Capital Structure Evaluation of Sample Firms Essay

Capital Structure Evaluation of Sample Firms - Essay Example Such sustainable growth requires increasing investment in long term assets, which in turn needs to be financed by long term funds. The two conventional long term sources of fund are debt and equity. The proportion of such debt and equity determines the capital structure of the firm. There are benefits and shortcomings of both the funding options. While debt funds are considered to be less costly owing to the interest tax shield that they provide, equity funds are considered to be more expensive owing to its inherent risk profile. Though debt funds reduce an organization's weighted average cost of capital (WACC), such funding increases the risk profile of the organization owing to long term commitments secured by asset collaterals, which could seriously increase the bankruptcy risk of the organization during an economic downturn. The modern thinking on capital structure is primarily based on the seminal work done by Franco Modigliani and Merton Miller. The Modigliani-Miller theorem (1958) states that in an ideal world, the value of a firm is independent of its capital structure. When a firm increases its gearing ratio, the overall risk to the equity holders increase thus increasing the cost of equity, thereby having no net effect on the value of the firm. One important aspect of this theorem is that it ignores the bankruptcy and transaction costs, and assumes information is freely available to all firms. The optimum leveraging point of an organization is, therefore, always a source of debate, and has been subject of various continuously evolving theories and models. Some of these recent theories and classical models are examined and validated by analyzing the capital structures of five organizations (PLCs) from four different industry sectors. The firms chosen are as below. Table 1-1 Company Name Industry Sector TESCO Food manufacturing and products BP Oil, gas and energy Exxon Mobil Oil, gas and energy BHP Billiton Metals and mining British Energy Utilities TESCO is a giant in the food manufacturing sector with an annual turnover of 47.3 billion. TESCO was founded in 1919 in the UK, and has since grown to set up footprints across the world in the Asia, Europe, and the US. It is one of the leading food retailers of the world, and has diversified into petrol retailing. BP is primarily in the business of oil exploration and refining, and operates out of several countries. Its other businesses include alternative energy, and shipping. It has an annual turnover of $361 billion. Exxon Mobil is also in the business of oil exploration/ production, gas, and power. Its downstream business includes oil refining, and marketing of fuel products and lubricating oil. Its annual turnover is $390 billion. BHP Billiton is the world's largest diversified natural resources company with businesses including alumina, aluminum, copper, energy, coal, iron ore, nickel, manganese, oil and gas and uranium, as well as gold, zinc, lead, silver and diamonds. It employs