Factors to consider in selecting public offers(2)
January 4th, 2008 Ugonna Maduagufor || ugonna@stockmarketnigeria.com
(By ugonna MADUAGUFOR)
Captital structure refers to the composition of the resources by which a company’s assets is financed (funded). it could include a varying mixture of equity, debt and/or hybrid securities. Modiglian - Miller theorem proposes that in a perfect capital market, the value of a firm is unaffected by its financial structure. This assumption is not realistic as the real market is imperfect due to the existence of such factors as transaction cost, bankruptcy cost, and information assymetry. In continuation of my previous article on “factors to consider in selecting public offers(1)”, the following questions and points would help to better assess a company’s share value.
1) What is the credit rating of the company? Credit rating is the published ranking based on a detailed financial analysis by a credit bureau of one’s financial history regarding ability to meet debt obligations. A company’s credit rating is very material in evaluating the value of its investments and so a little pain should always be taken to look it up in the company’s prospectus or annual report.
2) What is the ratio of funded debt to total debt in the ballance sheet? funded debts refers to the portion of company’s long term debt that is made up of fixed maturity debt instruments such as bonds, against the non-funded debts which includes bank loan-debts, ussually containing acceleration clauses that allows the lender to call up the loan at any time under certain circumstances. The more the ratio of funded debts to total debt, the safer and farther away from bankruptcy threat.
3) ‘Bankruptcy-cost’ risk: What should be the normal trade off between debt and equity for a company? under a classical tax regime, the tax savings on interest is an added advantage not obtainable from equity financing. According to the trade off theory which recognises the bankruptcy cost of debt financing: It states that there is an advantage due to debt finance - “the tax benefit of debt” and on other hand a disadvantage of same- “the bankruptcy costs of debt”. The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity that is most balanced. Empirically, this theory may explain differences in Debt-to-Equity ratios between companies in different industries, however it doesn’t explain differences within the same industry. The latter demands further x-ray to determine the financial stability of a target investment.
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