Capital Structure Theories: Review And Relationship With Profitability

Review of Theories

Task 1

With reference to contemporary academic literature, you are required to review any three (3) relevant capital structure theories. Your discussion must identify the conflicts and similarities between theories. Ensure your discussion is not dominated with ‘textbook description’ of the subject matter but rather a critical analysis of theories.

Task 2

Extract profitability and capital structure ratios for a period of 3-5years.: The ratios may include-Profitability (Return on capital employed – ROCE; Return on Equity – ROE; Return on Total Assets; etc.) and Gearing & Capital Structure ratios (Gearing; Interest Cover; Debt to Equity Ratio etc.)

Task 3

Using the two firms chosen, investigate the relationship between capital structure and profitability by

(i) Plotting the graph of the profitability and capital structure ratios for each firm;

(ii) Comparing the two firms with the aid of descriptive statistics (if possible some inferential statistics)

This report is prepared to evaluate and critically analyze the grounds on which decisions can be for long term investments. It is basically framed to show the importance of different capital structures, ratios and other strategies while making decision in the organization as well as while deciding about the organization as an investor. The two firms which have been chosen for the analysis are British Petroleum Plc. (BP) one of the most successful energy supplying company in the world. Their sustainability lies in minimizing and mitigating environmental impacts. The other organization is Exxonmobil (Exxon) which is world’s largest publicly traded American multinational oil and gas company. Both the organizations are from the same industry working in a highly competitive environment being most successful. (Exxonmobil) (BP)

Some of the capital structure theories we are discussing here are ModiGillani-Miller Theorem, Trade-off theory and Pecking-Order Theory. In the ModiGillani-Miller approach it has been emphasized that the value of the firm levered as well as the value of the firm unlevered i.e. firm financed only by equity is the same. This approach has certain unrealistic assumptions which cannot be applicable in real life situations. Such assumptions are transaction costs are nil and individual and corporations both borrow at the same rates. Due to such assumptions this approach is eventually criticized but is yet applied for simplified understanding. This theory is criticized because it assumes that the operating activities of the firm generate constant cash flows at all time till perpetuity which is not possible. It also assumes that both insiders and outside investors have the same symmetry of information which is practically not possible since organizations have to maintain confidentiality on much information. It also assumes that the capital structure of the company consists of borrowings at the risk free rate which is not realistic. It also assumes that there is no cost of bankruptcy which can be said correct as it is the cost of legal procedures during the event of liquidation and will have to be incurred. (Klimenok, 2014)

Profitability and Gearing/Capital Structure Ratios

Trade off theory of capital structure is like the above mentioned approach the difference being that this approach includes the factor cost of bankruptcy. In the changing world the organization’s capital structure are getting more levered and thus due to increasing debt the threat of bankruptcy is also increasing. Thus the firm has to minutely evaluate the merits and demerits of incorporating debt in its capital structure. This theory has also incorporated the effect of agency costs, since the lenders tries to satisfy themselves on the ground of recovery prospects so they conduct audit of the borrowers, in that scenario borrows are required to keep themselves well represented that incurs agency costs. (Chand)

In the Pecking-order Theory it is stated that if insiders are properly informed about the affairs of the firm more than the outside investors then the company’ shares will be undervalued by the market. Due to this undervaluation the financing of investment projects though IPO gets costlier. This also makes the stocks less attractive to the third party who is financing. This capital structure theory has the following nature and influence. It‘s profitability is inversely proportional to the financial leverage and thus it requires lesser experience for the foreign investment. The large scale company also lowers the financial leverage since the cost of issue of shares gets cheaper. (Reddy, 2014)

Therefore we can see that the above mentioned capital structures are similar to each other in some respects whereas different in other. The major conflicts about the above theories are its unrealistic assumptions or its incomplete coverage of overall scenarios.

In order to make decision we are evaluating the two companies on the basis of some financial ratios i.e. profitability ratios and capital structure and capital gearing ratios. The profitability ratios that are discussed here are P/E ratio, Return on equity, Return on Capital Employed and return on total assets. Whereas for the capital structure/ gearing ratios we will analyze on interest coverage ratio, debt to equity ratio, etc. (Oberoi, 2014)

Price-earnings ratio is the most commonly used parameter in all the financial ratios to decide whether to invest in the company or not. This ratio brings out the real valuation of the company. If the P/E ratio is too high it denotes that the company is overvalued and it is not suitable as a long term investment prospects whereas if the ratio is low then the company is undervalued and should be longed on. (Loth)

Return on equity is compared to see whether the annual income earned by the company is sufficient for the equity shareholders. Here as per our research we have computed that the ROE of Exxon is 0.19 for the year 2014 whereas of BP it is 0.04. It denotes that the investor’s money is less at risk if invested in Exxon.  (Jan)

Similarly the return on capital employed ratio also shows the earning earned against each penny of capital employed in the business. The difference between ROE and ROCE is that in the latter the availability for earnings before interest and tax is evaluated against all the capital employed including the debts whereas in the former only shareholders fund is considered. The ROCE of Exxon is 0.4 whereas of BP it is 0.03. Exxon is better of BP even in the ROCE denoting that Exxon is utilizing its fund in much more profitable manner and creating higher shareholders wealth.

Return on Total Assets Ratio shows how strategically and profitably the assets of the company are utilized to generate funds. Here also Exxon is far better off BP having the ratio of 0.32 as compared to 0.02 of BP. It simply imprints that Exxon is completely tactical in its asset utilization for creation of wealth and generate higher annual earnings.

We have analyzed two gearing ratios one is the interest coverage ratio in which Exxon has no competition with BP as its interest expense is very low. The interest coverage ratio of Exxon for the year 2014 is 397.01 whereas of BP it is 4.39. This denotes that BP is much more dependent on debts for its source of fund while same is not the case with Exxon.  The other gearing ratio is the debt to equity ratio which is compared to see the availability of shareholder’s equity in comparison with its creditors to evaluate the risk in the event of any mishap. The lower the ratio the lower is the risk and better it is. The debt equity ratio of Exxon is lower than that of BP which is favorable for Exxon when investment decision is made. (Gearing Ratio)

Below is shown some of the profitability ratios graphically of the Exxonmobil for the past three years. As per the graph we can see that apart from P/E ratio there is a decreasing trend for all the other profitability ratios.

The table given below is showing all the profitability as well as gearing ratios of Exxonmobil. (Summary Annual Reports, 2014)

Company : Exxonmobil
Ratios	Year 2014	Year 2013	Year 2012	Average
P/E Ratio	12.16	13.73	8.92	11.61
ROE	0.19	0.19	0.27	0.21
ROCE	0.40	0.44	0.55	0.46
ROTA	0.32	0.35	0.44	0.37
Interest Coverage	397.01	13504.33	449.60	4783.65
Debt Equity	0.37	0.41	0.39	0.39

Similarly, the graph below is showing the profitability ratio of British Petroleum. In the below mentioned graph we can see that the data for the year 2014 is drastically low as compared to the graph for the year 2013. (Annual Reports 2013, 2014)

The table given below shows the profitability as well as gearing ratio for the past three years of British Petroleum Company. Only the P/E ratio has increased all other profitability ratios have decreased if compared with the last year’s data.

Company : British Petroleum
Ratios	Year 2014	Year 2013	Year 2012	Average
P/E Ratio	1.85	0.39	0.72	0.99
ROE	0.04	0.18	0.09	0.10
ROCE	0.03	0.14	0.09	0.08
ROTA	0.02	0.10	0.07	0.06
Interest Coverage	4.39	20.52	12.07	12.33
Debt Equity	0.57	0.56	0.65	0.59

 As per the given research made we can analyze that the profitability ratios of Exxonmobil is much better than the ratios of British Petroleum. The interest coverage ratio is Exxonmobil is very good as it has very low interest expense which denotes that the company is not much dependant on leverage effect. It is doing business more on its own funds rather than from the borrowed funds where as in the BP the company depends upon leverage much more than Exxon do. Therefore it can also be said that Exxon is less risky for getting short of funds or being liquidated. (Historical Prices, 2015)

Debt is one of the sources of financing the business. The fund required may be for any purpose such as starting up a business, launching a new product or purchasing and installing new equipment. It is very popular source of funding. The basic advantages of debt funding are that it does not affect the ownership of the company. Borrowers have no right of ownership in the company unless the debts issued are convertible in nature. Debt financing is nothing more than borrowing money and repaying it off. It is treated as a liability. Repayment is done as per the loan contract entered at the inception of the agreement. Thus if a company has higher debt equity ratio it means that it is leveraging more and has funded it‘s most of the projects through debt source. (Kokemuller)

 However, some of the disadvantages are that since it is the liability no matter company has enough liquidity or not it has to pay off its creditors. Due to this many a time’s company goes into liquidation for the inability to pay off its lenders and creditors. When debt is raised an additional liability of interest payment is also added to it. In that case the future earnings which could have been utilized for the growth prospects of the organization are used to pay off the installments. (Merritt)

Other than debt financing some of the sources of financing are listed here equity financing, venture capital, angel investors, government grants or retained earnings. It seems that Exxon does not prefer debt financing much therefore it can use the above listed sources to finance its further projects. It can go for equity financing but it will only further liquidate its ownership stake however it is recommended that it should go for leveraging. But BP should not debt finance more it should rather opt for other sources. (Houfstrand)

Conclusions And Recommendations

We have researched and analyzed the data of two companies both being the oil and gas corporation. Both the companies are successful and compete in a highly competitive environment. We have computed few profitability and capital structure/ gearing ratios of both the companies (appendix attached as working sheet). All the financial ratios computed shows that being in the same industry if compared Exxonmobil is a better long term investing target when compared with the British Petroleum Plc. Exxonmobil has higher price earnings ratio which denotes that the company have higher valuation. Though if analyzed from a different perspective then BP if have any future growth prospects then is good buy since it is undervalued and can be invested in it for a long time period. In all the ratios Exxon wins over BP so we recommend the investor to invest its 200 million dollars in Exxon to earn profits in future. The investor will have a high dividend yield; it can even gain in the wealth created by the company. Therefore it is recommended to invest in Exxonmobil rather than on British Petroleum.

References

Annual Reports 2013. (2014). Retrieved 2015, from BP.com: https://www.bp.com/content/dam/bp/pdf/investors/BP_Annual_Report_and_Form_20F_2013.pdf BP. (n.d.). Retrieved 2015, from https://www.bp.com/en/global/corporate/sustainability/environment.html

Chand, S. (n.d.). Theories of Capital Structure. Retrieved 2015, from Your Article Library: https://www.yourarticlelibrary.com/financial-management/theories-of-capital-structure-explained-with-examples-financial-management/29398/

Exxonmobil. (n.d.). Retrieved 2015, from https://corporate.exxonmobil.com/

Gearing Ratio. (n.d.). Retrieved 2015, from Accounting Tools: https://www.accountingtools.com/gearing-ratio

Historical Prices. (2015). Retrieved 2015, from in.finance: https://in.finance.yahoo.com/q/hp?s=BP&a=11&b=31&c=2012&d=11&e=31&f=2014&g=d&z=66&y=462

Houfstrand, D. (n.d.). Types and sources of financing. Retrieved JUNE 2015, from Extension.iastate: https://www.extension.iastate.edu/agdm/wholefarm/html/c5-92.html

Jan, I. (n.d.). Return On Equity. Retrieved 2015, from Accounting Explained: https://accountingexplained.com/financial/ratios/return-on-equity

Klimenok, A. (2014). Master Thesis. Retrieved June 2015, from University of Nordland: https://brage.bibsys.no/xmlui/bitstream/id/240485/Klimenok.pdf

Kokemuller, N. (n.d.). The advantages and disadvantages of debt and equity financing. Retrieved 2015, from small business: https://smallbusiness.chron.com/advantages-disadvantages-debt-equity-financing-55504.html

Loth, R. (n.d.). Investment Valuation Ratios. Retrieved 2015, from Investopedia: https://www.investopedia.com/university/ratios/investment-valuation/ratio4.asp

Merritt, C. (n.d.). The advantages and disadvantages of debt equity financing. Retrieved 2015, from budgeting.the nest: https://budgeting.thenest.com/advantages-disadvantages-debt-equity-financing-22700.html

Oberoi, R. (2014, September). Between The Numbers. Retrieved June 2015, from Money Today: https://businesstoday.intoday.in/story/key-financial-ratios-analyze-company-stock-investment/1/209789.html

Reddy, D. B. (2014, March 25). 5 Capital Structure Theories. Retrieved June 2015, from Slideshare: https://www.slideshare.net/ShahidAfzalSyed/5-capital-structuretheories-32694984

Summary Annual Reports. (2014). Retrieved 2015, from Exxonmobil: https://cdn.exxonmobil.com/~/media/global/Reports/Other%20Reports/2015/2014%20Financials