Corporate and Capital Structure INTRDUCTION CORPORATE STRUCTURE Organization Forms Which one is...

Corporate and Capital Structure

INTRDUCTION

CORPORATE STRUCTURE Organization Forms Which one is appropriate?

CAPITAL STRUCTURE What determines the structure? Allocation of Risk, Income and Control Off balance-sheet financing The Cost of Capital

EVOLUTION OF THE STRUCTURES

THE MANAGEMENT CHALLENGES

CONCLUSION

Agenda

INTRODUCTIONCorporate and Capital Structure

Two major decisions the founders of the organization have to make:The Legal form of the organizationThe capital structure of the organization.

These decisions are guided by:The inherent nature of the businessThe strategy of the business

• The owners or shareholders generally must approve any changes in the initial corporate structure, such as creation of new classes of stock (capital structure change), issuance of new shares (corporate structure change) or even sale of the company – subject to shareholders approval.

• It is therefore essential that the directors understand the concepts and the dynamics

involved in corporate and capital structure.

CORPORATE STRUCTURE

Source: (Font, Arial, Font size: 9pt, Black)

Corporate and Capital Structure

Organization forms:

Proprietorships: Single owners. The owner is the business in that the enterprise has no economic value. E.g. Small service business or professional businesses.

Partnerships: Multiple owners with some engaged in the management:

Limited Liability Partnerships: Provides liability protection while maintaining tax benefits.

C Corporations: Standard form of corporate organization

S Corporation: Same as C corporation but income is taxable as partnership. Cannot have more than 75 shareholders

Limited Liability corporations. Same as LLP except that it has members instead of partners.

Public Corporations: Meet ownership criteria defined by SEC.

General Partners Limited partnersHass full authority to manage the affairs of the business Restricted authority

Unlimited liability. Liability limited to capital invested or committed.

CORPORATE STRUCTURECorporate and Capital Structure

Which is the most appropriate?

A degree of judgment is required. There are at least five variables that should be considered:

The size and complexity of the business The number of owners The Life span of the business Tax considerations Liability considerations

Generally speaking: Smaller, simpler businesses are more apt to be proprietorship

or partnerships. C Corporations are subject to double taxation: corporate

income tax + personal income taxes (dividends tax)


Public Versus Private?

Why go public?To raise capital to fund a growth or acquisition strategy. As an exit strategy for the venture capitalist.To gain liquidity for the previous investors as IPOs tend to yield the highest price compared to private sale or company buy-out.Self-interest on the part of both investment bankers seeking a fee and the owners of the company. E.g. the dot-com bubble (2000)

Public PrivateOwnership Refers to companies whose shares are widely owned and publicly

tradedHave fewer shareholders or single owner. Tend to have black ownership.

Size Tend to be large and may use public debt markets. Tend to be small and medium sized.

Investor relations and reporting.

Are required to report financials and other data regularly to the SEC. Handle their investor relations and financial reporting as a matter of company preferences.


When to go public?

Even though going public may be a sign of success or maturity, running a public company has additional challenges like costs of regulatory compliance, management of investor relations, and share market structure management.

Going public should therefore be undertaken only when:There are solid business reasons like access to capital, stockholder liquidity, and a currency to execute an acquisition strategy.The company is large enough to create a meaningful market for its shares. Market capitalization of about $100 million is realistic enough.

CAPITAL STRUCTURECorporate and Capital Structure

DefinitionThe details of the capital structure of a business describe the financing of the organization. Traditionally it refers to the relative amounts of debt and equity on a firm’s balance sheet.

Every firm is funded either through equity or debt.

The need for capital is driven by the nature, size and growth rate of the business.

Nature: Some businesses are more capital-intensive than others. E.g. Major manufacturing process operations would have higher investment intensity than a service business.

Size: It is the change in size that create the need for more or less capital. A basic maxim states that the nature of the business assets dictates the type of investment capital. Long term assets need to be funded by permanent capital (long term debt or equity.


Asset Types and Capital Sources: Debt/Equity balance

Trading Assets – Trading Liabilities = Trading Capital Required.

The more risky the business in terms of unpredictability or earnings, the more equity is needed. One of the principle mistakes that companies make is to overleverage hence need for a good balance. The table below gives some guidelines:

Assets Capital SourceSeasonal trading assets – accounts receivable, inventory, and pre-paid expenses

Trading LiabilitiesTrade credit:

Accrued expensesSeasonal bank line of credit

Permanent trading assets Trading LiabilitiesRevolving bank line of creditEquity

Fixed assets – Land, building, and equipment Long term debtEquity


Asset Types and Capital Sources: Debt/Equity balance

Trading Assets – Trading Liabilities = Trading Capital Required.

A conservative rule would be that all assets other than fixed assets are financed with equity (with a few exceptions depending on the nature of the assets)One of the key decisions a board must make is the amount of leverage the firm will assume. Leverage is a two-edged sword: When the interest rate on the debt is lower than the return on capital, the difference accrues to equity and leverages up the return on equity. The reverse, however is also true.

The mix of debt and equity determines two important things: The allocation of risk, income, and contro The cost of capital


The allocation of risk, income, and control.

For a strong company, the best debt gives up little control (it is unsecured but has tight covenants) and carries low interest rate, reflecting the low risk.As the risk increases, a lender will want more control (collateral and more restrictive covenants) and higher interest rate (more income.) The more risky debt is subordinated to senior debt and carries high rates (often high yield or junk bonds) and may even have equity features.Equity as a source of capital may involve the relinquishing of various degrees of control.A major question therefore: What is the optimal amount of debt?

EquityDebt


Off-Balance-Sheet Financing

It involves operating leases whose terms permit them not to be shown as liability.It is just an accounting technicality and has no financial impact.There are situations where off-balance-sheet obligations make good economic sense. Unfortunately, those who have wanted to cover up their actions or who have not wanted to disclose the full amount and nature of debt leverage have abused them.Often the complexity of off-balance-sheet vehicles make it very difficult for an outsider to understand a company’s true financial picture and even sometimes for insiders as well.Even though they should not be blanket condemned, the directors need to ensure the sound rationale of using such vehicles and that they are fully disclosed in company statements.


The Cost of CapitalDebt has a cost: the interest rate paid less tax savings.Equity also has a cost, although not so obvious: The cost of equity is the return that the owners desire on their invested funds. This return is a figure based on investors’ comparison of a given investment with their other opportunities. The cost of capital of a business can be estimated by computing weighted average of the costs of debt and equity. (See Example below)The return on capital before interest but after taxes should be compared to the cost of capital to see whether it is creating shareholder value or destroying it.Encouraging the earning of positive returns for shareholders, after all costs and including capital costs, is the basic intent of incentive systems.

Type of capital % of total capital Cost Weighted Cost

Debt 40 percent 4.2 percent 1.68 percent

Equity 60 percent 14 percent 8.4 percent

TOTAL 100 percent 10.08 percent* 7 percent interest rate less 40 percent taxes.

Example

STRUCTURE TRENDSCorporate and Capital Structure

Evolution of the Organization and Financial structure

CORPORATE MANAGEMENT CHALLENGESCorporate and Capital Structure

How to manage mix of business.

In a diversified, decentralized company, the corporate challenge is to provide an effective set of consistent results over the long term from a given mix of businesses, each of which has some inherent pattern of achievable results.The divisions are charged with producing outstanding results compared with similar companies, their own past performance, and of similarly managed ones.It follows that the only way the corporate office can make significant changes in the firm’s results for the measures of the return on investment and cash flow is to make changes in the portfolio of businesses. (acquire, divest, hold, etc)Corporations that perform superbly will find ready access to equity markets, will enjoy lower interest rates, and will be able to use strong stock prices to acquire additional business.The overriding objective is to enhance shareholder value, and this will be the ultimate objective of the boards of both public and private companies.


Restructuring to improve shareholder value: Strategic options.Strategy CharacteristicsContinue operations as is.

•Commits the corporation to the pattern of results reasonably available from the current business units.•Commits growth to the limits imposed by the natural growth rates available.

Sell one or more businesses

If it is perceived that the that the BUs lack long-term prospects consistent with the company objectives. Could also be due to other external factors.The sale would bring in cash that could be used in more advantageous ways.

Spin off some BUs Has some tax advantagesOccur when management feels that greater shareholder value can be achieved by separating the operations.The shares of the newly separated business are pro-rated to existing stockholders.

Sell the Entire Business

If the company may conclude that it is in the best interest of the shareholders to sell the entire business may be due to: fierce competition, prohibitive labor costs ,diminishing market share, etc

Acquire Additional Businesses

Use accumulated cash, debt or equity to purchase into strategic acquisitions.If well thought out can improve the company’s performance with regard to ROI, growth and/or cash flow.


How to manage mix of business: Strategic options.Strategy CharacteristicsRe-Purchase its own shares

•If the company is holding levels of cash beyond reasonable operation needs and it is believed the stocks are underpriced.•After debts are paid down to optimal levels, the cash in excess of internal needs normally earn less in interest income than prevailing return on investment from operations and thus result in a lower overall ROI

Why Re-Purchase?

Transfer excess funds to shareholdersIncrease the proportion of Debt in the Capital Structure: De-capitalizaton process can lower the cost of capital if an optimal mix of equity and debt is achieved.Signal Management’s confidence in the company’s stockDeter a takeover attempt.Likely positive market reaction and thus raisin the share price.

CONCLUSIONCorporate and Capital Structure

•A good understanding of the organization’s corporate and capital structure concepts would help the board and the CEO to meet the challenges and opportunities expressed in the following questions:

In what business should the firm compete? How should the company be re-structured? How should the company’s ongoing operations be financed? Is the level of corporate expenses consistent with that of other well-

run companies?•The more diversified the corporation is the more difficult it is for directors and corporate executives to understand the detailed problems and opportunities faced by opening divisions.

“Problems are always accompanied by opportunities” – a fundamental axiom for directors.

THE END Corporate and Capital Structure

Corporate and Capital Structure INTRDUCTION CORPORATE STRUCTURE Organization Forms Which one is...

Documents

Transcript of Corporate and Capital Structure INTRDUCTION CORPORATE STRUCTURE Organization Forms Which one is...