Question

a) What are the main factors affecting a company’s capital structure as suggested by the trade-off theory and the pecking order theory? Explain how these factors shape a company’s capital structure decisions.

b) How does an increase in financial leverage affect a company’s cost of debt and cost of equity? Explain in details.

c) Why might shareholders prefer rights issue to private placement as a method of capital raising?

What are the characteristics of off-market share buybacks in Australia? Why would shareholders participate in the buyback when the buyback price is set at below the market price?

Answer 1

a) The trade-off theory of capital structure means that a company decides how much debt capital and how much equity capital to use by balancing the costs and benefits. The advantage to financing with debt is the tax saving of debt however, debt financing often comes with a multitude of disadvantages including cost of bankruptcy and non bankruptcy costs which include suppliers demanding unfavourable terms etc.

As per the trade off theory, the marginal benefit of debt financing decreases as the amount of debt in a firm increases whereas the marginal cost of debt financing goes up.

Therefore a firm that wants to maximise its value, will have to strike a balance between debt and equity in its capital structure.

The pecking order theory postulates that the cost of financing increases with increase in asymmetric information.

This theory states that various sources of finance include internal funds, debt and new equity. A firm would always prefer internal funds, if the internal funds dry up, then "debt" is used and the last resort is to raise new equity.

This pecking order is important because it indicates to the public how a company is performing. If a company finances itself internally through retained earnings, it means the company is strong.

If a company finances itself through debt, it indicates that company management is confident the company can meet its monthly obligations.

If a company finances itself through new stock, it is usually a negative sign, meaning the company thinks its stock is overvalued and it seeks to raise money before its share price falls.

b) If a firm increases leverage by issuing/ taking on more debt, then the cost of debt tends to increase. This is due to the fact that an increase in debt will make the company more prone to financial distress and thus new debt can only be issued at higher rates of interest.  

An increase in financial leverage makes the firm more risky and the expectations of equity shareholders would therefore increase. This increase in risk due to financial leverage causes the cost of equity to rise due to an increase in the stock beta.

Thus a firm has to strike a balance between debt capital which is cheaper and provides tax saving and between equity financing.

c) Rights issue is a kind of share issue wherein companies offer shares to all existing shareholders in proportion to their holding. A cut off date is given by which shares can be subscribed to by the existing shareholders.

In private placement, shares are alloted to selected individuals/ persons.

Rights issues are preferred over private placement of shares because the number of shareholders remains the same, the stake of each shareholder in the company also remains the same in the case of rights issue. However in case of private placement of shares, the percentage of shareholding of existing shareholders can likely get diluted if new shares are issued.

Off-market share buybacks in Australia are often structured with the buyback price consisting of a large dividend component, carrying imputation tax credits and a small capital component. This structure is unique to the Australian market and the consequence of this structure is that institutions which have lower tax rates benefit most from selling their shares to the company compared to institutions liable to higher rates of taxes.

Shareholders/ investors prefer buybacks even when buyback price is lower than market price because buybacks can boost shareholder value and share prices in the future while also creating a tax-advantageous opportunity for investors.