Q2

Critically appraise how companies set their financing – both short-term and long-term policies, and explain the factors that a company should consider in setting its policies to raise capital for investment and in determining the level of debt equity balance to be maintained. The debt and equity financing strategy should be highlighted in detail.

Support your arguments by reference to TWO FTSE100 firms in the SAME INDUSTRY. Your comments should incorporate both theoretical and academic arguments and real world practices. You should research the subject beyond the basic facts, and must provide calculations, references and critical commentary to support the points. You should also provide a brief introduction on the key issues and a conclusion consistent to your discussion.

Note: You can visit the link below to select one industry of your choice from the available list of industries.

Please note both the firms must come from the same industry. You are suggested not to use banks, and companies engaged in financial services.

Word Count of answer = 1521

Target Word Count = 1500
Q2 makes up 40% of the paper.

Please structure the answer in the proposed headings:

1. Introduction (focus of the question and state how you will demonstrate the points)

2. Executive Summary (bullet points of the highlights)

3. Assumptions (list assumptions made)

4. Main points of appraisal should include the following:

  1. Introduction of the funding strategies (theory and practice) i.e. the need to raise capital for investment etc
  2. Factors that the company should consider in setting its capital investment policies
  3. Short Term and long term policies
  4. Financing working capital
  5. Capital Structure Polices (optimal capital structure)
  6. Benefits and costs of using debt financing and equity financing? Which is more appropriate in reference to GSK?
  7. Pecking Order Theory to be perhaps referenced or mentioned in the appraisal?
  8. Practical considerations that managers are concerned with when choosing a capital structure

6. Conclusion

7. References(Text and Cases where relevant)

8. Appendices (these are excluded from the word count and could include all working papers)

  1. Reference tables for the financials for GSK and Shire PLC
  2. Any key financial ratio workings that could be referenced in the appraisal above.

Additional considerations for the answer:

The appraisal must reference theory and the practices (in this case the texts for theory and GSK Plc and Shire Plc for practice)

A company needs financial capital in order to operate its business. For most companies, financial capital is raised by issuing a blend of debt securities and/or common stock equity. The amount of debt and equity that makes up a company’s capital structure has many risk and return implications. Therefore, corporate management has an obligation to use a thorough and prudent process for establishing a company’s target capital structure. The capital structure is how a firm finances its operations and growth by using different sources of funds. Short-term financing is important in that the enterprise must finance its needs and be able to repay that (most often) short term debt when due to avoid putting the enterprise at risk. Long-term financing, done with long maturity debt and equity, is executed to reduce financing risk, allow for returns to shareholders, and insure long term viability of the enterprise.
Financial leverage is defined as the extent to which debt and equity with characteristics of debt (preferred shares) are used in a company’s capital structure. Financial leverage creates enterprise value due to the interest tax subsidycreated by the deductibility of interest. The use of financial leverage has value when the assets that are purchased with the debt earn more than the cost of the debt used to acquire them. Under both of these circumstances, the use of financial leverage increases the company’s profits. When an enterprise loses money in leveraged enterprises, financial leverage will magnify losses. It will reduce equity value and thus reduce the value of the company.
The capital decision making process starts when company management decides how much external capital it will need to raise to operate its business. This can be either a long term and/or short term strategy decision. Once this amount is determined, management needs to examine the financial markets to determine the terms in which the company can raise capital. This step is crucial to the process, because current marketconditions may curtail the ability of the company to issue debt securities or common stock at an attractive level or cost. The management of a company can then design an appropriate capital structure policy, and construct a package of financial instruments that need to be sold to investors. Management should establish its financial structure according to its long-run strategic plan, and the manner in which it wants to grow the company over time.

One theoretical measure of the debt-equity mix is the Modigliani and Miller Theorem on Corporate Capital Structure from 1958. That is when Franco Modigliani and Merton Miller published their Nobel Prize winning work “The Cost of Capital, Corporation Finance, and the Theory of Investment.” Modigliani and Miller illustrated that under conditions where corporate income taxes and distress costs are not present in the business environment, the use of financial leverage has no effect on the value of the company. This view, known as the Irrelevance Proposition theorem, is one of the most important pieces of academic theory that has ever been published.
Unfortunately, this Theorem requires a number of impractical assumptions to apply the theory in a real world environment. In recognition of this problem, Modigliani and Miller expanded their Irrelevance Proposition theorem to include the impact of corporate income taxes, and the potential impact of distress cost, for purposes of determining the optimal capital structure for a company. Their revised work, universally known as the Trade-off Theory of capital structure, makes the case that a company’s optimal capital structure should be the prudent balance between the tax benefits that are associated with the use of debt capital, and the costs associated with the potential for bankruptcy for the company. Today, the premise of the Trade-off Theory is the foundation that corporate management should be using to determine the optimal capital structure for a company.
The use of financial leverage varies greatly by industry and by business sector. A review of two FTSE100-listed pharmaceutical companies, GlaxoSmithKline PLC (GSK) and Shire PLC, will show different uses of capital for different purposes. Both entities offer stable financing and returns for investors.

GSK has to have not only short term financing in place for operations, but has a long history of debt-based acquisitions of other pharmaceutical companies. Its short term financing is strong, with current assets of 13,692 million euros (2012 financials) against 13,815 million euros. A current ratio comparing the two is approximately 1.00, which shows the company can cover its current obligations. GSK has used significant leverage to finance assets and acquisitions, with long term assets of 27,783 million euros and 20,913 million euros of long term debt. The remainder, 6,747 million euros, is the historical cost of equity. From this perspective, GSK uses significant leverage to return benefits to shareholders.

Shire PLC has to have not only short term financing in place for operations, but has a long history of acquisitions of other pharmaceutical companies. Its short term financing is strong, with current assets of 3,212 million euros (2012 financials) against 1,646 million euros. A current ratio comparing the two is approximately 2.00, which shows the company can easily cover its current obligations. Shire PLC has used significant leverage to finance assets and acquisitions, with long term assets of 7,317 million euros and 1,862 million euros of long term debt. The remainder, 3,809 million euros, is the historical cost of equity. From this perspective, Shire PLC uses less leverage to return benefits to shareholders. Its total debt, 3,508 million euros, is almost an even 50-50 weighting with its historical equity of 3,809 million euros.
Perhaps the best way to illustrate the positive impact of financial leverage on a company’s financial performance is by reviewing appropriate metrics. Return on Equity (ROE) is a popular metricthat compares the profit that a company generates in a fiscal year with the money shareholders have invested. After all, the goal of every business is to maximize shareholder wealth, and the ROE is the metric of return on shareholder's investment.
Since the management of most companies relies heavily on ROE to measure performance, it is vital to understand the components of ROE to better understand what the metric conveys.

A popular methodology for calculating ROE is the utilization of the DuPont Model. The DuPont Model establishes a quantitative relationship between net income and equity, where a higher multiple reflects stronger performance. However, the DuPont Model also expands upon the general ROE calculation to include three of its component parts. These parts include the company’s profit margin, its asset turnover, and its equity multiplier. Accordingly, this expanded DuPont formula for ROE is as follows:

Based on this equation, the DuPont Model illustrates that a company’s ROE can only be improved by increasing the company’s profitability, by increasing its operating efficiency, or by increasing its financial leverage.
Factors Considered in the Capital Structure Decision-Making Process
There are several quantitative and qualitative factors that need to be taken into account when establishing a company’s capital structure. First, a company that exhibits high and relatively stable sales activity is in a better position to utilize financial leverage, as compared to a company that has lower and more volatile sales. Both GSK and Shire PLC have long operating histories, and stable product mixes and customers. They can be more aggressive in managing leverage, relying on their predictable revenues and stable operations.
Secondly, a company with less operating leverage can afford to add debt to increase returns to equity shareholders.
Third, faster growing companies are likely to rely more heavily on the use of financial leverage, because accessing equity investment can be a slow, laborious process. Accessing credit markets for financing can often be done more expeditiously.

Fourth, a company that makes taxable profits tends to utilize more debt to take advantage of the interest tax shield benefits.
Fifth, a company that is less profitable tends to use more financial leverage, because a less profitable company is typically not in a strong enough position to finance its business operations from internally generated funds.
The capital structure decision can also be addressed by looking at a host of internal and external factors. Companies that are run by aggressive vested owners will be inclined not to dilute their ownership by issuing additional equity.
Second, when times are good, capital can be raised by issuing either stocks or bonds. However, when times are bad, suppliers of capital typically prefer a secured position, which in turn puts more emphasis on the use of debt capital. With this in mind, management tends to structure the capital makeup of the company in a manner that will provide flexibility in raising future capital in an ever-changing market environment.
Corporate management utilizes financial leverage primarily to increase the company’s earnings per share and to increase its return-on-equity. With these advantages come increased earnings variability and the potential for risk when the benefits of leverage magnify the elements of loss. With this in mind, the management of a company should take into account the business risk of the company, the company’s tax position, the financial flexibility of the company’s capital structure, and the company’s degree of managerial aggressiveness when determining the optimal capital structure.