Capital Structure Dilemma

INTRODUCTION

The success of an organisation is the highly associated capital structure of the company. It determines an appropriate combination of funds such as debt and equity. A capital structure of an organisation is having a direct impact on risk, cost and revenue of the company (Gornall and Strebulaev, 2018). For this purpose, the evaluation of the capital structure of Royal Dutch Shell PLC and British Petroleum (BP) PLC is carried out. Therefore, this report is going to evaluate different capital structure theories. while providing the most valuable insights into business dissertation help. In the context of the present study, aim and objectives of the present study are mentioned below:

As per the aim, some objectives are mentioned below: To examine different theories of capital structure To analysis conflict argument against capital structure theories To assess different aspects of assessing changes in capital structure.

Capital structure theories play a critical role in determining an appropriate mix of capital as per distinct business requirement. In this context, the four most important capital structure theories are evaluated below:

Net income approach: This approach plays a critical role in determining an appropriate capital mix. According to this approach, a firm is able to minimise the weighted average cost of capital by enhancing the value of the firm or market price of equity shares and by using debt financing as an important source of funds (Ridley-Duff and Bull, 2015). The theory has defined that a company is able to increase its value as well as reduce the overall cost of funds by enhancing the proportion of loan financing in the capital structure of the firm (Ardalan, 2017).

Net operating income approach: This approach has found very effective for determining another extreme of the effect of leverage on the value of the firm. This approach has determined that alteration in the capital structure of a company is not having the significant impact on the market value of the companies along with the overall cost of capital (Mason and Harrison, 2017). This theory has determined that the cost of capital remains constant whether an organisation has adopted the debt-equity mix.

The traditional approach: The traditional approach is being termed as an Intermediate approach between the net income approach and net operating income approach. This approach has determined that the market value of the business entity can be increased or the cost of capital could be reduced by considering more debt financing because it offers funds at a very low price as compared to equity (Barclay and Smith, 2005). Therefore, an organisation is able to attain an optimum capital structure with the help of proper debt-equity mix. However, some extent determines that the cost of equity increases as a result of increased debt enhances the financial risk of the equity shareholders (Zhang, 2018). The increased cost of equity offsets the advantage of cheaper debt at this point of the capital structure. Therefore, the increased cost of equity cannot be managed by the assessing benefits from low-cost debt.

Modigliani And Miller Approach (Mm Approach): It is an important capital structure theory which has been formulated by the Franco Modigliani and Merton Miller (Graham and Harvey, 2001). MM theory proposed two propositions for determining an appropriate mix of capital structure:

Proposition I: In this context, this approach determines that the capital structure is irrelevant for determining the value of a firm. The value of two identical firms would remain the same, and it does not have a significant impact on the choice of different sources of finance (Lemmon and Zender, 2019). Therefore, the value of a firm is highly associated with the expected future earnings if management does not consider any taxes.

Proposition II: According to this approach, financial leverage plays a critical role in influencing the value of a firm along with the reduction in WACC. This proposition is considered when tax-related information is available (Myers, 2001).

According to Net income approach and Net income operating approach, it has found that cost of capital will be reduced by increasing the raising the funds through debt because cost debt is comparatively low to equity (Zhang, 2018). On the contrary to assumptions of two theories of capital structure, it has addressed that the increased use of debt will be enhanced the financial risk of the equity shareholders that would result in an overall cost of equity (Serfling, 2016). Therefore, it can be stated that capital structure theories are not appropriate because these approaches have determined that the cost of debt remains constant even with the increase in the proportion of debt as the financial risk and lenders are not having a significant impact due to change in the financial risk factor (Denis, 2012).

In a similar way, the study of Gornall and Strebulaev (2018) has stated that consideration of debt as a source of finance will be reduced the cost of capital in some extent but overall this thing enhances the overall cost of capital as a reason of an increase in financial risk. Therefore, an organisation needs to consider several factors such as market value, the market price of equity share, the interest rate on debt and financial risk for selection of an appropriate capital mix (Quan, 2002).

Royal Dutch Shell Plc and British Petroleum (Bp) Plc are addressed as leading companies in the field of petroleum and natural gas extraction. These companies have maintained huge capital for different business objectives (Ridley-Duff and Bull, 2015). In the context, consideration of an appropriate capital structure is a very critical task for both companies and evaluation of the capital structure of both companies is carried out below:

As per the above chart, it has found that British Petroleum PLC (BP Plc) has recorded downturn trends in equity value from 2013 to 2016. In 2013, the value of BP’s equity capital was $129302m that reduced to $95286m in 2016. However, the company has recorded the positive growth in equity capital which is reached to $98491m with 3.36% growth rate. On the other hand, there are positive trends addressed in the last five years in the value of debt capital (BP PLC ADR, 2018). This thing indicates that the management of BP Plc has tried to raise funds through debt capital for reducing the cost of capital with reference to Net income capital structure theory in which company is focusing on debt financing. This change in capital structure has reflected in gearing and interest coverage ratio. The gearing ratio of BP PLC for the period of 2013, 2014, 2015, 2016 and 2017 is respectively 0.32, 0.41, 0.48, 0.54 and 0.56. This increment shows an increase in debt funds or decrease in equity value.

On the basis of the above assessment, both companies have tried to follow Net Income Capital Structure theory by raising funds through debt capital. Therefore, significant changes are addressed in gearing ratio, capital mix along with interest coverage ratio.

CONCLUSION

On the basis of the above assessment, it is concluded that capital structure is having a significant impact on profitability and market value of an organisation. This report has found that different approaches to capital structure are playing a critical role in the selection of an appropriate capital mix. The evaluation of the capital structure of Royal Dutch Shell Plc and British Petroleum (Bp) Plc has found that both companies are paying extra attention to debt capital for minimising the cost of capital. However, the increment in debt capital enhances the financial risk of the company.

REFERENCE

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