mas midterm output 2

University of San Jose-Recoletos

Magallanes St. Cebu City

A Research and Insight Paper on the

Optimal Capital Structure Decisions

In fulfillment of the Prelim requirements in

Accounting 13 Managerial Accounting II

Submitted to

Earlie Edelwise M. Uy

February 16, 2015

Group No. 2

Ceniza, Jeanly Margarett

Ceniza, Jemaica P.

Sanchez, Dianne Rio S.

Del Campo, Kristine P.

Paler, Armel M.

Petralba, Katrina

Batingal, Ma. Grace


I. Introduction

Capital structure is a term that describes the proportion of a company's capital, or

operating money, that is obtained through debt versus the proportion obtained through

equity. Debt includes loans and other types of credit that must be repaid in the future,

usually with interest. Equity involves selling a partial interest in the company to investors,

usually in the form of stock. In contrast to debt financing, equity financing does not involve a

direct obligation to repay the funds. Instead, equity investors become part-owners and

partners in the business, and thus earn a return on their investment as well as exercising

some degree of control over how the business is run.

Since capital is expensive for small businesses, it is particularly important for small business

owners to determine a target capital structure for their firms. Capital structure decisions are

complex ones that involve weighing a variety of factors. In general, companies that tend to

have stable sales levels, assets that make good collateral for loans, and a high growth rate

can use debt more heavily than other companies. On the other hand, companies that have

conservative management, high profitability, or poor credit ratings may wish to rely on equity

capital instead.


II. The Optimal Capital Structure

Optimal Capital Structure is said to be the best debt-to-equity ratio for a firm that

maximizes its value. In fact, it offers a balance between the ideal debt-to-equity

ranges, thus minimizing the firm's cost of capital. The optimal structure rarely offers

the lowest cost of capital which is due from its tax deductibility since a company's

risk generally increases as debt increases.

In a study conducted, Michaelas et. al. (1999), it was found out that the

determinants for most of SMEs or those small and medium sized enterprises were

the size, profitability, growth and many other factors on deciding what structure to

use. It was also found out that an industry specific effects had an influence on the

maturity structure of debt raised by SMEs. By thorough research and studies, they

also found out that short-term debt ratios in SMEs appear to be negatively correlated

with changed in the economic growth while on the other hand, the long-term debt

ratios showed a positive relationship with factors such as changed in economic

growth. The study also concluded that it is more a task for future research to analyze

the important question of possible differences in the determinants between the small,

medium and large enterprises.

In business world, there are only two ways to earn money and that is through

debt while the other way is though equity. Debt works when you promise to make

certain payments, which includes interest and principal, in future and if you fail to do

so, you lose control of the business. Equity works when you do get enough cash

flows after making debt payments. In getting the right mix of debt and/or equity

financing that will maximize the value of the firm, most companies chose a financing

mix that minimizes the hurdle rate and matches the assets being financed. The

hurdle rate should at most times be higher in projects which are riskier.

Simply put, in order to get the right mix, company used ratio that look at the

proportion of debt in the total financing and it is called debt to equity ratio which is

equal to debt divided by the sum of debt and equity.

In a research study conducted by the University of the Philippines, the result

suggests that operating leverage and financial leverage have little effect at present in

evaluating the inherent riskiness of individual business firms. Further research also

indicated that the effects of operating and financial leverage on capital structure can

be looked into within the framework of competing capital structure theories.


III. Company’s Tax Structure – One of the Factors that Influence a Company’s

Capital Structure Decision

Tax exposure is the amount of taxes, that you can show, that have already been

paid out against your business financial records. This will decrease the amount of

money you will have to pay in taxes on the profit you are left showing for the

business. Every time a company purchase, this may or may not be taxable. If it is

taxable, then it should be charged by the seller.

A corporation has the most complex and can be quite tedious, but relatively pays

the least amount of taxes. Why? Since the taxable amount is reduced by the

chargeable interest income.

Considering tax exposure as one of the factors that influence a company’s capital

structure decision, it can make a business successful. Though the company will pay

taxes, thus, reducing its profit, through an effective tax strategy, it will help the

company reduce its tax liability and thus, increase its profitability. Understanding

one’s current tax liability and how this may change with planned company growth

and development is imperative to managing exposure and will cut unnecessary extra

costs. Taxation is always subject to change.

Given that debt payments are tax deductible, if a company’s tax rate is high using

debt as a means of financing a project is attractive because the tax deductibility of

the debt payments protects some income from taxes.


IV. Conclusion

The evidence presented above stresses the role of the company's tax exposure

in choosing the company's capital structure decisions. In assessing on whether what

capital structure a corporation must have and must use, it is then essential to

consider factor such as the company’s tax exposure. We stated that an increased

debt a company has would also mean an increased benefit in a way that it decreases

the amount of taxable income. This reduction is due to interest expense which is

chargeable against the taxable income. On the other hand, this would also mean a

higher business risk and greater uncertainty about the company's future financing

needs. Thus far, after thorough analysis, we concluded that corporations who relied

heavily on debt financing successfully lowers their tax base which would mean a

much lesser cost of capital.


V. Bibliography

Bevan, A. A. And Danbolt, J., (2000) Capital structure and its determinants in the

United Kingdom: a decompositional analysis, Working Paper, Dept. of Accounting

and Finance, University of Glasgow.

Bowman, J. (1980)., The Importance of a Market Value Measurement of Debt in

Assessing Leverage. Journal of Accounting Research, 18, 242-54.

Harris, M., Raviv, A., 1991. The theory of capital structure. Journal of Finance 46 (1).

Lööf, H., 2004, Dynamic optimal capital structure and technical change, Structural

Change and Economic Dynamics.

Aswath Damodaran. Finding the Right Financing Mix.

Dugan, M. T. and Shriver, K. A. (1992), An empirical comparison of alternative metho

ds for the estimation of the degree of operating leverage, Financial Review.

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