Capital Structure Decisions: Evaluating Risk and Uncertainty

By Yamini Agarwal

Inside the risk management and corporate governance issues behind capital structure decisions

Practical ways of determining capital structures have always been mysterious and riddled with risks and uncertainties. Dynamic paradigm shifts and the multi-dimensional operations of firms further complicate the situation. Financial leaders are under constant pressure to outdo their competitors, but how to do so is not always clear. Capital Structure Decisions offers an introduction to corporate finance, and provides valuable insights into the decision-making processes that face the CEOs and CFOs of organizations in dynamic multi-objective environments.

Exploring the various models and techniques used to understand the capital structure of an organization, as well as the products and means available for financing these structures, the book covers how to develop a goal programming model to enable organization leaders to make better capital structure decisions. Incorporating international case studies to explain various financial models and to illustrate ways that capital structure choices determine their success, Capital Structure Decisions looks at existing models and the development of a new goal-programming model for capital structures that is capable of handling multiple objectives, with an emphasis throughout on mitigating risk.

• Helps financial leaders understand corporate finance and the decision-making processes involved in understanding and developing capital structure
• Includes case studies from around the world that explain key financial models
• Emphasizes ways to minimize risk when it comes to working with capital structures

There are a number of criteria that financial leaders need to consider before making any major capital investment decision. Capital Structure Decisions analyzes the various risk management and corporate governance issues to be considered by any diligent CEO/CFO before approving a project.

• Language: English
• Publisher: Wiley
• Release date: Mar 29, 2013
• ISBN: 9781118203163

Book preview

Chapter One

The CFO’s Role in the New Global Economy

CAPITAL STRUCTURE DECISIONS ARE the central force determining the orientation of decisions that are capable of meeting several conflicting goals and priority structures that ever-demanding stakeholders place before a chief financial officer (CFO). Traditionally, most corporate finance books suggest a limited and isolated role for a CFO. A decision maker is not confined to making only range-bound decisions, governed by the economic costs and benefits associated with those decisions. Unlike a computer’s simulation program that generates optimal solutions to input cost and risk, a decision maker evaluates several qualitative aspects of a decision with a 360-degree approach to the organisation’s problem. CFOs face challenging environments that are not limited to the financial target values represented in annual reports. They extend beyond the expected financial goals of return on investment (ROE) and price-earnings ratio (P/E). CFOs’ actions need to meet the expectations of several stakeholders who communicate with the firm on a daily basis. Besides the natural stakeholders, such as shareholders, the government, creditors, debtors, and others, there may be several invisible stakeholders, such as the taxing authorities, victims of corporate tragedies like the Bhopal gas tragedy, or political boilovers such as the Tata Sindhur case. Each stakeholder has his own set of expectations for the company. Each expectation is translated into a financial obligation (immediate or long term) and measured against competitive barometers of success. This makes the role of a CFO highly demanding.

In this book, we present the role of a CFO as an active decision maker who creates value for his or her company’s stakeholders by undertaking strategic decisions about a firm’s capital structure. The book is divided into 4 parts and 14 chapters, covering the following topics:

How to understand the sources and types of funds, including off–balance sheet sources, international financing that is available to a firm in global markets, innovations, risks, and uncertainties faced by a firm (Chapters 1–8). Theories, determinants, and practises of capital structure decisions, as well as questioning the rationality of an existing single objective premise in the present era (Chapters 9–11).

Defining and developing the role of a CFO in decision making and how his/her personal attributes influence the decision (Chapters 12 and 13).

Developing a goal-programming model to handle capital structure decisions under multiple objectives and to provide for a fuzzy and a stochastic goal-programming model to handle risk and uncertainty (Chapter 14).

In this chapter, we try to understand the decision-making process of a CFO, his functions, and his success parameters with respect to capital structure decisions.

THE DECISION-MAKING PROCESS

Decision making is a process. It links several aspects of a business together. These aspects extend beyond the quantitative evaluations of the financial statements. Qualitative aspects can be discovered during the process of understanding, evaluating, and experiencing the decision. Capital structure decisions are not ubiquitous. They change for a firm during its lifetime, for firms in the same industry, across economic boundaries, and also against stakeholder expectations. Significant differences can be observed in capital structures throughout the world.

Ivo Welch (2004) once said, Capital structure decisions are a mystery. They are a mystery capable of creating and reinventing successes and defining failures, whether it is Kodak or Facebook. Capital decisions of a firm are usually evaluated independent of their circumstances, which do not provide a true and fair picture for their rationale. Such evaluations prove to be a poor means to measure a firm’s competitiveness in the game of survival of the fittest. The cloud of mystery is evaluated by external parties when performance is measured against benchmarks. The cost-benefit principle is practical but does not offer plausible solutions to the variations observed in capital structure decisions. Decisions are governed by goals, their priorities, and the constraints that influence their realisation. The decision-making process is highly complex, and we divide it into seven stages to understand the complexities that give rise to variability. The seven stages of decision making that influence the decision are:

1. Determining the goals of a firm, of management, and of other stakeholders using financial and nonfinancial parameters.

2. Reviewing, selecting, and eliminating goals to arrive at the most relevant ones.

3. Prioritising important goals.

4. Perceiving, identifying, reviewing, and quantifying the constraints (internal and external) on, and the limits of, the decision maker.

5. Identifying the possible courses of action to achieve such goals within the framework of constraints.

6. Evaluating and re-reviewing the possible choices that are available in order of their priority by ensuring that no goal or constraint is left unconsidered.

7. Implementing the choice, evaluating the outcomes, and modifying any future course of action.

Unlike the propositions of economists Franco Modigliani and Merton H. Miller, which concentrate on the single objective function of value maximisation through capital structure decisions, this process desires the establishment of more than one goal. Most capital structure models define decision making as a limited approach developed against two variables: one, the cost of capital, defined as the weighted average cost of capital; and two, the cash earnings of a firm. Researchers across the world have outlined several other goals that a decision marker attempts to achieve while undertaking this decision: risk, on one hand, and cost or return, on the other. Balancing the choices in order to meet the goals becomes difficult. Goals and choices would be in the domain of a CFO’s activities.

A CFO plays several roles in an organisation. His tasks can be delegated to the members of his team, who can take on various roles and designations. Top finance positions that undertake strategic decisions are popularly known as treasurer or vice president of finance, vice president and treasurer, treasurer and controller, vice president of finance and treasurer, secretary of finance, treasurer and secretary, executive vice president, vice president and controller of finance, president, and vice president.

The function of the CFO’s team is to ensure the firm’s smooth functioning and growth. The CFO’s team is concerned with the following eight activities of a firm:

1. Accounting operations. Evaluating and comparing the strengths and weaknesses of a firm through the preparation and analysis of financial statements. Comparisons are conducted on a standalone basis, on a trend basis, and on an inter-industry basis. This also includes the preparation of long-term budgets and cash budgets and compliance with regulations on accounting and taxation.

2. Financial planning. Planning the financial strategy of a firm by participating in long-range economic planning, advising on the expenditure of capital assets, analysing credits and collection, and liaising with financial intermediaries.

3. Capital resources. Identifying, selecting, and organising the sources of capital against their risk-and-return profiles and hence advising on capital structure decisions. Choosing instruments to hedge operational and financial risks that are faced by a firm. Providing and assessing contingent claims. Creating a necessary cushion to retain and nourish relationships with employees, investors, creditors, and business partners.

4. Expansion and contraction activities. Financial appraisal of various capital projects, takeovers, mergers, disinvestments, restructuring, and other asset-financing means, such as leasing and factoring against the benchmark rate of investment rate.

5. Shareholder reward policies. Creating desired effects on value drivers, such as return on assets (ROA) and P/E by determining the financial strategies of rewarding the shareholders through dividends, buybacks, bonus issues, stock splits, and employee stock ownership plans (ESOPs).

6. Asset and liability management. Management of current assets and liabilities that puts the least burden on the long-term funds of a firm and generates maximum return for a firm.

7. Accountability to regulators. Reporting and maintaining relationships with the government, the capital market, and other regulatory bodies, which secure the smooth functioning of a firm.

8. Investment opportunities. Creating a platform for investable partners and strategic board-level players.

The above-mentioned functions need a holistic approach to planning and implementation. Hence, decisions about investments, capital structure, dividend policy, and working capital management are interlinked by the basic accounting equation of

Capital + Liabilities = Assets

A business that begins with this capital, as mentioned in the above equation, is capable of determining the size, quality, and risks associated with the liabilities and assets of a firm. A CFO determines the strategic direction of a firm in terms of the relationship of capital to the assets and liabilities of the firm and how the firm should evaluate decisions against its goals and constraints to create value for its stakeholders. A firm’s sources of capital are interdependent and influence the assets and liabilities of a firm, thereby creating tangible and intangible benefits for future growth and development. Furthermore, the evaluation of several choices and operations become complex with penetrating globalisation, where every firm is a global player, even in its domestic operations.

GOALS OF A CFO’S TEAM

Given the roles and functions of a CFO and his or her team, these finance professionals are mostly like to establish several goals in various priority structures. Here are seven commonly established goals that are observed when CFOs make financial decisions:

1. Wealth maximisation. These are value additions made to enhance the performance of the firm that yield positive results to all stakeholders, without making anyone worse off. It is, however, difficult to assess whether the Pareto optimality condition can be fulfilled by any decision. One would commonly find all decisions in most corporate finance books being evaluated by using this criterion. Measured by the change in value of the market capitalisation of a firm, this goal is considered in most financial models the single objective against which all decisions should be evaluated. In the present era, this objective is highly questionable, which I discuss in later chapters.

2. Profit maximisation. This is a traditional goal of most businesses, which has been highly criticised. It refers to improvement in revenues and cost cutting, as measured by ROA, return on equity (ROE), and other profitability measures. Competition and globalisation have constantly stressed the need to improve top-line and bottom-line growth values in companies.

3. Survival. This is a lesser known objective when organic and inorganic growth agendas carry most of the weight in the decision-making process. Yet this objective continues to be relevant in light of the shocking bankruptcies around the world, especially when firms with many years of existence, such as Kodak, can file for bankruptcy, when Facebook is criticised for the destruction of value, and when capital access has no boundaries.

4. Sales maximisation and market leadership. This is a well-known objective, with advantages that Japan and Germany once used to create value for themselves in the world, and now China has used to its advantage to become an emerging power. The business world takes advantage of economies of scale to increase profitability, promote goodwill, broaden networks, and create many other linkages that are available with scalability alone.

5. Growth. This strategic objective is attempted at all levels in a firm and can be easily conveyed to all stakeholders. Rate of growth in different ratios of a firm is usually considered the means to measure this objective.

6. Stability. Achieving goals that create more certainty for all stakeholders is an objective that encompasses all of the other objectives. It is not the end but the means of achieving the end for a firm. It is easy to achieve high profitability, growth, or market value once, but to sustain it is a challenge. Many firms have been compared to shooting stars that were acknowledged only for a short period of time and then died out, such as the Daewoo-DCM joint venture in India.

7. Satisficing stakeholders. This means achieving goals and objectives at a satisfactory level, rather than at an optimal level. Thus, a business would keep in view multiple considerations while assessing and evaluating a decision and its consequences.

These objectives can have several subobjectives that CFOs may attempt to implement while they determine their strategic actions (which we discuss later in the book). The multiplicity of goals also gives rise to conflicting situations that need to be resolved by prioritisation. The simultaneous achievement of goals faces several constraining behavioural situations, commonly described as the problems of goal incongruence, agency cost, and others. In the decision-making process, it is important to clearly outline the goals and priorities for every CFO in light of the constraints faced by a firm.

A CFO’S CONSTRAINTS

In the decision-making process, just as goals are important, so are the factors that constrain the actions of the decision maker. Achievement of a goal is dependent on the internal and external environment in which a decision maker operates. Several constraints may influence a decision maker simultaneously. Internally, a firm may be constrained by its management knowledge, finances, operational capabilities, and control setup. Externally, the chain of suppliers, consumers, goods or services markets, government regulations, political affiliations, competitors, bankers, capital markets, economic growth rates, and the world economy may all act as constraining factors for a firm. They can be further divided into factors at the macro level, as economic, political, and social constraints, and factors that affect a firm at the micro level. A firm may face some or all of these constraints from time to time while undertaking capital structure decisions. CFOs attempt to minimise such constraints by their actions and decisions.

Once all of the goals and the constraints are clearly laid before a CFO, he must decide the best alternative course of action, as per the organisation’s priority structures. Various strategies, alternatives, and courses of action must be identified, estimated, and evaluated. The risk and uncertainty of undertaking every course of action must simultaneously be determined and incorporated into the process through stochastic or fuzzy goal estimates and constraint estimates. The firm should control excess deviation from actions and expected outcomes with a follow-up strategy. Risk should be hedged or diversified. The choice of an action then must be evaluated to assess specific outcomes in order of their priority. Traditionally, single objective premises in capital structure decisions have yielded optimal solutions, but when there are multiple goals and constraints before a CFO, a satisficing solution needs to be substituted for an optimal solution.

RECENT ISSUES IN CAPITAL STRUCTURE DECISION MAKING

Finance, as a field, has expanded in scope immensely in the last few decades. A CFO has the ability to define and change the scope and intensity of the goals and the constraints available to a firm by incentivising different stakeholders. Expectations are incentivised by financial prowess, which is generated by the judicious use of capital sources.

Incentives for stakeholders are not limited to dividend payments or bonuses but include the creation of a corporate governance structure that caters to the interests of parties other than the immediate beneficiaries, such as credit raters, media agencies, governments, and other regulators. Competitive landscapes have changed with globalisation, liberalisation, and privatisation. This has made the world a more competitive place for businesses that want to survive. With governments’ liberalising capital controls, the global arena is open for everyone to earn his or her returns. Goods and services, the movement of people, the size and speed of financial flow, and technological diffusion have marked a new developmental process. Financial integration by most businesses is predicted to intensify in the next twenty-five years, as technological advancements lead to a greater integration of markets. In addition, finance does not remain limited to domestic frontiers. CFOs have improved their returns on firm operations through managing international portfolios by entering several markets simultaneously, for which they need quick access to efficient and flexible capital.

Banks’, financial institutions’, and financial services’ boundaries of operations are slowly vanishing. They are entering into one another’s segments, introducing stiff competition in the financial markets. Highly liquid markets are willing to offer better loan terms, with lower rates, longer terms of maturity, and flexible credit. Avenues of capital have created several innovative financial structures, giving birth to a new stream of professionals known as financial engineers. Access to international equity and debt markets and cross-listing of firms on major stock exchanges has diversified the risk of raising capital. Firms are willing to commit themselves to international standards of accounting, reporting disclosure, and corporate governance, which adds more stakeholders for evaluating capital return performance.

New opportunities and challenges faced by CFOs are under serious scrutiny. One failure does not limit itself to the firm and its management but has a contagion effect on the industry, the economy, and the world. For example, we have seen firms make governments change regulations, as in the case of Kingfisher Airlines in India wanting a bailout from the government. It was able to make the Indian government increase the external commercial borrowing limit for the airline industry. Or, in the case of AIG, it forced the government to consider a bailout. There are many similar cases. The imaginative use of several financial stratagems and instruments, such as warrants, convertibles, other derivative instruments, and complex and complicated consideration schemes, all influence the growth and development of a firm. CFOs’ ability to effectively interact with the basic planning, administration, and operations of a firm can make a firm a long-term player in the global arena.

Unlike the basic premise that investment, dividend, financing, and working capital decisions are independent and isolated, the interdependence of these decisions is extremely high. With innovative contracts such as sale and lease back, in which a firm can sell its entire production plant and lease it back for operations, it would be difficult to judge whether the decision pertained more to investment, financing, or working capital. Another example of such strong interdependence is when firms finance their own customers’ purchases through their subsidiary units (or they finance wings of the firms) to purchase their products or to clear their inventory. Among corporates, this practise is commonly known as purchasing sales, which is an investment, working capital, and financing decision—financing, especially, when there is a chance of large defaults occurring. With ever-evolving capital structures, what remains close to the heart of all businesses is that a firm’s progress on business frontiers and its access to capital secures it a future vision and mission. This capital structure is not what is stated on the balance sheet but is the virtual or real ability of a CFO and his firm to withstand the test of time in the creation of wealth.

SUMMARY

The world is a global village, and a firm is a global competitor. Charles Darwin’s law of survival of the fittest continues to be the guiding principle for all decision makers. Capital structure decisions are a central decision that can absorb any failure and aid any success. Capital can simultaneously fuel and impede growth and survival. Firms need to continuously innovate their CFOs’ functioning to ensure a sufficient supply of funds for operations. The dynamic environment and competitive challenges put further pressure on CFOs to perform in an accountable manner.

Capital structure decisions, just like other decisions, go through a process of decision making that estimates goals and constraints in order to evaluate various alternatives. Decision making is a process and not a computerised solution of balancing the economic costs and benefits associated with a decision. The role of a decision maker is crucial in the process.

A CFO’s ability to guide a firm in determining its goals and identifying its constraints is amplified by the functions he handles at the organisation. The functions of a CFO and his team range from acting as an accountant to organising episodic events as a strategist. He needs to adapt to the variations in his role and adequately provide for growth opportunities and a cushion of survival for his firm. The role of a CFO is further challenged by recent innovations and engineering improvements in the world’s financial markets. The advent of new regulations and open economic structures offers both threats and opportunities to firms that have both forwards and backwards linkage with the other market participants. The ability to generate a capital structure that has virtual and real possibilities to expand and contract with firm-specific situations would determine the success of a CFO in the global economy.

Chapter Two

Time Dimensions of Capital Structure Decisions

CAPITAL STRUCTURE DECISIONS ARE long-term decisions involving the acquisition, retention, and redemption of funds at various time periods. We draw from economics the definition of long run, where all sources contributing to capital can be changed, and short run, where at least one source of capital is fixed. The capital needs of a firm for strategic dimensions have a long run period, but for operational and tactical decisions, firms have a short run period to devise the structure. Short-run decisions are enveloped by the long-term perspectives of a firm, of which the most important dimensions are flexibility and credit risk. During the initiation stage of business, restructuring, or liquidation, all sources of capital can be changed or adapted but not otherwise. The risk and uncertainty of the obligations arising out of capital sources increase as we go further in time. For the same reason, equity funding is considered more risky than debt.

Firms need to keep three things in mind before raising funds. First, the amount of cash flow that is sought by the action (both inflow and outflow); second, the time horizon for which the funds are to be raised and retained; third, the financial (such as interest charges, government taxes, and others) and nonfinancial obligations (such as risk perception, transition probabilities of credit defaults, and others) associated with the funds. Fund acquisition and redemption periods involve a significant movement of cash inflow and outflow. The cash outflow during the retention period is much lower in proportion to the cash flow of the acquisition or redemption period. These cash movements directly influence the overall liquidity and solvency position of a firm. At any given point in time, the profitability, market value, and activity level in a firm may or may not support its liquidity and solvency requirements. Capital structure in varying time periods should provide and magnify returns in both circumstances.