Advanced Financial Decisions Final Report

Introduction

Equity and debts form a company’s capital structure, and hence they are used to run the organisation’s operation and growth. This research examines the capital structure theories of 2 FTSE companies in the United Kingdom. In this study, we will examine the impact of ROA (return of assets), NDTS (net debt to total assets), liquidity, tangibility, size and growth on an organisation’s selection of debt which will define its capital structure. In this assessment, the panel data fixed effect approach has been utilised in determining the selected firms’ capital structure. Asymmetric information and internal forces as per the pecking order theory of capital structure are driving a company’s current desire to use power and influence, which is reflected in its capital structure. Consequently, to finance assets or investment possibilities, managers rely on internal financing or retained earnings from previous years. Profit growth is found to be inversely associated to long-term debt, short-term debt, and overall debt, according to the findings (Myers, 2001).

Overall, the data provides some support for the Pecking Order Theory of capital structure as well as the Trade-off Theory of economic development. In order to raise equity capital for a specific firm, ownership shares are issued, which the corporation can claim as profit or cash flow in the future. In addition, a combination of long- and short-term debt, common stock, and preferred stock might be evaluated in the context of a capital structure (Ardalan, 2017). During the analysis of the capital structure, the proportion of long-term debt vs. short-term debt is often taken into consideration by the organisation. There is a high likelihood that when professionals or experts have a discussion of the firm’s capital structure, they refer to the debt to equity ratio as it offers an insight into the borrowing habits of the company and helps in concluding if there are no major risks involved. In an event that an organisation has a huge debt which finances its operations, it exposes investors to increased risk since the company’s capital structure becomes more aggressive. Either firm has the option to raise additional debt or stock to fund its operations. When a corporation issues stock, it gives up some ownership in exchange for not having to pay back investors, however when a firm issues debt, it boosts its ability to do so by having to pay back investors. Therefore one of the ratios that can be utilised by investors as an indicator of risk is the debt–to–equity ratio.

Overview and Discussion of the Capital Structure Theories

Trade-off Theory

When it comes to capital structure, companies balance the costs and benefits of using debt and equity financing in order to make the best decision for their business. As far back as Kraus and Lichtenberger’s classic version of the theory goes, there was an attempt to find an equilibrium between the dead weight costs of bankruptcy and the tax benefits of debt (Atril, 2012). It’s not uncommon for agency fees to be included in the total cost. Competition to the pecking order theory of capital structure is frequently the case.

In order to explain why companies are typically financed with a combination of debt and equity, this theory is critical. The tax advantages of debt are cited as a reason for financing using debt. It is important to note that the costs of financial difficulty, which includes bankruptcy costs of debt and non-bankruptcy costs, diminish as debt increases, and the marginal benefit of subsequent increases in debt decreases (Bryman and Bell, 2007). If you’re trying to maximise the overall worth of your business, you’ll be looking at this trade-off while deciding how much debt and equity to utilise to fund your ventures.

Donaldson first proposed the theory of the pecking order in 1961. Investors make the assumption that when a new equity has been issued, the company has been overvalued, a view which would be updated in 1984 by Stewart C. Myers and Nicolas Majluf. Managers are making the most of this overvaluation to their advantage. As a result, the new share offering will have a lesser value in the eyes of investors. There is a notion in corporate finance called the pecking order theory. Theories like this one attempt to explain why businesses favour some forms of financing over others. As the level of asymmetric knowledge increases, the cost of borrowing tends to rise. It’s one of the most popular theories on capital structure. Debt dominates the company’s capital structure, according to the.

The Theory of Pecking Order

Using funding sources with a higher degree of asymmetric information, according to the Pecking Order Theory or Pecking Model, increases the cost of financial support. It gets increasingly difficult for corporations to raise capital internally as they raise more and more cash. Instead, they are compelled to rely on bank loans and public equity to stay afloat (Saunders et al., 2009). These types of funding are more expensive than other options. Companies choose to raise equity as a last alternative for financing because it is the most expensive of the available options, starting with internal finance and working their way up to it. As a result, internal funds are first utilised, followed by the issuance of debt and, finally, equity when the issuance of debt is no longer feasible.

The theory of pecking order is based on the fact that information is unevenly distributed throughout an organisation. When information is distributed in an unequal manner, we say that it is asymmetrical. Outside creditors or investors rarely have as much information about a firm as its managers do about its past, present, and future potential and risks (Hillier et al., 2010). The asymmetry of information might be particularly pronounced at organisations that produce highly complicated or technological goods or that have less open financial records. The greater the information asymmetry, the greater the risk for the company.

Investors, on the other hand, can’t know everything about a business. It’s impossible to eliminate all knowledge asymmetry in the workplace. Investors and creditors who are less familiar with the business are more likely to seek a bigger return on their investment (Collis and Hussey, 2003). When it comes to issuing debt and equity, the corporation must bear the costs associated with doing so. Paying board fees and other agency expenditures are necessary to ensure that shareholder interests are protected. For all of these reasons, internal sources of funding are less expensive and more convenient than relying on the outside world.

Tax Theory

To understand the harm produced by tax distortions, economists have relied on the allocation theory of taxation since its inception. Because of this, it has always been an element of the second-best theory. It has been more than 40 years since the use of formal, second-best, general equilibrium models to solve tax problems was first introduced (Barclay et al., 2005). The most significant expansions have occurred in the context of multi-person economies. It is now clearer to us the trade-offs between equity and efficiency in second-best situations. In addition, tax theory and public expenditure theory have become increasingly closely linked (Denis, 2012).

Market Timing Theory

The market timing theory is based on the idea that enterprises and corporations in the economy make their investment decisions based on the timing of the market. In contrast to the pecking order theory and the trade-off theory, it is one of many corporate finance theories. Firms have long believed that they can time the market by monitoring market circumstances.

A corporation’s capital structure is influenced by the timing of the market, according to Baker and Wurgler (2002). When it comes to financing, companies don’t really care if they go with debt or equity. They just go with what the financial markets liked at the time.

Discussion of Kingfisher and Land Securities Group Long-term Borrowing

Kingfisher has maintained long-term borrowings significantly lower over the past three years. According to Morningstar.com (2022), the long-term debt in 2021 stood at $0.003 billion dollars representing a 97.83% reduction from 2020. In 2020, the long-term borrowing stood at $0.119 billion dollars representing a 44.68% reduction from 2019. In 2019, the long-term debt stood at $0.219 billion dollars, which was a 358.75% rise from 2018.

Land Securities Group maintained a higher long-term debt than Kingfisher. According to Morningstar.com (2022), the long-term in 2021 stood at $3.415 billion dollars representing a 38.8% reduction from 2020. In 2020, the company’s long-term debt was $5.537 billion dollars representing a 48.14% increase from 2019. In 2019, the long-term debt stood at $3.738 billion dollars, which was a 2.37% rise from 2018.

The capital Structure Theory that Suits Kingfisher and Land Securities Group Company

Market timing theory can be linked with Kingfisher’s capital structure. It can be observed that the company makes investment decisions primarily by observing the market prior to making buying or selling decisions (Barclay & Smith, 2005). Kingfisher is known for predicting price movements of financial instruments in the market. The advantages of this theory is that it maximizes profits and minimizes losses. By applying this model, Kingfisher avoids market volatility and benefits from short-term movements in prices.

Land Securities Group, on the other hand, can be linked with the trade-off theory that is based on the premise that corporate leverage is achieved by establishing a balance between the tax-saving benefits of debt against the dead-weight impacts of bankruptcy (Myers, 2001). The main advantage of this theory is that this theory only takes into account the merits and demerits of debt in making a financing decision. The application of this theory could explain the high debt at Land Securities Group over three year period.

Companies’ Ratio Analysis

The analysis is between the capital structure of Kingfisher and Land Securities Group plc companies which are both listed on Financial Times Stock Exchange (FTSE). The ratios considered for comparison are the gearing ratio, interest cover, and earnings per share (EPS) ratio.

Gearing Ratio

The gearing ratio measures the company’s financial leverage and shows the degree to which a firm fund’s its activities through shareholder’s funds versus debtors’ funds. A high gearing ratio shows that a company has a large proportion of debt compared to equity (Watson and Head, 2013). On the other hand, a low gearing ratio indicates that the company has smaller debt compared to equity.

Kingfisher PLC’s gearing ratio (Debt/Equity) ratio over the five years period from 2017 through 2021 were 0.106 in 2017, 0.081 in 2018, 0.107 in 2019, 0.462 in 2020, and 0.384 in 2021 (Morningstar.com, 2022).

On the other hand, Land Securities Group PLC’s ratios were 0.362 in 2017, 0.498 in 2018, 0.291 in 2019, 0.267 in 2020, and 0.227 in 2021 (Morningstar.com, 2022).

Comparatively, Kingfisher’s debt to equity ratio is lower than that of Land Securities Group over the period under review. It is an indication that Land Securities Group relies heavily on debt to finance most of its activities compared to Kingfisher’s PLC.

Interest Coverage Ratio

The interest coverage ratio shows how easily a firm is able to pay interest on its outstanding debts. Lenders, creditors, and investors use this ratio to determine the level of risk relative to the existing debt (Ryan et al., 2012). A lower ratio shows that the company is burdened by expenses and has less capital to spend on other activities.

Kingfisher’s interest coverage ratio over the five years under review were 73 in 2017, 66 in 2018, 55 in 2019, 3.72 in 2020, and 5.75 in 2021 (Morningstar.com, 2022). The trend indicates that the level of risk increased from 2017 through 2021.

Land Securities Group PLC’s interest coverage ratio, on the other hand, were 1.1 in 2017, -3.125 in 2018, -15 in 2019, -10.375 in 2020, and -23.167 (Morningstar.com, 2022). The trend indicates high levels of risk for anyone intending to lend to this company.

Comparing the two firms, Kingfisher PLC has higher interest coverage ratio than Land Securities Group PLC during the entire period under review. A quick analysis shows that it is much risky to invest in Land Securities Group than at Kingfisher. The negative interest coverage ratio points to Land Securities Group inability to pay interest on its outstanding debts.

Earnings per Share Ratio (EPS)

The earnings per share ratio indicates how much dollars a firm generates per every share of its common stock. Investors use EPS as a metric to determine the corporate’s value (Smith, 2003).The higher the EPS of a company, the better it is in terms of profitability.

Kingfisher’s EPS during the five-year period stood at 0.275 in 2017, 0.220 in 2018, 0.010 in 2019, 0.004 in 2020, and 0.265 (Morningstar.com, 2022). The EPS ratio deteriorated between 2019 and 2020, mainly due to the effects of the COVID-19 pandemic.

Land Securities Group’s EPS, on the other hand, stood at 0.14 in 2017, -0.78 in 2018, -0.375 in 2019, -2.59 in 2020, and -4.34 (Morningstar.com, 2022). The negative sign between 2018 and 2021 is an indication that the company declared losses during this period.

Comparing the two firms in terms of EPS, Kingfisher has higher EPS than Land Securities Group. Kingfisher’s higher EPS shows that the company is more profitable than Land Securities Group. Therefore, investors of Kingfisher generate more dollars per share of common stock held than those of Land Securities Group.

Conclusion

The capital structure is an important component that is used to determine the value of a company. Since the relative levels of debt and equity affect cash flow and risk, changing the capital structure can influence shareholders’ wealth. Minimizing debt levels lowers the weighted average cost of capital, which increases the company’s value, thus increasing shareholders’ wealth. Considering the two firms, Kingfisher has managed to maintain its debt levels to minimal levels than Land Securities Group, which is why the share value of Kingfisher is greater than that of Land Securities Group.

The two FTSE companies’ capital structure was examined in this study using panel data analysis (Fixed Effect Model). As shown, management should initially use retained earnings, then debt, and finally equity to fund the project. The implicit reasons for the adoption of the pecking order go beyond capital formation, however the idea of pecking order can be useful in explaining organisations’ capital structures. To ensure that regular shareholders remain in a position of power, the management of a company is referred to as “pecking order”. Firm managers typically use the debt market before turning to the equity market when available retained profits aren’t adequate to fund new investments. When it comes to the equity market, rights issues are initially considered before public issues are even contemplated. Keeping existing ownership structures and shareholders’ trust are the primary goals of a pecking order system in business. Existing stockholders will reap the benefits as a result of this. The pecking order theory of capital structure dictates the actions of company management based on these objectives. The pecking order’s economic benefits should be viewed as a result of managers’ efforts to maintain job security while also serving the interests of investors. We predict that the use of debt-cantered governance will be less effective in the near future as more industries experience larger degrees of transformation.

Those who take the time to make the right decisions in increasingly competitive circumstances will be the ones who emerge victorious.

Considering the ratio analysis, Kingfisher has a balanced debt-to-equity ratio compared to Land Group Securities. From an investment point of view, it is safer to invest at Kingfisher than at Land Securities Group.

References

Ardalan, K. (2017). Capital structure theory: Reconsidered. Research in International Business and Finance, 39, 696-710.

Atril, P. (2012) Financial Management for Decision Makers. 6th Ed. Essex: Pearson Education Limited Blumberg, B. Cooper, D.R. and Schindler, P.S. (2011

Barclay, M. J., & Smith, C. W. (2005). The capital structure puzzle: The evidence revisited. Journal of applied corporate finance, 17(1), 8-17.

Bryman, A. and Bell, E. (2007) Business Research Methods. 2nd Ed. Oxford: Oxford University Press

Collis, J. and Hussey, R. (2003) Business Research: A Practical Guide for Undergraduate and Postgraduate Students. 2nd Ed. Hampshire: Palgrave Macmillan

Denis, D. J. (2012). The persistent puzzle of corporate capital structure: Current challenges and new directions. Financial Review, 47(4), 631-643.

Hillier, D. et al (2010) Corporate Finance. European Edition: Berkshire: McGraw-Hill Higher Education

Morningstar.com (2022, February 28). Kingfisher PLC financials. Retrieved from https://www.morningstar.com/stocks/pinx/kgfhf/financials

Morningstar.com (2022, February 28). Land Securities Group PLC financials. Retrieved from https://www.morningstar.com/stocks/pinx/lsgof/financials

Myers, S. C. (2001). Capital structure. Journal of Economic perspectives, 15(2), 81-102.

Ryan, B. Scapens, R. and Theobald, M., (2012) Research Method and Methodology in Finance and Accounting.2^nd ed. Hampshire: Cengage Learning EMEA

Saunders, M. Lewis, P. and Thornhill, A. (2009) Research Methods for Business Students. 5^th ed. Essex: Pearson Education Limited

Smith, M. (2003) Research Methods in Accounting. London: SAGE Publications Ltd.

Watson, D. and Head, A. (2013) Corporate Finance Principle and Practice. 6 ed. Essex: Pearson Education Limited.

APPENDIX

Kingfisher’s PLC Ratios

Land Securities Group PLC’s Ratios