Optimal capital structure for JSE listed companies

65 Pages·2009·0.63 MB·English

by  Ratshikuni, Murangi

Optimal capital structure for JSE listed companies.

Name: Murangi N. Ratshikuni
Student Number: 28531249

A research project submitted to the Gordon Institute of Business Science,
University of Pretoria, in partial fulfillment of the requirements for the degree
of Master of Business Administration.

11 November 2009
Abstract

This report details a study of capital structure for JSE listed companies. The
study considered historical financial information for JSE listed companies over
the period 1987 to 2009 and asked two central questions, with the benefit of
hindsight. Firstly, could JSE listed companies have used more debt to finance
their operations during this period? Secondly, how much additional debt could
these companies have used and thereby increase shareholder value? An
optimal debt ratio maximises shareholder value by optimising tax benefits of
debt.

This study analysed data for 97 companies that were within the top 160 JSE
listed companies. For each year of data, debt was increased while maintaining
certain pre-selected debt service ratios, to determine how much additional debt
these companies could have had. These ratios were interest coverage, cash
coverage and DSCR.

The results indicate that in most sectors of the JSE companies could have used
significantly more debt to finance their operations over the past 22 years. By so
doing these companies would have increased shareholder value over the years.
i
Declaration

I declare that this research project is my own work. It is submitted in partial
fulfilment of the requirements for the degree of Master of Business
Administration at the Gordon Institute of Business Science, University of
Pretoria. It has not been submitted before for any degree or examination in any
other University. I further declare that I have obtained the necessary
authorisation and consent to carry out this research.

------------------------------------------- -------------------------------------------
Murangi Ratshikuni Date
ii
Acknowledgements

I wish thank my supervisor Prof Mike Ward for his advice and guidance on
research topic.

I would like to thank my wife Tshililo and daughter Zwonaka for putting up with
my many hours away from home throughout this research project and
throughout the entire MBA.

iii
Table of contents
Abstract ……………………………………………………………………………………i
Declaration………………………………………………………………………………..ii
Acknowledgements……………………………………………………………………...iii
Table of contents………………………………………………………………………...iv
1 Introduction to Research Problem...............................................................1
1.1 Introduction.............................................................................................. 1
1.2 Research Aim........................................................................................... 2
1.3 Research Purpose................................................................................... 2
2 Literature Review........................................................................................3
2.1 Introduction.............................................................................................. 3
2.2 The static trade-off theory........................................................................ 3
2.3 Pecking order theory................................................................................ 7
2.4 The agency theory................................................................................... 8
2.5 The existence of an optimal capital structure........................................... 9
2.6 Capital structure in practice.................................................................... 10
2.7 Corporate credit rating........................................................................... 11
2.7.1 Credit rating criteria......................................................................... 11
2.7.2 The impact of credit ratings on capital structure decisions.............. 13
2.7.3 Credit ratings and default rates....................................................... 14
2.8 Relevant financial ratios......................................................................... 15
2.8.1 Capital structure ratios.................................................................... 15
2.8.2 Debt service ratios.......................................................................... 16
2.9 Conclusions from literature.................................................................... 18
3 Research questions and hypotheses........................................................20
3.1 Research question 1.............................................................................. 20
3.2 Research question 2.............................................................................. 20
4 Research Methodology.............................................................................21
4.1 Population.............................................................................................. 21
4.2 Sampling................................................................................................ 21
iv
4.3 Unit of Analysis...................................................................................... 22
4.4 Data collection........................................................................................ 22
4.5 Data Analysis......................................................................................... 23
4.5.1 Estimating corporate credit ratings.................................................. 24
4.5.2 Estimating the cost of debt.............................................................. 27
4.5.3 Modelling the impact of increased debt........................................... 28
4.6 Research Limitations.............................................................................. 30
5 Results......................................................................................................31
5.1 Sample description................................................................................. 31
5.2 Model Verification................................................................................... 36
5.3 Research Question One......................................................................... 37
5.3.1 Debt Service Ratio Analysis (cover = 1.1)....................................... 37
5.3.2 Debt Service Ratio Analysis (cover = 5.0)....................................... 38
5.3.3 Credit Rating Based Analysis.......................................................... 38
5.4 Research Question Two......................................................................... 39
6 Discussion of Results................................................................................43
6.1 The results in general............................................................................. 43
6.2 Research Question One......................................................................... 43
6.2.1 Debt Service Ratios = 1.1............................................................... 44
6.2.2 Debt Service Ratios = 5.0............................................................... 44
6.2.3 Credit Rating Based Analysis.......................................................... 45
6.3 Research Question Two......................................................................... 45
7 Conclusions...............................................................................................48
7.1 Key findings............................................................................................ 48
7.2 Recommendations to stakeholders........................................................ 50
7.3 Recommendations for future research................................................... 50
8 Reference list............................................................................................51

Appendix A-1 Actual ratings vs. modeled ratings………………………………55
Appendix A-2 Historical risk-free rate for South Africa…………………..……..57
Appendix A-3 Company betas……………………………………………………58
v
1 Introduction to Research Problem
1.1 Introduction

Capital structure decisions offer opportunities to create value for shareholders.
Yet these opportunities are often neglected because of the difficulties in
identifying the optimal capital structure that will maximise shareholder value
(Opler, Saron and Titman, 1997). Researchers in the field of capital structure
have observed that many firms are geared below the optimal levels that are
predicted by theory (Graham, 2000; Strebulaev, 2007).

In an American based study Graham (2000) found that by gearing up a typical
firm could add 15.7% to firm value. Furthermore 44 percent of sampled firms
could double interest payments and still expect to realise the full tax benefit
from their tax deductions. In a study of the top 25 companies listed on the
Johannesburg Securities Exchange (JSE) between 1990 and 1997, Wimberley
(2001) concludes that these companies could have realised a 3% to 14%
increase in value through the increased use of debt. Wimberley (2001) also
found that many of these top 25 companies had the necessary cash on the
balance sheet to accommodate increased debt levels.

Harrison (2003) found that South African firms have substantially lower
leverage than those in G7 countries.

1
The central question of this research was: “Can South African companies,
listed on the JSE, afford more debt?”

1.2 Research Aim

The aim of this research was to study capital structures of the top 160 JSE
listed companies (by market capitalisation) over the 22 year period between
1987 and 2009 and determine whether these companies could have used
more debt to finance their operations and thereby increase shareholder value.
The study looked at the historical financial performance of these companies
and with the benefit hindsight sought to determine how much additional debt, if
any, they could have had while still being able to meet their debt service
obligations.

1.3 Research Purpose

The purpose of the study was to help company managers, investors and
lending institutions realise how much additional debt companies could add to
their balance sheets without defaulting on their obligations. The results of this
study could help managers to maximise shareholder value through the use of
the appropriate capital structure. The results of the study could also help
shareholders to realise the value that is left on the table when managers use
too little debt to finance their operations.

2
2 Literature Review
2.1 Introduction

Bradley, Jarrell and Kim (1984) suggested that one of the most contentious
issues in the theory of finance during the preceding quarter century was the
theory of capital structure. Today, another quarter of a century later it appears
that there is still no consensus on the theory of capital structure. Myers (2001)
– one of the leading researchers on capital structure – stated that “there is no
universal theory of the debt-equity choice and no reason to expect one”.
However, several theories on capital structure have been developed over many
years.

2.2 The static trade-off theory

The theory of optimal capital structure always starts with the Modigliani and
Miller value-invariance Proposition I (Myers, 2001). M&M Proposition I stated
that, under certain conditions, the value of the firm is independent of its capital
structure (Firer, Ross, Westerfield and Jordan, 2008). One of these conditions
was the absence of taxes. However, in the real world taxes do exist and
specifically interest payments on debt are tax deductible. Thanks to the tax
deductibility of interest, the value of a firm will increase as the debt/equity ratio
increases (Miller, 1988). Another way of stating M&M Proposition I, with taxes,
is that the value of a levered firm is equal to the value of a firm with no debt
plus the present value of the interest tax shield. The interest tax shield is the
3
benefit that results from the fact that profits are only taxed after interest
payments have been deducted. The tax benefits of debt give a clear reason
for firms to borrow rather than issue equity (Opler et al., 1997).

In Figure 2.1 the value of the firm is plotted against the debt/equity ratio (Firer
et al., 2008). M&M proposition I is illustrated by the horizontal line (firm value
without taxes). In this case the value of the firm remains constant regardless of
the debt/equity ratio. The increase in firm value as a result of the tax
deductibility of interest is illustrated by the upward sloping line. This line
suggests that the optimal capital structure might be all debt (Miller, 1988).
However, a run of very bad years might actually find a highly-levered firm
unable to meet its debt service requirements resulting in bankruptcy (Miller,
1988).

Figure 2.1 The optimal capital structure and the value of the firm
dT dF
ue of the firm ebtax shied on istress costsinancial Firm tvaaxluees with
al
V
Maximum firm
value
Trade-off thoery
Firm value without
taxes
Optimal D/E Debt/Equity ratio

4