managed by the owner, he will make operating decisions that maximize his utility. These decisions will involve not only the benefits he derives from pecuniary returns but also the utility generated by various non-pecuniary aspects of his entrepreneurial activities such as the physical appointments of the office, the attractiveness of the office staff, the level of employee discipline, the kind and amount of charitable contributions, personal relations (friendship, respect and so) with employees, a larger than optimal computer to play with, or purchase of production inputs from friends. A company can be viewed as simply a set of contracts, the most important of which is the contract between the firm and its shareholders. This contract describes the principal-agent relationship, where the shareholders are the principals and the management team the agents. An efficient agency contract allows full delegation of decision-making authority over use of invested capital to management without the risk of that authority being abused. However, left to themselves, managers cannot be expected to act in the shareholders’ best interests, but require appropriate incentives and controls to do so. Agency costs are the difference between the return expected from an efficient agency contract and the actual return, given that managers may act more in their own interests than the interests of shareholders.

The capital structure of a firm is divided between debt capital and equity. Debt capital is the use of borrowed funds by the management of a firm to carry out its financial decisions. Most companies borrow money on a long-term basis by issuing loan stocks. The terms of the loan will specify the amount of the loan, rate of interest and date of payment, etc. Equity capital on the other hand is the long-term finance of a firm which is provided by the shareholders of a company. By purchasing a portion of, or shares in, a company, almost anyone can become a shareholder with some degree of control over the company. Ordinary share capital is the main source of new money from shareholders. For an established business, the majority of equity funds will normally be internally generated from successful trading. Any profits remaining after deducting operating costs, interest payments, taxation, and dividend are reinvested in the business and regarded as part of the equity capital. The finance manager will monitor the long-term financial structure by examining the relationship between loan capital, where interest and loan repayments are contractually obligatory, and ordinary share capital, where dividend payment is at the discretion of directors. This is known as gearing. There are two basic types of gearing, they are capital gearing which indicates the proportion of debt capital in the firm’s overall capital structure; and income gearing indicates the extent to which the company’s income is pre-empted by prior interest charges. Both are indicators of financial gearing.

Now, the advantages of debt capital centre on its relative cost. Debt capital is usually cheaper than equity because, the pre-tax rate of interest is invariably lower than the return required by shareholders. This is due to the legal position of lenders who have a prior claim on the distribution of the company’s income and who in liquidation precede ordinary shareholders in the queue for the settlement of claims. Debt is usually secured on the firm’s assets, which can be sold to pay off lenders in the event of default, i.e. failure to pay interest and capital according to the pre-agreed schedule; debt interest can also be set against profit for tax purposes; the administrative and issuing costs are normally lower, e.g. underwriters are not always required, although legal fees are usually involved. Jenson and Meckling (1976) argue that if the manager owns only 95 percent of the stock, he will expend resources to the point where the marginal utility derived from a dollar’s expenditure of the firm’s resources to the point where the marginal utility derived from a dollar’s expenditure of the firm’s resources on such items equals the marginal utility of an additional 95 cents in general purchasing power (i.e., his share of the wealth reduction) and not one dollar. Such activities, on his part, can be limited (but probably not eliminated) by the expenditure of resources on monitoring activities by the outside stockholders. They also add that prospective minority shareholders will realize that the owner-manager’s interests will diverge somewhat from theirs; hence the price which they will pay for shares will reflect the monitoring costs and the effect of the divergence between the manager’s interest and theirs. As the owner-managers fraction of the equity falls, his fractional claim on the outcomes falls and this will tend to encourage him to appropriate larger amounts of the corporate resources in the form of perquisites. This also makes it desirable for the minority shareholders to expend more resources in monitoring his behaviour. Thus, the wealth costs to the owner of obtaining additional cash in the equity markets rise as his fractional ownership falls.

The issue of asymmetric information to a firm’s capital structure

It follows that, to understand how firms behave, we must understand the nature of the contracts and monitoring procedures. Information is not usually available to all parties in business in equal measure. For example, the board of directors will know more about the future prospects of the business than the shareholders, who have to rely on published information. Thus information asymmetry means that investors not only listen to the board’s rhetoric and confident projections, but also examine the information content in its corporate actions. This signally effect is most commonly seen in the reaction to dividend declaration and share dealings by the board An increase in dividends signals that the company is expected to be able to sustain that level of cash distribution in the future. Now, shareholders and other investors in a business do not possess all the information available to management. Nor do they always have the necessary expertise to appreciate fully the information they do receive. Capital rationing may arise because senior managers, convinced that their set of investment proposals is wealth-creating, cannot convince a more sceptical group of potential investors who have far less information on which to make an assessment and who may be influenced by the company’s recent performance record. According to Myers and Majluf (1977), new-issue dividend reinvestment plans could elicit negative stock price reactions due to information effects, leverage effects, or downward sloping long-run demand for shares due. Myers and Majluf (1977) also adds that the information effects with regard to the possession of information between shareholders and management, signalling that the firm’s assets are overvalued, and signalling management’s expectation that the firm’s cash flow distribution will deteriorate in terms of the level of cash flow distinguished empirically by recognizing that a dividend reinvestment plan issue should convey information at the same time to both parties (i.e. shareholders and management). In addition, Myers and Majluf (1977) argue that setting the firm’s management seeks to sell overvalued shares in order to benefit current shareholders at the expense of new investors. Adding to the issue of information asymmetry on a firm’s capital structure decisions, Ross (1977) state that managers naturally have vested interest in not making the company insolvent, so an increase in gearing might be construed by the market as signalling a greater degree of managerial confidence in the ability of the company to service a higher level of debt. This argument relies on asymmetric information between managers and shareholders, and reflects the pervasive principal/agent problem. Financial managers, as appointees of the shareholders, are expected to maximise the value of the enterprise, but it is difficult for the owners to devise an effective, but not excessively costly, service contract to constrain managerial behaviour to this goal. In the context of capital structure theory, the financial manager acts as an agent for both shareholders and debt-holders. Although, the latter do not offer remuneration, they do attempt to limit managers’ freedom of action by including restrictive covenants in the debt contract, such as restrictions on dividend payouts, to protect the asset base of the company. Such restraints on managerial decision-making may adversely affect the development of the firm and, together with the monitoring costs incurred by the shareholders themselves, may detract from company value. Conversely, it is possible that the close monitoring by a small group of creditors, aiming to protect their capital, may induce managers to pursue more responsible policies likely to enhance the wealth of a widely diffused group of shareholders.

The practical methods a firm may use to determine its optimal financing mix

For many years, it was thought advantageous to borrow so long as the company’s capacity to service the debt was unquestioned. The result would be higher earnings per share and higher share value, provided the finance raised was invested sensibly. The dangers of excessive levels of borrowing would be forcibly articulated by the stock market by a down rating of the shares of a highly geared company. This prompted the concept of an optimal capital structure which maximised company value. However, while the critical gearing ratio is thought to depend on factors such as the steadiness of the company’s cash flow and the saleability of its assets, it has proved to be like the Holy Grail, highly desirable but illusory, and difficult to grasp.

Capital Gearing

A widely-used measure of capital gearing is the ratio of all long-term liabilities (LTL), i.e. amounts falling due after more than one year, to shareholders’ funds. This purports to indicate how easily the firm can repay debts from selling assets, since shareholder funds measure net assets:

Capital gearing = LTL

Shareholders’ funds

There are several drawbacks to this approach. First, the market value of equity maybe considerably higher than the book value, reflecting higher asset values, so this measure may seem unduly conservative. However, the notion of market value needs to be clarified. When a company is forced to sell assets hurriedly in order to repay debts, it is by no means certain that buyers can be found to pay acceptable prices. The break-up values of assets are often lower than those expressed in the accounts, which assume that the enterprise is a going concern. However, using book values does at least have an element of prudence. In addition, the dynamic nature of market values may emphasise the case for conservatism, even for companies with safe gearing ratios. A second problem is the lack of an upper limit to the ratio, which hinders inter-company comparisons. This is easily remedied by expressing long-term liabilities as a fraction of all forms of long-term finance, thus setting the upper limit at 100 per cent. A third problem is the treatment of provisions made out of previous years income. Technically, provisions represent expected future liabilities. Companies provide for contingencies, such as claims under product guarantees, as a matter of prudence. Provisions thus result from a charge against profits and result in lower stated equity. However, some provisions turn out to be unduly pessimistic, and may be written back into profits, and hence equity, in later years. A good example is the provision made for deferred taxation. This is a highly prudent device to provide for possible tax liability if the firm were to sell its fixed assets. Provisions could thus be treated as either equity or debt according to the degree of certainty of the anticipated contingency. If the liability is highly certain, it is reasonable to treat it as debt, but if the provision is the result of ultra-prudence (i.e. conservatism), it may be treated as equity.

Interest Cover and income gearing

The trigger for a debt crisis is usually inability to make interest payments, and the frontline is therefore the size and reliability of the company’s income in relation to its interest commitments. Although, in reality, cash flow is the more important consideration, the ability of a company to meet its interest obligations is usually measured by the ratio of profit before tax and interest, to interest charges, known as interest cover, or times interest earned:

Interest Cover = Profit before interest and tax

Interest charges

Strictly, the numerator should include any interest received and the denominator should become interest outgoings. This adjustment is rarely made in practice; net interest charges are commonly used as the denominator. The inverse of interest cover is called income gearing, indicating the proportion of pre-tax earnings committed to prior interest charges. If a company earns profit before interest and tax of 29 million, and incurs interest charges of 2 million, then its interest cover is (20m / 2m) = 10 times, and 10 percent of profit before interest and tax is pre-empted by interest charges. Arguably, cash flow-to-interest is a better guide to financial security, given that profits are expressed on the accruals basis, i.e., recognised even through cash may not have been received yet for sales. Hence, the formula below is sometimes used:

Cash flow cover = Operating cash flow

Net interest payable

Operating and financial gearing

A major reason for using debt is to enhance or gear up shareholder earnings. When a company is financially geared, variations in the level of earnings due to changes in trading conditions generate a more than proportional variations in earnings attributable to shareholders if the interest charges are fixed. This effect is very similar to that exerted by operating gearing. Most businesses operate with a combination of variable and fixed factors of production, giving rise to variable and fixed costs respectively. The particular combination is largely dictated by the nature of the activity and the technology involved. Operating gearing refers to the relative importance of fixed costs in the firm’s break-even volume of output. As sales rise above the break-even point, there will be a more than proportional upward effect on profits before interest and tax, and on shareholder earnings. Firms with high operating gearing, mainly capital-intensive ones, are especially prone to fluctuations in the business cycle. In the downswing, as their sales volumes decrease, their earnings before interest and tax decline by a more than proportional amount; and conversely in the upswing. Hence, such companies are regarded as relatively risky. If such companies borrow, they add a second tier of fixed charges in the form of interest payments, thus increasing overall risk, the higher the interest charges, the greater the risk of inability to pay. Consequently, the risk premium required by investors in such companies is relatively high. It follows that companies that exhibit high operating gearing should use debt finance sparingly.

The target capital structure

A solution commonly adopted in practice is to specify a target capital structure. Here, the firm defines what it regards as the optimal long-term gearing ratio, and then attempts to adhere to this ratio in financing future operations. If for example, the optimal ratio is deemed to involve 50 per cent debt and 50 percent equity (i.e. a debt-to-equity ratio of 100 percent), any future activities should be financed in these proportions. For example, a 10 million project would be financed by 5 million debt and 5 million equity, via retained earnings or a rights issue. The corollary is to use the WACC as the cut-off rate for new investment. When shareholders require 20% and debt costs 7.0% post-tax, the WACC is:

{Cost of equity × equity weighting} + (post-tax cost of debt × debt weighting)

= (20% × 50%) + (7.0% × 50%) = (10% + 3.50%) = 13.50%.

The WACC is recommended because it is difficult to anticipate with any precision how shareholders are likely to react to a change in gearing. The somewhat pragmatic solution proposed assumes that the new project will have no appreciable impact on gearing: in other words that the company already operates at the optimal gearing ratio and does not deviate from it.


This essay has looked at the effect of the agency problem on determining the firm’s capital structure decisions, i.e. the pursuance of managerial incentives which is seen as a problem; such as splendid offices, company cars, and lavish life styles, etc, with no direct control by the shareholders on the activities of the management. Additionally, we have discussed about the ownership of the firm with regards to the latter mentioned, i.e. if the manager owned 95 percent of a company, how would that affect the firm’s capital structure decisions. We have also identified that capital structure is divided between debt capital and equity. Following, we have also examined the issue of asymmetric information to a firms capital structure, i.e. when there are two parties to a contract in which one party has more or all the information regarding an organisations operations and the other party has very little or no information regarding the previous mentioned; and looking at how that affects the capital structure of the firm. Finally, practical methods by which management within firms may use to determine their optimal financial mix are critically analysed. They are capital gearing, interest cover and income gearing, operating and financial gearing, and lastly, the target capital structure.

It will be worthwhile to conclude that gearing can lower the overall or weighted average cost of capital that the company is required to achieve on its operations, and can raise the market value of the enterprise. However, this benign effect can be relied upon only at relatively safe gearing levels. Companies can expect the market to react adversely to excessive gearing ratios. Strictly, the appropriate cut-off rate for new investment is the marginal cost of capital, but if no change in gearing is caused by the new activity, the WACC can be used. Also considerable care should always be given when prescribing the appropriate use of debt that will enhance shareholder wealth without ever threatening corporate collapse, a major trend with regards to the agency problem. The capital structure decision, like the dividend decision, is a secondary decision, that is, to the company’s primary concern of finding and developing wealth-creating projects. Many people argue that the beneficial impact of debt is largely an illusion. Clever financing cannot create wealth (although it may enable exploitation of projects that would not otherwise have proceeded). It may however, transfer wealth if some stakeholders are prepared, perhaps due to information asymmetry, to accept too low a return for the risks they incur, or if the government offers a tax subsidy on debt interest. The decision to borrow should not be over-influenced by tax considerations. There are other ways of obtaining tax subsidies, such as investing in fixed assets, which qualify for tax subsidies. A highly, geared company could find itself unable to exploit the other tax-breaks offered by governments when a favourable opportunity is uncovered.


Jensen, M.C., and Meckling, W.H., (1976), Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure, Journal of Financial Economics, October, pp. 305 - 360.

Myers, S., and Majluf, N.S., (1977), Corporate Financing and Investment Decisions when firms have information that investors do not have, Journal of Financial Economics, November, pp. 147 - 176.

Ross, S.A., (1977), The determinants of Financial Structure: The Incentive Signalling Approach, Bell Journal of Economics Spring 1977, pp. 23 - 40.

Ross, S. A., Westerfield, R.W., and Jaffe, J., (1996), Corporate Finance, 4th Edition.

Copeland, T.E., and Weston, J.F., (1988), Financial Theory and Corporate Policy, 3rd Edition.

Brealey, R.A., and Myers, S.C., Principles of Corporate Finance, McGraw Hill.

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