125980519

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Royal Melbourne Institute of Technology **We aren't endorsed by this school
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BAFI 1002
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Finance
Date
Oct 21, 2023
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7
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Possible Factors Affecting Companies' Capital Structure Kaiyi Bao ( B ) Durham University, Durham, England [email protected] Abstract. The capital structure shows the composition of a public corporation. The decision to change a company's capital structure made by managers is not only a method of increasing the profitability of the firm but also the prediction of the future development of the market. Thus, some of the most common ways of changing structure will be explained in this paper, and a major proportion of factors that may lead to the change of capital structure, including internal and external factors, as well as the process of influencing the change and the possible consequences. After the analysis, it can be summarized that these factors do not all affect the profitability of a firm, but some of them influence the survival of the firm. So the board of directors and managers of the firm should make the proper decision at the right time to make sure the positive trend of the company's development. Keywords: Capital Structure · Change · Factors · Aims 1 Introduction The assets of a company are composed of equity and debt, and capital structure is always used to express the condition of composition of debt and equity. The change in capital structure is a signal of the company's operation. For example, based on the background of the rapid development of the world, companies need to develop accompany with the economy. Thus, published companies have to raise sufficient capital for the future development, and it will lead to a change of capital structure. Also, there are a series of reasons that will make companies to change, not only for investing but also to protect the firm from bankruptcy and other dangers. This essay aims to list the pros and cons of stock and debt, common approaches to changing capital structure, and a possible portion of factors of changing capital structure, and discuss the relation between these factors and the possible action the company will take to overcome these problems through referring to some examples in the real world. 2 Basic Definition The capital structure is defined as the mix of debt and equity. It can be expressed by the debt-to-equity-ratio, which is calculated by the formula Debt/Equity = Total Liabili- ties/Total Shareholders' Equity [ 1 ]. Based on the background of the world and company, © The Author(s) 2022 F. Balli et al. (Eds.): ESFCT 2022, AEBMR 226, pp. 1447-1453, 2022. https://doi.org/10.2991/978-94-6463-052-7 _ 160
1448 K. Bao there are many factors that drive the change in the capital structure of a company, includ- ing internal and external factors, in order to adjust the debt-to-equity ratio to the best for the development of the company. When a company wants to change its capital structure, they must take the pro and con of stocks into consideration. It is changed through several combinations of methods: issuing debt and purchasing back the stocks, issuing debt, and paying a large dividend to equity holders or issuing equity and repaying debt. This essay will analyze the reasons for changing the capital structure and the anticipated results of the action they decide to take and the influences on the company, like the stock price of the company. 3 Stocks and Debts Pros and Cons A company's capital structure is defined by the number of stocks and debts it holds on its balance sheet. When the company wants to change it, the advantages of it are the primary reasons they will consider since they must get benefit from holding it. For holding stocks, the company does not need to pay the interest to shareholders before the maturity date than debt. What's more, companies are not necessarily required to pay the dividend to the shareholder since the residual income can be reinvested in other projects to increase the value of the company, and thus the value of the stock they own tends to improve. However, for stockholders in a company, increasing the number of stocks will dilute the percentage holders originally have, which means it is possible that the right of vote of one shareholder is going to decrease if common stocks are issued. Then the major manager must be changed as the change of voting right and it will inevitably cause the loss of management. Moreover, the cost of capital is higher than that of debt since the risk of investing in debt is higher than stocks for investors. Because of the higher expected return, the risk for company with lower leverage (the value of stock is higher than debt) will be required to earn a larger profit than high leverage companies to satisfy the expectation even though it is flexible to distribute the dividend. In contrast, the disadvantage of stock is the advantage of debt. Moreover, the cost of issuing debt is less than that of stock, and the interest payment to the debt holder can offset the tax paid to the government. Companies, therefore, are more willing to raise capital and then change their capital structure. This theory is called the pecking order theory [ 2 ]. However, in real life there are other reasons affecting the choice of financing. In Poland, bond issuing is not a popular financing polish because of too many legal restrictions. Although the Polish government canceled some restrictions in 2000, companies are not willing to issue bond. The main reason of this phenomenon may be the information failure in the bond issuer [ 3 ]. 4 Capital Structure Change Approach In order to change the capital structure, companies can only change the percentage value of debt or stock to the total value of the company. There are three general approaches companies would like to use in general.
Possible Factors Affecting Companies' Capital Structure 1449 4.1 The First Combination The first one is the combination of issuing debt and purchasing equity. It changed the capital structure by selling debt to the public to raise money and using them to buy back the stock sold in the secondary. This could make the percentage of debt value on the balance sheet increase and the company would become more leveraged. 4.2 The Second Combination The second method is issuing debt and pay a large dividend to equity investors. Com- panies firstly give debts to lenders. Then, the goal of altering the capital structure is achieved by sending a special dividend with greater value than normal. Thus, the value of equity (stock price) will go down, which will reflect the dividend paid to shareholders. 4.3 The Third Combination The final one is the opposite of the first approach, which is collecting money by issuing stocks to the market and collecting them to pay debt. However, this strategy is not closed most of the time. Because according to the pecking order theory, the cost needed to issuing stock is higher than debt, the companies only use this method when they are overleveraged and desperately needs to reduce its debt. 5 Possible Factors of Changing Capital Structure Generally, factors that can affect the capital structure should be divided into two different types: external and internal factors. For a firm's managers, they have to adjust the capital structure level to their best in order to maximize the value of the firm and decrease the bad effect brought by these factors. 5.1 External Factors The first external factor is the degree of development of the country. In developing countries, since the income level per person is relatively lower, the total cash flow in the market is not sufficient motivation and sources for firms to issue debt and stocks for development. Also, most developing countries do not have a complete financial system, which means it is hard to collect scattered capital and transform it into investment. So, in developing countries, companies are hard to change the capital structure into maximum. However, in developed country, large number of financial institutions can make sure the smoothness and legality of capital turnover to satisfy these companies' demand for capital structure. The second external factor is the economic cycle. The economic cycle is defined as the fluctuation of a country's economy between expansion and recession [ 4 ] (See Fig. 1 ). Normally, it is measured by the gross domestic product (GDP) level. When the economy is in a recession, firms generally want to reduce the amount of debt they hold since most debt has a maturity date and in a recession condition, it is hard to get
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