Gearing Analysis of FacebookIntroductionThis report presents a literature review and assessment of an example company to illustrate concepts in capital structure decisions. The company selected, Facebook, is listed on the NASDAQ exchange, and the launch of the Facebook IPO earlier this year has probably attracted more media attention than any similar offering ever. The assessment of Facebook’s capital structure decisions – of which the IPO was of course a significant part – is made in the context of the company’s very low gearing; for example, its debt-to-equity ratio as of the end of September was just 0.0374, and the company’s highest D/E ratio over the past five years was only 0.1698 (YCharts, 2012).
Other indicators, such as the long-term debt-to-working capital ratio, are similarly low. Thus the objective of this report will be to discover how these low gearing indicators are related to Facebook’s capital structure decisions. Literature ReviewIrrelevance of Debt-to-Equity RelationshipModigliani and Miller (1958) established the idea that the valuation of a firm was not based on the relative levels of the firm’s debt and equity, but rather that its value was entirely dependent on its future earning potential and what sort of risk-return proposition the business of the firm represented (Altman & Hotchkiss, 2006: 129).
In other words, the same company could finance itself with all debt or all equity and still have the same value. In that light, the gearing ratio of the firm would be irrelevant both as a measure of the firm’s value and – implication – as a factor in future capital structure decisions (Modigliani & Miller, 1958). Nevertheless, Modigliani and Miller themselves pointed out that different kinds of financial structures did still fit into their model, and they described some conditions in which firm owners might wish to make different decisions, using common-stock financing as an example (Modigliani & Miller, 1958: 292).
If a company had an opportunity for a very productive investment, stock markets would drive the company’s stock price up in anticipation of high future returns. Under those conditions, funding the investment through equity might not be possible, because the new stock issue might not provide enough to fund the new venture; that would make debt financing a more attractive option.
That example clearly works against the assertion that the debt-to-equity relationship has no bearing on capital structure decisions, and seems to work against Modigliani and Miller’s basic assertion that the relationship has no bearing on firm value. Higher debt might tend to drive stock prices lower, and if we accept that stock prices are a reflection of perceived firm value, then debt does have an impact. Trade-Off Theory and Agency CostsThe trade-off theory states that there is a balance between the tax benefits of financing with debt and the costs associated with it, primarily the costs of financial distress (Frank & Goyal, 2008; 2009).
There is also a balance between the benefits of financing with equity and the agency costs of doing so. Thus, the “trade-off” is a decision that presumably maximises the benefit and cost of both debt and equity, and produces a capital structure decision that includes a proportion of both.