Corporate and Capital Structure

1. Agenda Corporate and Capital Structure • INTRDUCTION • CORPORATE STRUCTURE • Organization Forms • Which one is appropriate? • CAPITAL STRUCTURE • What determines the structure? • Allocation of Risk, Income and Control • Off balance-sheet financing • The Cost of Capital • EVOLUTION OF THE STRUCTURES • THE MANAGEMENT CHALLENGES • CONCLUSION

2. INTRODUCTION Corporate and Capital Structure • Two major decisions the founders of the organization have to make: • The Legal form of the organization • The capital structure of the organization. • These decisions are guided by: • The inherent nature of the business • The strategy of the business • The owners or shareholders generally must approve any changes in the initial corporate structure, such as creation of new classes of stock (capital structure change), issuance of new shares (corporate structure change) or even sale of the company – subject to shareholders approval. • It is therefore essential that the directors understand the concepts and the dynamics involved in corporate and capital structure.

3. Corporate and Capital Structure CORPORATE STRUCTURE • Organization forms: • Proprietorships: Single owners. The owner is the business in that the enterprise has no economic value. E.g. Small service business or professional businesses. • Partnerships:Multiple owners with some engaged in the management: • Limited Liability Partnerships: Provides liability protection while maintaining tax benefits. • C Corporations: Standard form of corporate organization • S Corporation: Same as C corporation but income is taxable as partnership. Cannot have more than 75 shareholders • Limited Liability corporations. Same as LLP except that it has members instead of partners. • Public Corporations: Meet ownership criteria defined by SEC. Source: (Font, Arial, Font size: 9pt, Black)

4. CORPORATE STRUCTURE Corporate and Capital Structure • Which is the most appropriate? • A degree of judgment is required. There are at least five variables that should be considered: • The size and complexity of the business • The number of owners • The Life span of the business • Tax considerations • Liability considerations • Generally speaking: • Smaller, simpler businesses are more apt to be proprietorship or partnerships. • C Corporations are subject to double taxation: corporate income tax + personal income taxes (dividends tax)

5. CORPORATE STRUCTURE Corporate and Capital Structure • Public Versus Private? • Why go public? • To raise capital to fund a growth or acquisition strategy. • As an exit strategy for the venture capitalist. • To gain liquidity for the previous investors as IPOs tend to yield the highest price compared to private sale or company buy-out. • Self-interest on the part of both investment bankers seeking a fee and the owners of the company. E.g. the dot-com bubble (2000)

6. CORPORATE STRUCTURE Corporate and Capital Structure • When to go public? • Even though going public may be a sign of success or maturity, running a public company has additional challenges like costs of regulatory compliance, management of investor relations, and share market structure management. • Going public should therefore be undertaken only when: • There are solid business reasons like access to capital, stockholder liquidity, and a currency to execute an acquisition strategy. • The company is large enough to create a meaningful market for its shares. Market capitalization of about $100 million is realistic enough.

7. CAPITAL STRUCTURE Corporate and Capital Structure Definition The details of the capital structure of a business describe the financing of the organization. Traditionally it refers to the relative amounts of debt and equity on a firm’s balance sheet. Every firm is funded either through equity or debt. • The need for capital is driven by the nature, size and growth rate of the business. • Nature: Some businesses are more capital-intensive than others. E.g. Major manufacturing process operations would have higher investment intensity than a service business. • Size: It is the change in size that create the need for more or less capital. A basic maxim states that the nature of the business assets dictates the type of investment capital. Long term assets need to be funded by permanent capital (long term debt or equity.

8. CAPITAL STRUCTURE Corporate and Capital Structure Asset Types and Capital Sources: Debt/Equity balance Trading Assets – Trading Liabilities = Trading Capital Required. The more risky the business in terms of unpredictability or earnings, the more equity is needed. One of the principle mistakes that companies make is to overleverage hence need for a good balance. The table below gives some guidelines:

9. CAPITAL STRUCTURE Corporate and Capital Structure • AssetTypes and Capital Sources: Debt/Equity balance • Trading Assets – Trading Liabilities = Trading Capital Required. • A conservative rule would be that all assets other than fixed assets are financed with equity (with a few exceptions depending on the nature of the assets) • One of the key decisions a board must make is the amount of leverage the firm will assume. Leverage is a two-edged sword: When the interest rate on the debt is lower than the return on capital, the difference accrues to equity and leverages up the return on equity. The reverse, however is also true. • The mix of debt and equity determines two important things: • The allocation of risk, income, and contro • The cost of capital

10. CAPITAL STRUCTURE Corporate and Capital Structure • The allocation of risk, income, and control. • For a strong company, the best debt gives up little control (it is unsecured but has tight covenants) and carries low interest rate, reflecting the low risk. • As the risk increases, a lender will want more control (collateral and more restrictive covenants) and higher interest rate (more income.) The more risky debt is subordinated to senior debt and carries high rates (often high yield or junk bonds) and may even have equity features. • Equity as a source of capital may involve the relinquishing of various degrees of control. • A major question therefore: What is the optimal amount of debt? Equity Debt

11. CAPITAL STRUCTURE Corporate and Capital Structure • Off-Balance-Sheet Financing • It involves operating leases whose terms permit them not to be shown as liability. • It is just an accounting technicality and has no financial impact. • There are situations where off-balance-sheet obligations make good economic sense. Unfortunately, those who have wanted to cover up their actions or who have not wanted to disclose the full amount and nature of debt leverage have abused them. • Often the complexity of off-balance-sheet vehicles make it very difficult for an outsider to understand a company’s true financial picture and even sometimes for insiders as well. • Even though they should not be blanket condemned, the directors need to ensure the sound rationale of using such vehicles and that they are fully disclosed in company statements.

12. CAPITAL STRUCTURE Corporate and Capital Structure • The Cost of Capital • Debt has a cost: the interest rate paid less tax savings. • Equity also has a cost, although not so obvious: The cost of equity is the return that the owners desire on their invested funds. This return is a figure based on investors’ comparison of a given investment with their other opportunities. • The cost of capital of a business can be estimated by computing weighted average of the costs of debt and equity. (See Example below) • The return on capital before interest but after taxes should be compared to the cost of capital to see whether it is creating shareholder value or destroying it. • Encouraging the earning of positive returns for shareholders, after all costs and including capital costs, is the basic intent of incentive systems. Example

13. STRUCTURE TRENDS Corporate and Capital Structure Evolution of the Organization and Financial structure

14. CORPORATE MANAGEMENT CHALLENGES Corporate and Capital Structure • How to manage mix of business. • In a diversified, decentralized company, the corporate challenge is to provide an effective set of consistent results over the long term from a given mix of businesses, each of which has some inherent pattern of achievable results. • The divisions are charged with producing outstanding results compared with similar companies, their own past performance, and of similarly managed ones. • It follows that the only way the corporate office can make significant changes in the firm’s results for the measures of the return on investment and cash flow is to make changes in the portfolio of businesses. (acquire, divest, hold, etc) • Corporations that perform superbly will find ready access to equity markets, will enjoy lower interest rates, and will be able to use strong stock prices to acquire additional business. • The overriding objective is to enhance shareholder value, and this will be the ultimate objective of the boards of both public and private companies.

15. CORPORATE MANAGEMENT CHALLENGES Corporate and Capital Structure Restructuring to improve shareholder value: Strategic options.

16. CORPORATE MANAGEMENT CHALLENGES Corporate and Capital Structure How to manage mix of business: Strategic options.

17. CONCLUSION Corporate and Capital Structure • A good understanding of the organization’s corporate and capital structure concepts would help the board and the CEO to meet the challenges and opportunities expressed in the following questions: • In what business should the firm compete? • How should the company be re-structured? • How should the company’s ongoing operations be financed? • Is the level of corporate expenses consistent with that of other well-run companies? • The more diversified the corporation is the more difficult it is for directors and corporate executives to understand the detailed problems and opportunities faced by opening divisions. • “Problems are always accompanied by opportunities” – a fundamental axiom for directors.

18. THE END Corporate and Capital Structure