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Capital Structure Analysis

Trade-Off Theory

The Trade-off Between Tax Benefits of Debt and Financial Distress Costs

The trade-off theory assumes that a firm can benefit by leveraging within its capital structure up to a point where it reaches its optimal capital mix. Ideally, companies determine their capital structure by trading off the tax shield benefit of debt against the financial distress costs (Brusov et al., 2014). In this case, the value of a levered firm would be equal to the value unlevered firm plus the PV of tax savings from debt minus the PV financial distress costs that are expected. For Blackmores Company, the trade-off theory is likely to affect its optimal capital structure mix in that if the management trades off its tax shield benefit of debt with its financial distress costs, it will be able to benefit in the long run up to a point where it reaches its optimal capital structure mix (Blackmores, 2018).

Analysis of Tax Benefits

In the US tax system, the shareholders are tax twice when they are paid dividend income. One may find that companies in the USA pay both corporation tax and income tax, thus realizing lower profitability. This process is called the double taxation(Brusov et al., 2014). Australia has tried to come up with a tax system that avoids double taxation, the Australian imputation system. Here, the primary objective of the Australian imputation system is to tax dividend incomeat an effective tax rate which would be equal to the investor’s return. Blackmores Company is likely to benefit from the Australian imputation system in that the management will not have to pay tax twice on dividend income and thus they would be able to realize higher profitability (Blackmores, 2018).

To compute the tax savings on equity, one would first determine whether Blackmores Ltd. Is fully funded by debt or equity. If Blackmores is fully funded by equity, the tax savings on equity would be as follows:

On the other hand, if Blackmores is fully funded by debt, the tax savings on debt would be as follows:

Below is the computation of VL of Blackmores Ltd considering that the VU is A$178m, the TC, TS and TB are 30% while the B is A$79M.

From this, it is evident that Blackmores has a higher value due to the fact that personal taxes have been incorporated. As a result, the firm will be able to realize tax benefits.

Implications of the Trade-off Theory Determinants

Profitability

The profitability of companies is usually measured regarding ROA. Organizations with a higher Return on Assets (ROA) have a higher chance of utilizing the interest tax shields, which means that they have higher leverage or debt than firms with a low ROA(Brusov et al., 2014). For instance, the ROA of Blackmores Ltd is 13.95% which is rated the fifth among its competitors. This means that since Blackmores Company has a higher ROA than the competitors, the firm has a high chance of utilizing its interest tax shields on debt because they have a higher debt level than equity (Blackmores, 2018).

Uncertainty of Operating Income

Corporations that are risky may have uncertain income, and therefore they have a higher chance of going into financial distress. Such companies would be advised to keep low debt level than debt. Ideally, the riskiness of a business is measured using beta or standard deviation (Brusov et al., 2014). For instance, Blackmores Company has a beta of 0.55. Apparently, a beta of less than 1 indicates that the security or the company in consideration is less volatile than the market. This means that Blackmores is a less risky company (Blackmores, 2018). For this reason, the firm does not have uncertain income and therefore keeping higher debt levels would not make it go into financial distress.

Growth Opportunities

The growth of a business may be measured using the price-earnings ratio. Companies that have a high growth opportunity should try to keep low levels of debt, since such opportunities may not be realized if the company goes into bankruptcy(Brusov et al., 2014). Considering our case example of Blackmores, the company has a price-earnings ratio of $49.25. This price earnings ratio may be regarded as high, and therefore Blackmores company has a higher growth opportunity. With this P/E ratio, the corporation should try to keep its debt levels to a minimum to take advantage of such growth opportunities (Blackmores, 2018).

Type of Assets

The kind of assets may be a determinant in the capital structure mix of a firm. If a business has more intangible assets than tangible assets, it should have a lower debt level since bankruptcy may be costly to such companies. However, if an organization has more tangible assets than intangible assets, it should have a higher debt level (Brusov et al., 2014). Ideally, this determinant is measured using the R & D intensity of the firm or rather by looking at the tangible and intangible assets of the corporation. For instance, Blackmores Corporation had intangible assets amounting to $35 million for the year ended 2016 while its tangible assets amounted to $87 million. This means that the tangible assets are more than the intangible assets and thus the company would be said to have a lower research and development intensity. As a result, Blackmores should consider having a higher debt level since even if they go into bankruptcy, they can liquidate the assets and thus it will not cost them so much (Blackmores, 2018). This is evident in the agency theory where a company with a high R & D intensity has a high growth rate and should keep low leverages while one with a small R & D intensity such as Blackmores has a low growth rate and therefore it should maintain a high debt level.

Determinant Blackmores Ltd. Optimal capital structure
Profitability (ROA) 13.95% Higher debt levels
Uncertain income () 0.55 Higher debt levels
Growth opportunities  (P/E) $49.25 Lower debt levels
Type of asset (PPE/Assets) 71% Higher leverage

References

Blackmores, 2018. More About Blackmores Ltd. [Online]. Available at https://www.blackmores.com.au/?gclid=EAIaIQobChMIs9D15t_m2AIVhhWPCh10QAF5EAAYASAAEgLzTvD_BwE [Accessed 22nd January 2018].

Brusov, P., Filatova, T. and Orekhova, N., 2014. Mechanism of formation of the company optimal capital structure, different from suggested by the trade-off theory. Cogent Economics & Finance2(1), p.946150. [Accessed 22nd January 2018].

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