Is there an Optimal Capital Structure?

There is not a definite answer to this question.

According to the traditional view of capital structure, as the level of gearing increases, the cost of equity also increases and the cost of debt remains constant. This is shown in Figure 1. Although the cost of equity increases, this has an overall effect as a result of the lower cost of debt. The weighted average cost of capital (WACC) falls as gearing increases. Once a certain level of debt (not identified) is reached, then the cost of debt starts to increase because of the gearing risk. Therefore, the continuing increase of both the cost of debt and equity causes the WACC to increase (ICSA, 2009).

Figure 1. Traditional view of capital structure

(ICSA, 2009)

Point A in Figure 1 is associated with the minimum cost of capital. It is the financial managers job to come to the decision of determining the appropriate mix of debt and equity to minimise the WACC.

Theorists such as Modigliani and Miller (M&M) (1958) argued against the traditional view of capital structure and developed a proposition described as the ‘irrelevance of capital structure”. They came to the conclusion that the traditional approach is incorrect and the value of the firm depends on its assets and the operating income that has been derived from them, therefore there is no optimal structure.

There are many criticisms with M&M’s theory:

1.    They assume that the capital market is perfect.

2.    Ignore taxation

3.    Assume WACC remains constant at all levels of gearing

However, in 1961 M&M admitted that corporate tax is necessary in their analysis. This altered their conclusion dramatically. They believed that debt became cheaper, as a result of the tax relief on interest payments. They came to the conclusion that if a firm wishes to reduce its weighted average cost of capital (WACC), then it should borrow as much debt as possible which would lead to an optimal capital structure of 99.99% (Samuels, Wilkes & Brayshaw, 1998).

There are also criticisms with M&M's revised theory:

1.    Company’s capital structures are not almost entirely made up of debt.

2.  Assume perfect capital market- however we live in the real world and companies are     exposed to increased interest payments, which could lead to bankruptcy.

Moreover, changing the capital structure of companies can help to create more shareholder value. For example, Aventura Equities announced capital structure changes including a forward stock split.  The company’s CEO believes that this action creates more liquidity for their shareholders and will give the company better opportunities presented as a result of these actions. Enhancing shareholder value is their main aim, and they believe they can meet this goal by changing their capital structure (OTC Markets, 2014). 

So is there an optimal capital structure? I would say no. Given how risky a business is and depending on the circumstances, the appropriate proportion of debt and equity should be used.

Are family businesses really that important?

The answer to this question is yes as family businesses represent the most enduring business model in the world. Continuous success of family firms through generations relies on ensuring that the next generation, in which the baton will be passed on to those who are motivated to take up the challenge and who are fit for the job (Drake, 2013). 

Whether the firm is private or public, family businesses constitute a major segment of the American economic system (Dreux, 2012). The greatest part of America’s wealth lies with family owned businesses. They comprise of 80%-90% of all the business enterprises in North America (Family Firm Institute, Inc. 2014). A great example of an American family owned business is Wal-Mart. Figure 1 shows a family tree of the Waltons, who are one of the richest and most powerful families in the world, own Wal-Mart and according to Bloomberg the family controls more than 50% of the Wal-Mart Corporation. Similarly, based on Forbes’ wealth estimates they have a combined net worth of at least $150 billion. So why does this company matter?  Even though the Walton’s are building billion-dollar museums, driving million dollar cars, Wal-Mart is the country’s largest private employer and pays its employees an average of $8.81 an hour. As a consequence, this company significantly impacts the US economy as growth, increased stability and wealth can be achieved (Willett & Nudelman, 2013).

Figure 1. 

Other famous and successful family businesses include Mars Inc. which is one of the world’s largest companies as it operates in six segments: Chocolate, Petcare, Wrigley Gum and Confections, Food, Drinks, and Symbioscience (Forbes, 2011). It is the 7^th largest private company in the USA and has an income of over $15m. According the President of Mars Incorporated, the company has an objective to create long lasting, mutual benefits for all those involved in the business success. They strive to create positive social impacts, minimising environmental impacts and also create economic value. Therefore companies such as Mars help to increase the prospects of the economy. 

So how are family owned businesses financed? 

It is does not come as a surprise to me that the most popular forms of finance for family owned businesses are self-finance and debt finance. Both forms of finance do not alter the share ownership of the company and so therefore preserve family ownership and control. Though family businesses tend to steer away from equity finance in order to try and retain ownership of their business. However, there is also the case of external investors are often deterred from offering equity finance to family-owned ventures due to the limited opportunities to secure an exit. If family businesses are not able to source finance and capital then how will they grow? This is a key limitation that can affect their ability to continue in an upward track. 

Although family businesses may be successful, problems may occur in larger family firms. Family businesses that wish to obtain outside equity capital will face agency problems. This may cause conflicts, as what the family members wish to achieve may be different to what the investors wish to achieve. Therefore, this may lead to the investors not trusting the family business and their wealth, which can therefore lead to wealth constraints preventing family firms from undertaking activities that can increase growth. Other problems such as conflict between family members and believing in different values may also be a concern when making financial decisions. If a company has generations of family members involved, generational differences can occur as the younger generations can have a different view compared to the older generations. 

Therefore, to sum up family businesses around the world are very important to the global economy as they bring a lot of wealth and growth. As a result they are really important and we must not forget them. 

What is "Crowdfunding"? Is it really that good?

Larralde (2010) defines crowdfunding as “an open cell, essentially through the internet, for the provision of financial resources either in the form of donation or in exchange for some form of reward and/or voting in order to support initiatives for specific purposes”. 

The definition includes many types of crowdfunding:

·  Civic Crowdfunding /Philanthropic Donations i.e. Statue of Liberty example

·  Reward Based Crowdfunding i.e. Kickstarter, Indiegogo

·  Securities Crowdfunding/ Equity Based Crowdfunding (many legal issues involved). 

Over the last couple of years, there has been impressive growth in crowdfunding. This has especially been seen in rewards-based and peer-to-peer lending industries. In 2013 alone, there has been significant progress in legislation regarding equity crowdfunding in the US. There has been a growing trend in companies using Kickstarter as a source of crowdfunding as part of their marketing strategy to attract media attention and approach professional investors such as business angels and venture capitalists (Mikhaylova, 2013).

How do crowdfunding platforms work?

Crowdfunding platforms generally work on a basis of ex post facto (Kappel, 2009). This is where the product/service is offered for after when the financing is provided. This is sometimes called an ALL OR NOTHINg (AoN) system. If we say for example, when a project on Kickstarter hits its project goal, the crowdfunding platform is able to release the funds to the company. Therefore, when the goal is actually achieved the customer’s payment pledge is only then acted upon. On the other hand, the ex ante crowdfunding method of capital formation has been increasingly popular in the entertainment industry by independent filmmakers, artists, writers and performers (Kappel, 2009). This is where financial support is obtained before the goal has been reached (Koren, 2010). An example of this method is further supported by Obama’s success with online fundraising for his campaign. This was evidence for people’s willingness to give financial support and invest in someone who they believe in.

 Is this a good idea? 

Personally, I think that crowdfunding is great idea. People do tend to say that it allows good ideas that might not be able to get bank loans or conventional funding to be set out directly to the members of the public with the like-mined interests wherever they may be. Due to their limited resources, many small charities are usually overlooked in favour of more established ones. Through crowdfunding, this allows these causes to find supporters via the Internet and social media. This can also help causes all over the world (Quinan, 2012). 

There are many examples of people using crowdfunding. If we look at Kickstarter, we would be able to find many crowdfunding examples. Many of these crowdfunding projects have been increasingly successful. However, on the other hand some have not. 

If we look at the device in the example in Figure 1, we can see that this project was successfully funded on 23^rd March 2012 and has been pledged for $76,340, higher than the initial $50,000 goal. This device is called the ‘NODE’, and is a modular, Bluetooth enabled device that puts the power of practical sensors in your hands. Now is this impressive or what? It amazes me how fast the world is changing and with the support of platforms such as Kickstarter, new inventions can be supported to help achieve success in the future.

Figure 1.

But what are the dangers involved? 

However with everything in life, there are dangers involved. If the crowdfunding campaign fails and stays on the crowdfunding website, it would affect reputation of the company, thus could be harmful. Additionally, some rewards can cost a lot of money and valuable time. Time is not an unlimited resource, it is important to take this into consideration and be practical. It has often been experienced that the creators will add extra rewards as it gets closer to the end, without considering the extra time those rewards will actually involve and also not to mention the added cost. Therefore, rewards need to be considered very carefully. 

By weighing up both the pros and cons of crowdfunding, I believe that this is a good platform for companies to receive funding for their investments. Platforms such as Kickstarter and Indiego are ideal for this as they help to raise awareness. Hopefully at some point in the future I would like to open my own business and I would most definitely use these crowdfunding platforms to get my ideas running.