Debt, equity and capital structure

COMPANIES finance their investment by raising capital through equity or debt, or a mixture of the two. Of course, the beauty of equity is that it looks like a perpetual debt, that is, there is no obligation to repay while there is no such thing as a debt. debt. The gain for stock holders also mimics that of a call option, as company law limits the maximum loss for a stock investor to his invested amount and no limit to the upward gain on his investment.

Returns to creditors are limited, while returns on equity vary with performance. The claim on the assets of a company is less than that of creditors and, by nature, the payment of interest gives the right to a tax deduction subject to the rules of thin capitalization and restriction of interest. All of this makes equity an expensive form of financing, as it is obvious that equity holders take more risk than debt holders.

The corporate finance literature sheds light on how companies choose to finance themselves through debt or equity. We explain this literature in the simplest and most acceptable form as follows:

Compromise theory

This theory claims that companies have an optimal leverage ratio determined by trading the tax benefit of interest deductibility for the cost of financial distress. They can do this by shifting the leverage ratio to a target or optimal leverage ratio or by allowing it to vary within an optimal range.

Theory of hierarchical order

This suggests that there is a pecking order in the financing of business investment. Since internally generated funds are the cheapest, companies will resort to it before debt financing, and since equity is the most expensive form of financing, equity will be the form of financing of last resort.

Market timing theory

He claims that companies are more likely to raise funds through equity if they perceive their stocks to be overvalued, and if they are undervalued, then they would raise funds through debt. It further assumes that the observed leverage ratio matches the cumulative attempts of companies to time the equity and debt markets.

The empirical evidence for these theories produces mixed results, but like any other social science study, no single school of thought is sufficient to explain social behavior. Corporate finance is no exception. However, the literature provides useful informative value in practice to assist sophisticated investors in their investment decision making.

Let us enlighten you with a relevant illustration of a recent capital raising exercise in our Malaysian corporate scene, with Top Glove Corp Bhd’s announcement in Bursa Malaysia on February 26, 2021 that it intends to raise 7.7 billion RM from a seasoned stock offering. of 1.495 billion new shares. The objective was to finance the extension of its production capacity and to pursue a double listing on the Hong Kong Stock Exchange in addition to the Singapore Stock Exchange. It also has excellent credit scores.

Top Glove has very low debt ratios and has the significant potential ability to increase its debt levels or debt ratio comfortably by following its peer group in the industry. This had the potential benefit of unlocking tax breaks on interest rates to add to its enterprise value, and its leverage ratio is well below its optimal level.

In addition, he was also sitting on a huge pile of money that is earning less than the expected returns from the capital providers. The reasonable question any investing public would ask is why it hasn’t used its mountain of cash, including borrowing to finance its expansion, which would have lowered Top Glove’s cost of capital. It appears Top Glove didn’t fully explore cheaper sources of funding from in-house funds or debt raising before heading for a seasoned equity offering.

Top Glove’s share price closed at RM 5.24 when it was announced, which was fueled significantly by abnormal demand for disposable rubber gloves. However, the sustainability of abnormal prices for rubber gloves in the near future remains uncertain with the expected increase in production capacities and the emergence of vaccines to treat Covid-19 infections. The timing of the seasoned stock offering subtly signals to the market that managers felt their stocks were overpriced and their offering could generate higher cash income.

The offer experienced delays and reductions in the amount to be raised. We consider that the attractiveness of the offer has diminished because it does not correspond well to the three conceptual theories of the structure of capital. As of November 15, 2021, the Top Glove share price closed at RM 2.49 on Bursa Malaysia.

A basic understanding of the concepts of capital structure here can be helpful to the investing public in making their investment decision while also highlighting a company’s underlying purpose of a stock offering. Likewise, the three concepts explained above are also applicable when companies go into debt. The same concepts can also relay information about a company’s financial strategy. We hope that this article will be able to impart fundamental knowledge about corporate finance and clarify the basic understanding of capital structure.

This article was written by Sukh Deve Singh Riar, Business and Financial Advisor and Roger Loh Kit Seng, Associate Director of Mazars and Fellow of the Malaysian Institute of Chartered Accountants (MICPA). The opinions expressed here are those of the authors.

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