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). A world class asset base. Annual Report and Accounts 2011. https://www.annualreports.com/HostedData/AnnualReportArchive/a/LSE_AFR_2...
Wikipedia (n.d.). Afren. Retrieved October 2, 2018, from https://en.wikipedia.org/wiki/Afren
Afren (n.d.) About Afren. Retrieved October 2, 2018, from http://www.afren.com/about_afren
Almazan, A., & Molina, C. A. (2005). Intra-industry capital structure dispersion, Journal of Economics and Management Strategy, 14(2), 263-297. https://doi.org/10.1111/j.1530-9134.2005.00042.x
Bancel, F., & Mittoo, U. R. (2004). Cross-country determinants of capital structure choice: a survey of European firms. Financial Management, 33, 103-132. https://www.jstor.org/stable/3666330
van Binsbergen, J. H., Graham, J. R., & Yang, J. (2011) Optimal capital structure. Available at SSRN. http://dx.doi.org/10.2139/ssrn.1743203
BP. (2012). BP Statistical Review of World Energy June 2012. http://www.bp.com/statistical review
Brealey, R., Myers, S., & Marcus, A. (2007). Fundamentals of corporate finance. McGraw-Hill/Irwin, New York.
Bureau of African Affairs. (2012). Background note: Nigeria. Bureau of African Affairs, US Department of State. http://www.state.gov/r/pa/ei/bgn/2836.htm .
Byoun, S. (2011), Financial Flexibility and Capital Structure Decision. Baylor University
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1108850
Byoun, S. (2011), Financial flexibility and capital structure decision. Available at SSRN. http://dx.doi.org/10.2139/ssrn.1108850
Castanias, R. (1983). Bankruptcy risk and optimal capital structure. The Journal of Finance, 38(5), 1617-1635. https://doi.org/10.1111/j.1540-6261.1983.tb03845.x
Damodaran, A. (2011). Applied corporate finance. John Wiley & Sons, New Jersey.
Desai, M. A., Foley, C. F., & Hines Jr, J. R. (2008). Capital structure with risky foreign investment. Journal of Financial Economics, 88(3), 534-553. https://doi.org/10.1016/j.jfineco.2007.05.002
De Wet, J. (2006). Determining the optimal capital structure: A practical contemporary approach. Meditari: Research Journal of the School of Accounting Sciences, 14(2), 1-16. https://hdl.handle.net/10520/EJC72523

Eldomiaty, T. I., & Ismail, M. A. (2009). Modeling capital structure decisions in a transition market: empirical analysis of firms in Egypt. Review of Quantitative Finance and Accounting, 32(3), 211-233. https://doi.org/10.1007/s11156-008-0091-x
Ferri, M. G., & Jones, W. H. (1979). Determinants of financial structure: A new methodological approach. The Journal of Finance, 34(3), 631-644. https://doi.org/2327431
Frank, M. Z., & Goyal, V. K. (2008). Trade-off and pecking order theories of debt. Handbook of Empirical Corporate Finance, 2, 135-202. https://doi.org/10.1016/B978-0-444-53265-7.50004-4
Giambona, E., & Schwienbacher, A. (2008), Debt capacity of tangible assets: What is collateralizable in the debt market?. Available at SSRN. http://dx.doi.org/10.2139/ssrn.1099331
Graham, J., & Harvey, C. (2002). How do CFOs make capital budgeting and capital structure decisions?. Journal of Applied Corporate Finance, 15(1), 8-23.. https://doi.org/10.1111/j.1745-6622.2002.tb00337.x
Graham, J. R., & Leary, M. T. (2011). A review of empirical capital structure research and directions for the future. Annual Review of Financial Economics, 3(1), 309-345. https://doi.org/10.1146/annurev-financial-102710-144821
Halov, N., & Heider, F. (2011). Capital structure, risk and asymmetric information. The Quarterly Journal of Finance, 1(04), 767-809. https://doi.org/10.1142/S2010139211000171
Kraus, A., & Litzenberger, R. H. (1973). A state-preference model of optimal financial leverage. The Journal of Finance, 28(4), 911-922. https://doi.org/2978343
Leary, M. T., & Roberts, M. R. (2010). The pecking order, debt capacity, and information asymmetry. Journal of Financial Economics, 95(3), 332-355. https://doi.org/10.1016/j.jfineco.2009.10.009
Leary, M. T., & Roberts, M. R. (2014). Do peer firms affect corporate financial policy?. The Journal of Finance, 69(1), 139-178. https://doi.org/10.1111/jofi.12094
Lev, B. (1969). Industry averages as targets for financial ratios. Journal of Accounting Research, 7(2), 290-299. https://doi.org/2489971
Mahajan, S. (2006). Concentration ratios for businesses by industry in 2004. Economic Trends, 635(1), 25-47.
Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review, 48(3), 261-297. https://www.jstor.org/stable/1809766
Modigliani, F., & Miller, M. H. (1963). Corporate income taxes and the cost of capital: A correction. The American Economic Review, 53(3), 433-443. https://www.jstor.org/stable/1809167

Moorfield, A. (2011). Funding international oil and gas projects. Lloyds Banking Group, SPE International.
Morningstar. (2011). International Equity Risk Premia Report 2011, Morningstar, Chicago.
Myers, S. C. (1993). Still searching for optimal capital structure. Journal of applied Corporate Finance, 6(1), 4-14. https://doi.org/10.1111/j.1745-6622.1993.tb00369.x
Myers, S. C. (2001). Capital structure. Journal of Economic Perspectives, 15(2), 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.
Reiss, P. C. (1990). Economic and financial determinants of oil and gas exploration activity. In R. G. Hubbard Asymmetric information, corporate finance, and investment (pp. 181-206). University of Chicago Press. https://doi.org/10.7208/9780226355948
Sabir, M., & Malik, Q. A. (2012). Determinants of capital structure–A study of oil and gas sector of Pakistan. Interdisciplinary Journal of Contemporary Research in Business, 3(10), 395-400.
Sunley, E. M., Baunsgaard, T., & Simard, D. (2003). Revenue from the oil and gas sector: Issues and country experience. In J. M. Davis, R. Ossowski, and A. Fedelino (pp. 153-183). Fiscal policy formulation and implementation in oil-producing countries, International Monetary Fund.
U.S. SEC. (2012). Company search. Company Filings, U.S Securities and Exchange Commission. https://www.sec.gov/edgar/search-and-access
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, 11(1), 1-17. https://doi.org/10.1111/j.1468-2443.2010.01125.x

Page: 
25-50.
Issue: 
Volume 3, Number 1, January-April 2019
Content Status: 
Published