What is Capital Structuring?
Capital structure “is the relationship between the various long-term sources financing such as equity capital, preference share capital and debt capital. It refers to a firms permanent financing sources as represented mostly by its long-term debt and equity and deciding the suitable capital structure is the important decision of the financial management because it is closely related to the value of the firm. Gitman and Zutter (2012) defined capital structure as the mix of long-term debt and equity maintained by the firm. A firm’s capital structure comprises a range of financial decisions which may include, its choice of a target capital structure, its debt maturity period as well as the type of financing it adopts for a particular period. Managers of a firm ensure they make capital structure decisions that enhance the value of their firm. From the foregoing, capital structure can be defined as the mixing of financial sources to finance a firm’s activities.
Objective of Capital Structuring
The key objective of firm structuring is to maximize the firm’s intrinsic value. To achieve this objective, managers aim to reduce the firm’s cost of capital structure to its barest minimum. The point where cost of capital structure reaches its barest minimum is referred to as the firm’s optimum capital structure level. The optimum capital structure is defined as the capital structure or a firm’s combination of debt and equity that results in the firm reaping the maximum value. It is the point where the Weighted Average Cost of Capital (WACC) is minimum and therefore firm value is at its maximum. In addition, an entrepreneur may set up his or her business so that profits are taxed at a lower rate than other forms of income. Aside the direct employment of capital in the form of equity or debt, Capital structure can also be applied in a firm’s tax procedure as profits can be moved from one country to another and back again or the firm’s profits are used to invest in low-return but tax-free transaction such as purchasing real estate in in order to reduce the firm’s tax liabilities. Companies that work with “tax advisors” and transfer pricing specialists commonly form “partnerships” for these purposes.
Application of Capital Structuring.
Capital structuring is used in connection with mergers and acquisitions (M&A) to avoid a hostile takeover. A company can issue a large number of new shares, diluting the percentage of the company owned by the “target” stockholders. This makes them less valuable because they have a smaller percentage of the total company. In addition, issuing new shares creates additional voting stock for management to control, thus preventing unfriendly takeover attempts by making it difficult for third parties to obtain a controlling interest. A combination of both dilution and new share issuance is also possible if it is deemed necessary or desirable.
Also, if an M&A deal is successful, one or both parties can do a “tax inversion”, by which the target company changes its legal domicile to another country. This allows it to take advantage of lower taxes for companies within that country, which are often much higher than those faced by US-based companies under current US law.
Capital structuring is also often used to allow a business venture raise money from more than one investor in a given transaction. It can also be used to take advantage of special tax treatment, such as the foreign earned income exclusion. There is a poor correlation between structuring and tax breaks. For example, if a business obtains a generous tax break, it may be structured so as to take advantage of poor or inflated accounting methods, such as phantom income or undervaluation of assets. It will then operate at a loss for tax purposes and find itself unprofitable.
Capital structuring can have an impact on jobs if a corporation is trying to avoid paying taxes. In this case, the company may move its money from a high-tax jurisdiction to a low-tax one. In the process, it might close down its operations in the high-tax jurisdiction and lay off employees there. To avoid this situation, some countries have tax treaties with other jurisdictions which attempt to prevent it from happening by imposing a certain tax on profits sent outside of the high-tax jurisdiction. Critics argue that these tax treaties serve mainly to make it more difficult for ordinary citizens and foreign firms to pay less taxes than domestic firms.
The importance of adopting an appropriate capital structure cannot be overemphasized given its impact on various aspect of a firm especially in terms of its continuation as a going concern. Engaging an expert to advise on the appropriate structure to adopt could very well determine the status of the business.