Debt, Equity and Capital Structure

by David Singh and Roger Loh

Corporations fund their investment by raising capital through equity or debts, or a mixture of both.?Of course, the beauty of equity is that it resembles perpetual debt, i.e. there is no obligation to repay while it is not the case for debts.?The payoff for equity holders also mimics that of a call option payoff as corporate law limits the maximum loss to an equity investor to his invested amount and no limit to upside gain on his investment.

Debtholders returns are finite, while returns on equity vary with the firm performance.?Equity holders claim over a firms assets ranks lower than debtholders, and by nature, interest payment qualifies for tax deductions subject to thin capitalisation rules and interest restriction rules.?All this results in equity being an expensive form of financing as it’s apparent that equity holders take more risk than debtholders.

The corporate finance literature provides some light on how firms make the choice of raising financing either through debt or equity.?We explain this literature in the simplest and most palatable form as follows: -

Trade-off theory - this theory claims that firms have an optimal leverage ratio determined by trading off the tax advantage benefit of interest deductibility against the cost of financial distress.?They can do this by moving the leverage ratio towards a target or optimum leverage ratio or letting it vary within an optimal range.

Pecking order theory -?it suggests that there is a pecking order in financing corporate investments. Since internally generated funds are the cheapest, firms will resort to this before funding with debt and that since equity is the most expensive form of financing, it will be the last resort form of financing.

Market timing theory -?it claims that firms are more likely to raise funds through equity if they perceive that their stocks are overvalued, and if it’s undervalued, then it would raise funds through debt.?It assumes further that the observed leverage ratio is the cumulative attempts by firms to time equity and debt markets.

Empirical evidence on these theories produces mixed results, but like any other social science study, no one school of thought suffices to explain a social behaviour.?Corporate finance is no exception to that.?However, the literature provides useful informational value in practice to assist sophisticated investors in their investment decision making.

Let us enlighten you with an illustration that is relevant from a recent capital raising exercise in our Malaysian corporate scene, with Top Glove announcement to Bursa Saham on Feb 26, 2021 for its intentions to raise RM7.7 billion through seasoned equity offering of 1.495 billion new shares.?The purpose was to finance its production capacity expansion and pursue a dual listing on Hong Kong Stock Exchange in addition to Singapore Stock Exchange.?It also has excellent credit ratings.

Top Glove has very low leverage ratios and has significant potential capacity to increase its debt levels or leverage ratio comfortably following its peer group in the industry.?This had the potential benefit to unleash interest rate tax benefits to add to its enterprise value, and its leverage ratio is way below its optimum level.?

Moreover, it was sitting on a massive pile of cash too that earns returns less than the capital providers expected returns.?The reasonable question any investing public would ask is why it did not utilise its cash mountain, including raising debts to finance its expansion, which would have reduced Top Glove’s cost of capital.?It appears that Top Glove has not fully explored cheaper funding sources from internal funds or raising debts before heading for a seasoned equity offering.

The share price of Top Glove closed at RM5.24 on its announcement, which was fuelled significantly by the abnormal demand for disposal rubber gloves.?However, the sustainability of the abnormal prices for rubber gloves over the near future remains doubtful with planned increase of production capacity and the emergence of vaccines to treat the covid-19 infections.?The timing of the seasoned equity offering subtly points to signal the market that managers viewed that their equity value is overvalued, and their offering can gain higher cash proceeds.?

The offering has seen delays and reductions in the amount to be raised. We view that the attraction of the offering lessened because it doesn’t sync well with all the three conceptual theories of capital structure. As of Nov 15, 2021, Top Glove’s share price closed at RM2.49 on Bursa Malaysia.

A basic understanding of capital structure concepts here can be helpful to the investing public in making its investment decision whilst shedding light on a corporation’s underlying purpose of an equity offering.?Similarly, the three concepts explained above are also equally applicable when corporations are raising debts.?The same concepts also can relay information on a corporation’s financial strategy.?

We hope that this article today was able to impart some fundamental knowledge on corporate finance to the readers and provide some clarity on the basic understanding of capital structure.

This article was first published by?The Sun on Nov 29, 2021 (click here) in collaboration with the Malaysian Institute of Certified Public Accountants . The views expressed here are the writer's own and do not reflect the opinions and views of any organisation or its members.