Assessing the Optimal Capital Structure: A Case Study of Afren Public Limited Company - A Small Exploration and Production Oil and Gas Company

Authors: 
Tokunbo S. Osinubi, Lloyd Amaghionyeodiwe, Chikaodili C. Okoye
DOI Number: 
http://doi.org/10.31039/jomeino.2019.3.1.3
Abstract: 
This study assessed the optimal financing mix for Afren Public Limited Company based on the trade-off theory and evaluated the cost to the firm from deviating from that position. In doing this, we derived a firm-specific optimal capital structure using the cost of capital approach, which involved the use spreadsheet modelling through an iterative process to determine series of discount rates based on different combinations of debt and equity under the assumption of constant earnings to the firm. The base result shows that as the debt intensity increases, the equity Beta has a multiplier effect such that the cost of equity increases more than proportionately to the increase in leverage. As more debt is introduced, the risk of loan default increases, thus increasing the credit spread over the riskless rate and effectively the pre-tax cost of debt. The result from the firm’s weighted average cost of capital (WACC) and value as a function of leverage, implied optimal debt ratio is 40% and yields a WACC of 8.63% which is effectively the minimum cost of capital that maximizes the value of the firm. Between 40% and 45% leverage, the debt servicing capacity of the firm measured by the interest coverage ratio drops significantly from 4.6 to 1.4 due to high interest burden. This increased credit risk has a direct impact on the firm’s credit quality rating.
Keywords: 
Optimal capital structure, Cost of capital, Trade-off theory, Weighted average cost of capital, Debt.
Full Text: 
File download
References: 

Afren. (2012), Annual Report and Accounts 2011 “Financial Reports’’, [Online]

Available: http://www.afren.com/investor_relations/financial_reports/                                 

Afren (n.d) assessed on October 2nd and retrieved from https://en.wikipedia.org/wiki/Afren

Afren (n.d) assessed on October 2nd and retrieved http://www.afren.com/about_afren

Almazan, A. and C. A. Molina (2005): "Intra-Industry Capital Structure Dispersion", Journal of Economics and Management Strategy, Vol. 14, No. 2, pp. 263-297.

Bancel, F., and Mittoo, U.R., (2004): Cross-country determinants of capital structure choice: a

survey of European firms. Financial Management 33, 103-132. Retrieved from: https://repub.eur.nl/pub/1923/ERS%202005%20005%20FA.pdf

Binsbergen, J., Graham, J. and Yang, J. (2011), Optimal Capital Structure, National Bureau of Economic Research [Online] Available:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1743203  

BP (2012), BP Statistical Review of World Energy June 2012. [Online] Available: bp.com/statistical review. 

Brealey, R., Myers, S. and Marcus, A. (2007), "Debt and Payout Policy" in Fundamentals of Corporate Finance, 5th ed. McGraw-Hill/Irwin, New York, pp. 393-452. 

Bureau of African Affairs (2012), Background Note: Nigeria. [Online] Available: http://www.state.gov/r/pa/ei/bgn/2836.htm .

Byoun, S. (2011), Financial Flexibility and Capital Structure Decision. Baylor University [Online] Available: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1108850  

Castanias, R. (1983), "Bankruptcy Risk and Optimal Capital Structure", The Journal of Finance, vol. 38, no. 5, pp. 1617-1635. 

Damodaran, A. (2010), "Capital Structure: The Optimal Financial Mix" in Applied Corporate Finance, ed. J. Manios, 3rd edn, John Wiley & Sons, New Jersey, pp. 393-420. 

Desai, M.A., Foley, F. & Hines, J. (2008), "Capital structure with risky foreign investment", Journal of Financial Economics, vol. 88, no. 3, pp. 534. 

De Wet, J. (2006), "Determining the Optimal Capital Structure: A Practical Contemporary Approach", Meditari Accountancy Research, vol. 14, no. 2, pp. 1-16. 

Eldomiaty, T.I. (2009), "Modeling capital structure decisions in a transition market: empirical analysis of firms in Egypt", Review of Quantitative Finance and Accounting, vol. 32, no. 3, pp. 211. 

Ferri, M. & Jones, W. (1979), "Determinants of Financial Structure: A New Methodological Approach", The Journal of Finance, vol. 34, no. 3, pp. 631-644. 

Frank, M. & Goyal, V. (2007), Trade-Off and Pecking Order Theories of Debt. [Online] Available: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=670543

Giambona, E. and Schwienbacher, A. (2008), Debt Capacity of Tangible Assets: What is Collateralizable in the Debt Market? Available:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1099331& [Accessed 21 July 2012]

Graham, J & Harvey, C. (2002), "How Do CFOs Make Capital Budgeting and Capital Structure Decisions?" Journal of Applied Corporate Finance, vol. 15, no. 1, pp. 8-23. 

Graham, J. and Leary, M. (2011), "A Review of Empirical Capital Structure Research and Directions for the Future", Annual Review of Financial Economics, vol. 3, pp. 3-26. 

Halov, N. and Heider, F. (2011), "Capital Structure, Risk and Asymmetric Information", Quarterly Journal of Finance, vol. 1, no. 4, pp. 767-809. 

Kraus, A. and Litzenberger, R. (1973), "A State-Preference Model of Optimal Financial Leverage", The Journal of Finance, vol. 28, no. 4, pp. 911-922. 

Leary, M. and Roberts, M. (2010), "The pecking order, debt capacity, and information asymmetry", Journal of Financial Economics, vol. 95, no. 3, pp. 332. 

Leary, M. and Roberts, M. (2011), “Do Peer Firms Affect Corporate Financial Policy”. [Online] Available: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1623379

Lev, B. (1969), "Industry Averages as Targets for Financial Ratios", Journal of Accounting Research, vol. 7, no. 2, pp. 290-299. 

Mahajan, S. (2006), Concentration Ratios for Businesses by Industry in 2004, Office for National Statistics, United Kingdom. 

Modigliani, F. and Miller, M. (1958), "The Cost of Capital, Corporation Finance and the Theory of Investment", The American Economic Review, vol. 48, no. 3, pp. 261-297. 

Modigliani, F. and Miller, M. (1963), "Corporate Income Taxes and the Cost of Capital: A Correction", The American Economic Review, vol. 53, no. 3, pp. 433443. 

Moorfield, A. (2011), “Funding International Oil and Gas Projects”. Lloyds Banking Group [Online] Available:

http://www.spegcs.org/attachments/studygroups/8/Lloyds%20Banking%20Grou p%20%20Funding%20International%20Oil%20and%20Gas%20Projects%201110-11.ppt  

Morningstar (2011), International Equity Risk Premia Report 2011, Morningstar, Inc., Chicago. 

Myers, S. (1993), "Still Searching for Optimal Capital Structure", Journal of Applied Corporate Finance, vol. 6, no. 1, pp. 4-14. 

Myers, S. (2001), "Capital Structure", The Journal of Economic Perspectives, vol. 15, no. 2, pp. 81-102. 

Reiss, P. (1990), "Economic and Financial Determinants of Oil and Gas Exploration Activity" in Asymmetric Information, Corporate Finance, and Investment, ed. G. Hubbard, illustrated ed., University of Chicago press,1990, Chicago, pp. 181-206. 

RNS, London Stock Exchange (2012), Farm-Out Agreement Signed with Premier Oil plc [Homepage of London Stock Exchange], [Online]. Available:

http://www.londonstockexchange.com/exchange/news/market-news/marketnews-detail.html?announcementId=11262774  

Sabir, M. & Malik, Q. (2012), "Determinants of Capital Structure- A Study of Oil and Gas Sector of Pakistan", Interdisciplinary Journal of Contemporary Research in Business, vol. 3, no. 10, pp. 395-400. 

Sunley, E., Baunsgaard, T & Simard, D. (2002), Revenue from the Oil and Gas Sector: Issues and Country Experience. IMF conference on Fiscal Policy Formulation and Implementation in Oil Producing Countries pp.1-29. [Online]. Available: http://siteresources.worldbank.org/INTTPA/Resources/SunleyPaper.pdf   

U.S. SEC (2012) “Company Search’’, Company Filings, U.S Securities and Exchange Commission < http://www.sec.gov/edgar/searchedgar/companysearch.html>

Welch, I. (2011), "Two Common Problems in Capital Structure Research: The Financial Debt-To-Asset Ratio and Issuing Activity Versus Leverage Changes", International Review of Finance, vol. 11, no. 1, pp. 1-17.

Page: 
25-50
Content Status: 
Accepted