Financial management is the process which is highly associated with making optimum use of money. Hence, planning, organizing, directing and controlling financial resources are one of the main objectives of business unit. Moreover, sound strategic and financial framework is high required for the attainment of organizational goals as well as objectives. In the recent times, stiff competition takes place in business environment which in turn closely influences the growth and success of firm. In this, by developing sound plan business organization can execute plan within then suitable time frame which in turn aid in the profit margin of firm. The present report will shed light on the extent to which inclusion of debt affects the financial structure and wealth of shareholders. Besides this, it will develop understanding about the level to which dividend policy of firm has an impact on shareholders wealth.
A. Critically evaluating the impact of debt on shareholders wealth
Capital structure of the firm presents the manner in which it finances all the operations through the means of debt and equity sources. In the recent times, there are mainly two sources which are undertaken by large sized business organizations to fulfill the financial needs. Hence, company places high level of emphasis on the issuance of share for meeting the financial needs and requirements (Zsidisin, 2016). The rationale behind this, investors are always ready to invest money in the shares of firm which is highly growing. Moreover, it offers opportunity to the firm to make value addition in the money. Thus, by considering all such aspects business unit makes focus on the issuance of equity shares to the general public at large.
Along with this, companies also make focus on the issuance of bonds or debt instruments with the motive to fulfill monetary requirements. The reason behind this, debt instruments are highly secured which in turn enables firm to attract large number of investors. Hence, by taking into consideration such aspects business unit includes such two elements in the financial structure. According to the views of Finkler and et.al., (2016) debt is one of the main aspects that have high level of impact on shareholders wealth and company’s profitability. Moreover, debt instruments impose fixed financial burden in front of business organization. In the case of bonds and debt instruments company is obliged to make payment of interest to the debt holders whether they make sufficient amount of profit or not. In this way, bonds or debt closely influences the profit margin of firm. Further, such aspect also influences the dividend decision of firm. Moreover, company pays dividend to the shareholders from the profit amount which it has after the fulfillment of all financial obligations. In this way, dividend decision of the company is highly influenced from the extent to which capital structure of firm contains high debt.
In accordance with the views of Bir (2016) business units need to place emphasis on maintaining ideal ratio while determining the capital structure of firm. Ideal ratio such as .5:1 entails that company must issue 1 debt instrument namely bond in against to 2 equity shares. This in turn helps company in developing sound and effectual financial structure. Goal or objective of each and every business organization is to develop highly optimal capital structure which in turn helps in increasing the share price. Along with this, maintenance of minimum cost of capital is another main objective of business organization. In this regard, by following ideal ratio business unit can build and maintain highly effectual financial structure. The reason behind this, capital structure has high level of impact on the financial performance and profitability aspect of firm.
Along with this, such aspect also influences the profit margin of firm. Thus, for increasing the shareholders wealth and decreasing the cost of capital firm is required to lay emphasis on developing as well as maintaining optimal structure. Hence, debt-equity mix which increases the wealth of shareholders is recognized as suitable capital structure. Thus, by developing suitable structure business unit can maximize the wealth of shareholders to the significant level (Leland, 2017). For instance: If business organization wants to provide shareholders with high return then they need to include less debt in the financial structure. Moreover, in the case of bonds or debenture business unit is obliged to make payment of interest which directly affects the profit margin. In this way, by reducing the tax burden business unit can enhance its profitability aspect and thereby would become able to offer higher return to the shareholders in the form of dividend. Hence, by offering higher return to the shareholders company can increase the value of firm. Moreover, goodwill of the business organization is enhanced in the market when investors are highly satisfied from the return or dividend aspect.
However, on the critical note, Geske, Subrahmanyam and Zhou (2016) said that decreasing WACC may result into incline in the value of firm. Hence, by following such aspect highly optimal capital structure can be developed by the company. Nevertheless, there is lack of standard theory and framework which in turn helps in farming highly suitable or optimal capital structure. Authors stated that sometimes company focuses on including high debt with the aim to gain benefits in terms of tax brackets. The rationale behind this, interest which is paid by company to debt holders comes under the category of tax deductions. Hence, for reducing the tax liability firm makes focus on issuing debt to the investors. In contrast to this, Schepens (2016) claimed that high debt affects the trust level of investors to a large extent. Moreover, increasing debt level develops negative image in the mind of investors that business unit fails to meet the obligations more effectively and efficiently. In addition to this, increasing debt level also impacts future investment decision of shareholders. Moreover, along with the debt level interest expenses of firm also increased significantly. Hence, such increased level of expense negatively affects earning per share aspect.
Besides this, high debt impacts the level of investor’s faith significantly on the basis of bankruptcy implications. The reason behind this, at the time of bankruptcy investors get least priority in attaining back money invested at initial level. Hence, by taking into consideration all the above mentioned aspects it can be said that shareholder wealth and firm’s value is highly affected when organization introduces high or more debt in the capital structure (Lin and et.al, 2016). Thus, manager of the business unit needs to keep in mind all such factors while determining the financial structure of firm. This in turn helps company in achieving success in the highly strategic and competitive business arena.
From investigation, it has been assessed that due to situation of global crisis Tesco plc which is one of the retail business organization facing high level of debt. Global crisis occurs in the year of 2007-08 had negatively affected each and every sector including retail. Moreover, customers prefer to spend high on luxury only when their disposable income is greater. In this way, sales volume of firm is highly affected when economic condition is not highly effectual (Firth and et.al., 2016). Further, inflation and deflation are the major conditions which have high level of impact on the purchasing power of customers. Hence, with the aim to manage business operations and functions Tesco Plc has undertaken more debt. In 2007, level of debt was £16.7, whereas it reached on £24.20. It shows that for managing the business functions and activities company has taken more debt in the last 8 years.
Along with this, debt-equity ratio of Tesco Plc was 1.51 and 1.24 at the end of 2015 and 2016. Thus, by considering such aspect it can be stated that debt-equity position of company was not sound in the year of 2015 and 2016. Such ratio of company shows that business unit has generated high amount of fund through debt instruments rather than equity. Due to the rise in interest expense EPS of Tesco plc was reduced significantly after the period of financial crisis. Earnings per share of Tesco Plc were 0.36 and -2.12 at the end of accounting year 2016. Hence, by taking into consideration such aspect it can be said financial or capital structure of Tesco Plc is not sound (Glendening, Khurana and Wang, 2016). Thus, business unit is required to reduce its dependency level in relation to debt instruments. Moreover, high debt level resulted into rise in interest expenses which in turn directly impacts the profit margin of Tesco Plc. Thus, to develop highly optimal capital structure business unit needs to issue share in the near future. It enables firm to improve its solvency position and shareholde