Gearing Analysis of Facebook - Assignment Example

Gearing Analysis of Facebook Introduction This 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 Review Irrelevance of Debt-to-Equity Relationship Modigliani 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 Costs The 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. The costs of financial distress are costs associated with the risk of defaulting on the debts or becoming bankrupt, and are related to the risks presented by general economic conditions for the firm; when economic conditions are not favourable, firms tend to use debt more conservatively (Almeida & Philippon, 2007). The lack of credit availability after the 2008 financial crisis could be an indirect indication of this. While the banks were generally blamed for not extending credit, supply and demand is a two-way street; it is conceivable that if firms were more aggressively demanding credit at that time, banks would have been inclined to respond. Regardless of economic conditions, one way in which firms can address costs of financial distress is to hedge on their risks (Smith & Stulz, 1985), which helps to overcome unexpected future conditions that might upset assumptions the firm makes about meeting its debt obligations. Hedging allows for a greater degree of debt financing, but the benefits of hedging are usually inversely proportionate to the firm’s agency costs (Leland, 1998; Chernenko, Foley & Greenwood, 2010). In other words, low agency costs support hedging (and subsequently, higher leverage), while high agency costs support equity issuing. An agency is defined as a relationship in which an owner or principal delegates some authority to an agent to act on the principal’s behalf (Jensen & Meckling, 1976: 4). For example, the relationship of shareholders to a board of directors is an agency relationship; the relationship of the board to the firm’s managers is also an agency relationship. According to Jensen and Meckling (1976) agency costs arise when an agent does not act according to the utility maximisation of the principal. In other words, what represents maximum utility from the point of view of a firm’s managers might differ from what represents maximum utility for its owners; the difference created between the two is an agency cost. Relationship of Trade-Off Theory to Pecking-Order Theory The balance firms seek between benefits and costs of different finance choices leads to a “pecking order,” a common viewpoint towards which forms of financing are more preferable, and these preferences depend on the type and size of the firm. A ‘standard’ pecking order prefers financing new investments through retained earnings first, then debt, then the issue of new equity (Frank & Goyal, 2008; 2009). Factors that are important for firms making a capital structure decision include the average or median level of leverage throughout the industry, anticipated inflation, available collateral, profit margin, the firm’s market-to-book ratio, and dividends that must be paid (Frank & Goyal, 2009). Surveys of firm capital choices indicate some general patterns. Frank and Goyal (2008) found that private firms use retained earnings and bank debt for capitalisation, while small or new public firms prefer equity financing, and large, established public firms use retained earnings and bond issues. Hackbarth, Hennessy, and Leland (2007) divide firms into “weak” or “strong” categories, but have similar results; weak firms tend to favour bank debt as the first option for financing, while strong firms pursue mixed financing. Market Timing Market timing is a fairly simple proposition. Firms tend to issue equity when market values are high, and repurchase equity when market values are low. Baker and Wurgler (2002) specify that the judgment of high or low market value is based on a comparison to book value and historical market values. As a result, in Baker and Wurgler’s view, capital structures are reflective of the cumulative outcome of the firm’s record of timing the market. This implies that firms which have been successful in timing equity reissues and purchases prefer equity over debt for financing, while firms that have not been as successful have higher gearing. In a study which focused specifically on initial public offerings, and therefore has great relevance to an assessment of Facebook’s recent IPO, Alti (2006) found that firms with IPOs issued in hot markets tended to issue more equity and lower their debts at the moment of issue more than IPO firms in cold markets. But, immediately after going public, hot-market IPO firms do the reverse, increasing their debt and reducing equity. The Relationship of Facebook’s Gearing and Capital Structure Decisions The debt-to-equity ratio (D/E) is a common leverage ratio, and is used to provide a relative assessment of a firm’s risk to its creditors (Colbert, 1994: 6). As a general rule, the higher the level of debt, or gearing, the more risky the firm is. As was noted in the Introduction, Facebook has typically reported a very low level of gearing; the company’s D/E ratio at the end of March, the data reported in the most recent version of the IPO prospectus, was 0.0766, which had dropped to 0.0374 by the end of the third quarter, almost certainly due to the massive increase in equity from the IPO (YCharts, 2012; Facebook, 2012). The financing choice illustrates the findings of Alti (2006), in that the IPO was made in a hot market – the NASDAQ, which features many volatile tech stocks – and was preceded by a reduction in debt as indicated by a decrease in the D/E ratio; the decrease was somewhat gradual prior to the IPO, and dramatic afterwards (YCharts, 2012). There is also evidence the IPO was a matter of market timing; it was issued in a period in which the market was rising. In addition, the price of the IPO, which was being offered at a level that was 100 times earnings, also reflected market timing in the sense described by Baker and Wurgler (2002); it was based not only on the anticipation that Facebook’s revenue and profit trends would continue, but also on what similar offerings such as Google had achieved in the past (McBride & Gupta, 2012). What is not known yet, however, is whether Facebook will hold true to the rest of the pattern discovered by Alti (2006) and increase its debt. There may be some basis for forecasting that it will; since the IPO at $39.00, the share price has declined by half to about $20.00 in a little less than a year (“FB Stock Chart”, 2012). This is possibly an illustration of a finding by Chernenko, et al. (2010), that major shareholders tend to offer a number of their shares in the market if they are overvalued; whatever the underlying reason for it, this did happen to Facebook in mid-August, when a proscription period against insider stock sales ended (“FB Stock Chart”, 2012). The purpose of the capitalisation – in that Facebook states in its prospectus that it does not have a particular investment for which it needs the funds generated by the IPO (Facebook, 2012) – may have much to do with the decision to fund through equity. Previously, Facebook had followed the usual pattern described by pecking-order theory; whole or partial acquisitions of other tech firms such as Zynga and Instagram were achieved with retained earnings, the first choice in the pecking order, as is evidenced by the company’s low gearing and its low ratio of retained earnings to assets, which is about 1:12 (McBride & Gupta, 2012; Facebook, 2012). The lack of a specific investment to which to apply IPO funds also fits – or more properly, does not contradict – the observation of Modigliani and Miller (1958: 292) that equity issues are probably not the best first choice for funding in some cases, because of the effect of market enthusiasm on share prices. Facebook also fits the patterns described by Hackbarth, et al. (2007) and Frank and Goyal (2008): Even though Facebook is a large, well-known company, it was a new entrant to the general equity market at the time of the IPO, which partly explains the preference for equity rather than debt financing as described above. It is also a “strong” company in the sense described by Hackbarth, et al. in that Facebook is at least perceived to be an established company with a huge earning potential, a perception that allows the company to move debt financing farther down the list of options. Conclusion Facebook’s capital structure choice can be briefly summarised as a strong preference for equity financing with very little debt financing, as indicated by its enormous and well-publicised recent IPO and the company’s very low gearing of about 3 cents’ worth of debt for every dollar in assets. The low level of gearing is primarily explained by pecking-order theory and market timing. Facebook fits the pattern of a strong but relatively new public firm which prefers equity financing, and since the objective for the funding is non-specific, the company is untroubled by trade-offs for agency costs – a problem that was largely absent from its decision-making equation since Mark Zuckerberg as Chairman, CEO, and largest stockholder is basically both the principal and agent – or concerns about achieving a predetermined level of funding with its equity issue. All things considered, Facebook is a typical example of the models and patterns described in the academic literature, which is beneficial to investors as it provides a guide to what capital structure decisions the company is likely to make in the future. References Almeida, H., and Philippon, T. (2007) “The Risk-Adjusted Cost of Financial Distress”. The Journal of Finance, 52(6): 2557-2586. Alti, A. (2006). “How Persistent Is the Impact of Market Timing on Capital Structure?” The Journal of Finance, 61(4): 1681-1710. Altman, E.I., and Hotchkiss, E. (2006) Corporate Financial Distress and Bankruptcy, 3rd Ed. New Jersey: John Wiley & Sons. Baker, M., and Wurgler, J. (2002) “Market Timing and Capital Structure”. The Journal of Finance, 57(1): 1-32. Chernenko, S., Foley, C.F., and Greenwood, R. (2010) “Agency Costs, Mispricing, and Ownership Structure”. National Bureau of Economic Research Working Paper 15910, April 2010. http://www.nber.org/papers/w15910. Colbert, J.L. (1994) “Analytical Procedures for Management Accountants and Auditors”. Managerial Auditing Journal, (9)5: 3-7. Facebook. (2012) Prospectus. Facebook, Inc., 3 May 2012. Available from TechCrunch: http://www.scribd.com/doc/92290808/TechCrunch-Facebook-IPO-Prospectus. “FB Stock Chart”. (2012) NASDAQ. http://www.nasdaq.com/symbol/fb/stock-chart. Frank, M.Z., and Goyal, V.K. (2008) “Trade-off and Pecking Order Theories of Debt”. In: B.E. Eckbo (Ed.), Handbook of Empirical Corporate Finance, Vol. 2. Amsterdam: North-Holland, 136-194. Frank, M.Z., and Goyal, V.K. (2009) “Capital Structure Decisions: Which Factors are Reliably Important?” Financial Management, 38(1): 1-37. Hackbarth, D., Hennessy, C.A., and Leland, H.E. (2007) “Can the Trade-off Theory Explain Debt Structure?” The Review of Financial Studies, 20(5): 1389-1428. Jensen, M.C., and Meckling, W.H. (1976) “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure”. Journal of Financial Economics, 3(4): 305-360. Leland, H.E. (1998). “Agency Costs, Risk Management, and Capital Structure”. The Journal of Finance, 53(4): 1213-1243. McBride, S., and Gupta, P. (2012) “A Sobering Look at Facebook”. Reuters, 3 February 2012. http://www.reuters.com/article/2012/02/03/us-facebook-investment-idUSTRE81206020120203. Modigliani, F., and Miller, M.H. (1958) “The Cost of Capital, Corporation Finance and the Theory of Investment”. The American Economic Review, 48(3): 261-297. Smith, C.W., and Stulz, R.M. (1985) “The Determinants of Firms' Hedging Policies”. The Journal of Financial and Quantitative Analysis, 20(4): 391-405. YCharts. (2012) Facebook (FB). 30 September 2012. http://ycharts.com/companies/FB/ debt_equity_ratio. Read More