Capital Structure Decisions

All else being equal, higher financial leverage will decrease a company’s debt rating and increase the interest rate it must pay.

Business risk refers to the chance a business's cash flows are not enough to cover its operating expenses like cost of goods sold, rent and wages. Unlike financial risk, business risk is independent of the amount of debt a business owes (Guzman & Media, 2015). Financial risk refers to the chance a business's cash flows are not enough to pay creditors and fulfill other financial responsibilities (Guzman & Media, 2015). Financial risk is the additional business risk concentrated on common stockholders when financial leverage is used and depends on the amount of debt and preferred stock financing (Brigham & Ehrhardt, 2014).

Book ratios are calculated by looking at historical costs or accounting values of the firm whilst market ratios are determined in stock markets through capitalization processes. From the above figures, it is apparent that market ratios are lower than book ratios. This indicates that either equities were overvalued or debts were undervalued to result in the higher debt-to-equity ratios. The two companies therefore have to rectify their valuation methods that concern liabilities and equities. When their valuations tend to match those of market valuations, they may correspond to what the company can actually be valued at when sold today. It is evident that BHP Billiton has a higher leverage ratio, indicating that the company uses a higher proportion

Increased leverage would increase the risk for the shareholder. This is due to the fact that an increased amount of debt would increase the financial return that investors expect. For example, if a company has no debt and posts better than expected earnings, the equity holder would get all of this benefit. If the company had some debt and posted better than expected earnings, the bond holders would get a fixed payment as usual, and shareholders would still enjoy increased profits; the problem arises if worse than expected profits were shown by Kelly Services. If Kelly Services had no debt and posted bad earnings, then the equity bears all the risk in that situation. However, if Kelly

Long-term debt-to-equity is very similar to debt-to equity, but it reveals an important characteristic of the company’s debt make-up, that is how much of it is long-term. This is important because long-term debt means long-term interest payments, and generally involves larger principles. This can mean greater leverage, but it also indicates greater risk. Many banks are wary of companies that hold too much debt, and especially the companies that hold too many long-term debt obligations. Another downside from this perspective is that higher perceived risks by creditors generally can lead to increased interest rate, making this debt even more expensive.

Landry’s Debt to Asset ratio also increased from year 2002 to 2003. In 2002 Landry had a debt to asset ratio of 0.39. In 2003 Landry’s debt to asset ratio increased to 0.45. While both numbers are acceptable and considerably low, the increase from 2002 to 2003 could influence potential investors to not invest in Landry’s stock. This increase also suggests that Landry’s debt also increased from 2002 to 2003. Overall, while there was a slight increase from 2002 to 2003 Landry’s still had a good debt to asset ratio. We think that a contributing factor to the debt

It seems then that companies should fully leverage the company or a least come close to doing so but there is a probability that the company enters financial distress as its leverage (D/E) increases. Financial distress can be very costly for companies, and the cost for this scenario is shown in the current market value of the levered firm's securities. Investors factor the potential for future distress into their assessment of the present value (this is where PV of distress costs is subtracted from un-levered company value and the PV of the tax-shield.) The value for the costs

Scott (1976) studied that there exists the optimal capital structure in the static trade-off theory, which is optimal balancing between the benefit (tax shield) from interest payment for debt financing and bankruptcy cost. In addition, there are also some empirical researches about trade-off theory. Frank and Goyal (2008) found that with the increasing of leverage, the earnings is increasing too. In opposite, some study has different opinion. Timan and Wessels(1988) predicted that a negative relationship between leverage and earnings. The trade-off topic was more popular after the opposite opinions. Then the dynamic trade-off theory has been found. The dynamic trade-off theory suggests optimal leverage structure analyse the relationship between tax and bankruptcy cost in a dynamic framework when companies face external financing costs. The basic expectation of trade-off theory is the existence of target cash holdings and the company will continue to adjust to this target level when the deviation occurs. The traditional trade-off theory does not take into account the adjustment cost caused by capital market flaws and the company's risk in different deviations situation. In short, the static trade-off theory focuses on how the firm determines

If the firms funding requirements are larger than their retained earnings, they must issue debt as this is preferred to issuing equity. Based on this theory, a firm’s financing policies could be viewed as signalling management’s view of the firm’s stock value (Wang & Lin 2010).Myers and Majluf (1984) also add that if firms issued no new securities but only used its retained earning to support the investment opportunities, the information asymmetric could be resolved. This suggests that issuing equity turn out to be more expensive as asymmetric information insiders and outsiders increase. Large firms should then issue debt to avoid selling under priced securities. As the requirement for external financing increases, businesses will work down the pecking order, from safe to riskier debt, perhaps to convertible securities or preferred stock, and finally to equity as a last resort. Each firm's debt ratio therefore reflects its cumulative requirement for external financing (Myers 2001).The pecking order theory clarifies why the bulk of external financing comes from debt. It also describes why organizations that are more profitable borrow less: since their goal debt ratio is, low-in the pecking order they do not have a goal since profitable firms have more internal financing available.

Nevertheless, firms have used leverage even before corporate taxes have been introduced (Maris and Elayan, 1990). This implies the existence of some market imperfections, which benefit the use of debt financing, thus enable a trade-off of the cost and benefits of debt resulting in an optimal capital structure, where marginal cost equal marginal benefits.

Parallel to the study of Bujiki and McConomy (2002); Lang and Gul (2004); Patelli and Prencipe (2007) that growth firms are expected to disclose more information rather than non-growth firms. The debt or the leverage ratio was also analysed. The results have the mean of 0.52 percent and a standard deviation which is moderate.

Halfords capital risk management policy details that Halfords aims to maintain an optimal capital structure and that operating capital is managed by ratios. It details how those ratios are calculated and their value. The policy also details how Halfords might adjust its capital structure (adjusting dividends, returning capital to shareholders, issuing shares and selling assets). The annual report does not specify an optimal capital structure. This allows the firm to set an optimal structure for its needs rather than be tied to an inflexible target. This is consistent with Modigliani and Miller 's Capital structure Irrelevance Theory (Arnold, 2013, p.772) and other studies which suggest there is not a strong link between capital structure and growth (Bevan & J. Danbolt 2004). If the board wishes to adjust the capital it will face some limitations. The firm could issue new shares to adjust the equity to debt weighting. This however appears to be a method the board wishes to avoid. The firm could buy back shares using internal or external funds. Retained earnings amount to only 25% of current market, limiting it as source of funds if dividend levels are to be maintained. The board has shown a preference maintain dividend levels over varying profits it is unlikely they would choose this method. Halfords could raise debt to repurchase share, and shareholders may support this as it would increase both EPS and share price, it might also

If external financing is required, the “safest” securities, namely debt, are issued first. Although investors fear mispricing of both debt and equity, the fear is much greater for equity. Corporate debt still relatively little risk compared to equity because, if financial distress is avoided, investors receive a fixed return.. Thus, the pecking order theory implies that, if outside financing required, debt should be issued before equity. Only when the firm’s debt capacity is reached should the firm consider equity.

The paper relates to three sets of literature: the capital structure, the location effect, and the peer effect. In the classical capital structure context, Fischer, Heinkel, and Zech-ner (1989) and Leland (1994; 1998), Hovakimian, Opler, and Titman (2001) show that firms periodically readjusts capital structures toward a target ratio. Lemmon, Roberts, Zender (2008) show that the majority of changes in leverage ratio are caused “by an unobserved time-invariant effect that generates surprisingly stable capital structures.” Lemmon et al. (2008) show that this factor is present before the IPO. They conclude, “variation in capital structures is primarily determined by factors that remain stable for long periods of time.”

In fact, in different economic and political situations, each country pursues different legal systems, such as American economic law and Chinese monetary law. Alves and Ferreira (2011: 120) assumed that the market timing could be one of the most significant factors and it might change the market-to-book value, which might provide a permanent change of leverage. This view has also been mentioned in other studies (Jouida & Hallara, 2015: 894; Mishra & Tannous, 2010: 485). Wald and Long (2006: 300) explicitly studied that the law might affect the booking value; the higher market value leads the firms to issue equity rather than debt, and when the market value is lower, the firms always issue debt.