Building a reasonable capital structure to improve financial quality for T&H Information Technology and Telecommunication Joint Stock Company

CHAPTER I: THEORETICAL BASIS OF A REASONABLE CAPITAL STRUCTURE OF ENTERPRISES

1.1. THEORETICAL BASIS OF A REASONABLE CAPITAL STRUCTURE FOR ENTERPRISES

1.1.1. Concept.

To implement business plans and investment projects, enterprises can mobilize capital from many different sources such as short-term loans, long-term loans or equity. Each type of capital will have its own characteristics, so it will create different impacts on the financial situation of the enterprise in aspects such as payment risk, financial structure stability, and current return on equity. Information about the enterprise's capital sources is presented on the balance sheet and explained in detail on the financial statements, including two groups: liabilities and equity.

Liabilities are capital sources formed by borrowing, purchasing goods and services on credit from suppliers, accumulated debts (unpaid taxes to the state, unpaid salaries and insurance for employees).

Unlike liabilities, equity is formed from the contributions of owners or accumulated during the business process. Most items in equity have the characteristics of not having to be repaid and are highly stable.

Capital structure is a term that refers to the ratio between debt and equity of a business. The difference between debt and equity is shown in many aspects such as payment terms, payment responsibilities, cost of capital and impact on corporate income tax.

Criteria

Liabilities

Equity

Deadline

pay.

There is a repayment period.

No refund period

Payment responsibility.

Interest must be paid on borrowed money minus any outstanding debts.

A business will go bankrupt if it cannot pay its debts and interest.

No interest payment but profit sharing based on business performance and profit distribution policy.

The business is not bankrupt.

if not divided profit to owner.

Maybe you are interested!

Image

affect corporate income tax.

Interest is included in the cost of determining taxable income, so interest has the effect of reducing corporate income tax.

career

Profits distributed to owners do not reduce corporate income tax.

Cost of capital.

Lower cost than cost of equity because:

Lower risk to creditors.

Debt creates a tax shield so the actual interest burden that businesses bear is lower.

The cost of equity is higher than the cost of debt because the risk of using equity is higher than that of using debt, as follows:

Owners receive profits after paying interest and taxes.

In case of dissolution or bankruptcy, they are ranked last in priority when dividing assets.

liquidation

Table 1.1: Comparison of liabilities and equity.

1.1.2. Indicators reflecting capital structure.

In the financial reporting system, the value of debt and equity of the enterprise is presented on the balance sheet. Based on the balance sheet, the capital structure can be determined through indicators such as: debt ratio, financing ratio, debt to equity ratio, financial leverage ratio.

Target

Meaning

In 100 dong of total capital, how many dong of debt does the enterprise use? A debt ratio greater than 50% indicates a capital structure

debt bias

In 100 dong of total capital, how many dong of equity capital is there? A ratio greater than 50% indicates that the business uses

more equity than liabilities

For every 1 dong of equity, how many dong of debt does it bear? If this number is greater than 1, it means that the capital structure is inclined towards debt, the ability to pay debt is low and vice versa.

again.

How many times is the total capital of a business greater than the equity? When the leverage ratio is greater than 2 times, it means that in the capital structure, debt is used more than equity.

ownership, that is, the capital structure leans towards debt.

Table 1.2: Indicators reflecting capital structure.

The relationship of the indicators reflects the capital structure.

Through the above indicators, it is possible to measure the contribution of the owner to the total capital that the enterprise is using. If the owner contributes more to the total capital, the financing ratio is high, the debt ratio is low, the financial leverage ratio is low and the debt to equity ratio is also low and vice versa.

Based on the capital structure indicators, creditors see the level of safety for the loans. A high debt ratio reflects that the owner's equity only accounts for a small part of the total capital, which can become a motivation to encourage the irresponsible attitude of business owners towards business activities, they can make reckless investment decisions beyond their control, speculate or do illegal business in search of high returns, but if they fail, the business owner will only lose a little, most of the risk will be borne by the creditors. Therefore, creditors often prefer businesses to maintain a moderate debt ratio, the lower the debt ratio, the more secure the loans are in case the business goes bankrupt.

On the business owner's side, a high debt ratio means that the capital invested in the business is mainly from debt. The business owner will benefit from maintaining control with little or no additional capital contribution. In addition, the business owner also has the opportunity to increase the return on equity when the efficiency

good business performance (return on loan capital is greater than loan interest rate). Thus, business owners need to consider each case of the correlation between loan interest rate and return rate to decide on a reasonable debt ratio. Businesses with a return rate lower than loan interest rate will have less loss if the debt level is low or businesses have the opportunity to increase profits very quickly if they maintain a high debt level with a return rate greater than loan interest rate.

From the above analysis, it can be seen that increasing profits is the desire of creditors, on the contrary, owners do not like risks. Therefore, financial decisions need to be considered based on the balance between profits and risks.

1.1.3. Reasonable capital structure and its basic benefits.

From the differences between debt financing and equity financing combined with the needs and financial capabilities of the business as well as the risks in investment decisions, financial managers will consider the combination of debt and equity in a reasonable way to contribute to increasing the value of assets for the owner while still ensuring safety in business.

Thus, reasonable capital structure is a term referring to the harmonious combination of debt and equity depending on each industry, each enterprise in each specific stage of development to ensure a balance between profit and risk.

Basic benefits when businesses build a reasonable capital structure:

- Save on capital costs.

- Create the highest business value, gain investor trust and make it easier for businesses to raise necessary capital.

- Control losses related to representative issues.

- Actively utilize financial leverage, ensuring a harmonious relationship between profitability and risk for the business.

- Financial structure ensures stability and flexibility.

- Establish a reasonable tax shield for the business.

- Minimize financial distress costs, limit bankruptcy risks.

1.2. THEORIES OF CAPITAL STRUCTURE OF ENTERPRISES.

1.2.1. Optimal Capital Structure Theory

This theory suggests that there is an optimal capital structure through which the value of the firm can be increased by using an appropriate debt-to-equity ratio.

The first thing this theory considers is that the optimal capital structure will have to use debt to reduce the firm's overall cost of capital (WACC), because the cost of debt is lower than the cost of equity.

The reason for the optimal capital structure theory is that the cost of debt is lower than the cost of equity, which is a tax savings. When a company uses debt, the interest expense is recorded as a pre-tax expense, which reduces taxable income and thus reduces corporate income tax; while the profit that the company distributes to its owners comes from after-tax profit, so it does not create tax savings.

However, the optimal capital structure theory also recommends that the level of debt use (the debt-to-equity ratio increases) increases risk and investors will increase their required rate of return. Initially, when the increase in the investor's required rate of return cannot completely eliminate the benefit from the above tax savings and the use of debt is still considered a source of capital with a cheaper cost, the overall cost of capital of the enterprise will continue to decrease and increase the use of debt. And at a certain level of debt use, the increase in the investor's required rate of return will eliminate all the benefits of using debt, at which point the cost of capital will begin to tend to increase as the enterprise increases its use of debt.

Figure 1.1: Cost of capital according to optimal capital structure theory.

1.2.2. The Net Operating Income Approach

Assuming a tax-free environment, perfect financial markets, firms distributing all profits to owners and zero dividend growth rate; net operating profit theory suggests that the weighted average cost of capital and firm value do not change when capital structure changes. Thus, firms will

There is no optimal capital structure and stock price and firm value do not depend on capital structure. This theory will be illustrated by the following example:

The initial capital structure of enterprise N includes: debt 200 (interest rate 8%) and equity 800. Operating profit is 120, ROA is 12%. Thus, the initial enterprise value is 1000 [=120/12%] and ROE is 13% [=(120 – 200.8%)/800].

If enterprise N changes its capital structure in the direction of increasing the debt-to-equity ratio from 0.25 to 1.00 but total assets remain unchanged, it means mobilizing debt to buy back equity. Because it does not depend on the capital structure, ROA is still 12%, operating profit is 120 and enterprise value is still 1000, but ROE is 16% [=(120–500.8%)/500].

The above example shows that when enterprise N increases the level of debt use, ROE will increase while ROA and interest rate for creditors remain unchanged; in addition, the enterprise value also does not change when there is a change in capital structure.

Figure 1.2: Graph of cost of capital according to net operating theory.

1.2.3. MM theory of corporate capital structure.

This theory was published in American Economic Review No. 48, June 1958 with the title "The cost of capital, Corporate Finance and The Theory od Investment" by two researchers Franco Modigliani and Merton Miller, so it is often called MM theory.

The theory states that the total risk to investors in a firm's securities is not affected by changes in the firm's capital structure, meaning that the total value of the firm remains unchanged with any changes in its financing structure. Simply put, no matter how the debt-equity ratio is divided, the investment value remains the same, the MM view.

assumes that there is a transfer of value between creditors and owners when the capital structure changes, which is illustrated by two pies of equal total area for different cases of capital structure.

Figure 1.3: The principle of constant total value according to MM's perspective.

The MM theory is based on the existence of arbitrage and a number of assumptions (perfect financial markets, no taxes, transaction costs and financial distress costs).

If two businesses are identical in all respects except for different capital structures, if there is a difference in the value of the business, an arbitrage opportunity will appear and will bring the two businesses to equilibrium. MM theory is illustrated by the following example:

Two companies A and B are identical in every way, with the same level of business risk, except that company A does not use debt while company B uses debt through the issuance of 400 bonds (assuming market value equals book value) with an interest rate of 10%. The required rate of return of the owner of company A is 12% and company B is 12.5%. Knowing that the two companies have the same EBIT of 120. The enterprise values are compared in the following table:

Target

Enterprise A	Enterprise B
1.EBIT.	120	120
2. Interest expense.	0	40
3.EAT.	120	80
4.Required return on equity.	12%	12.5%
5. Market value of equity.	1000[=120/12%]	640[=80/12.5%]
6. Market value of debt	0	400
7. Market value of the enterprise.	1000[=1000+0]	1040[=640+400]
8. Cost of capital.	12%	11.54%

Table 1.3: Comparison of enterprise value between A and B

From the data in Table 1.3, it can be seen that: Enterprise B has a lower general cost of capital and a higher enterprise value than Enterprise A. Although the capital structure is different, Enterprise B cannot demand a higher total value than Enterprise A, so according to MM, the owner of Enterprise B will trade the price difference by selling Enterprise B shares (highly valued assets) and buying back Enterprise A shares (undervalued assets). For example, investor X owns 1% of Enterprise B's equity and acts as follows:

(1) Selling shares of company B for 6.4.

(2) Borrow 4 (equivalent to 1% of enterprise B's debt) at an interest rate of 10%.

⇒ Total capital available for investment in enterprise A is 10.4.

(3) Buy 1% of company A's equity at a price of 10.

⇒ At the end of the transaction, investor X owns 1% of company A's equity and has a surplus of 0.4.

⇒ The profit that investor X earns is:

+ Expected profit when investing in business B: 6.4 * 12.5% = 0.8

+ Expected profit when investing in business A: 10 * 12% = 1.2

+ Interest payable: 4 * 10% = 0.4

+ The profit that investor X earns after conducting arbitrage trading: 1.2 – 0.4 = 0.8, exactly equal to the profit when investing in enterprise B but the investment capital is only 10 – 4 = 6 (lower than investing in enterprise B). Thus, the return on equity when investing in enterprise A is higher, so investor X prefers to buy shares of this enterprise, and the reason why the financial market as assumed by MM is perfect is that other investors also act similarly to investor X. Transactions will continuously take place, causing the stock price of enterprise B to decrease while the stock price of enterprise A increases until the total market value of the two enterprises is equal and the arbitrage trading activity ends. From there, MM concluded that: the value of a business without financial leverage and the value of a business with financial leverage are the same, or in other words, it is impossible to change the value of a business or the cost of capital by changing the capital structure.

MM theory continues to be studied in an environment with corporate income tax and finds that firm value increases when the firm