In the wake of Kenya Airways, the Pride of Africa, declaring its performance that points to balance sheet insolvency, finance scholars will be reminded of the importance of the capital structure of a firm. Balance sheet insolvency occurs when a firm does not have enough assets to pay all of its debts, as shown by negative equity. It is also referred to as technical insolvency.
At the heart of theories and practices on capital structure is the question of what constitutes the optimal capital structure. The determination and achievement of that proportion of debt and equity that will maximise the value of the firm and at the same time minimise the cost of capital is both contentious and complex.
KQ is a practical example of the complexities involved in capital structure decisions. The recently announced results show a firm that is mostly financed by debt with a gearing ratio-debt/(debt+equity)- of 106 per cent, increasing from 64 per cent the previous year. Whichever optimal capital structure policy KQ may have pursued was evidently not achieved, as witnessed from the declining value of the firm. Market capitalisation - computed by multiplying its share price with the number of shares - has declined to Sh8 billion, a substantial erosion of value compared with the highest capitalisation achieved in the last 12 months amounting Sh20 billion. Share price at the stock exchange has declined from a high of Sh13.50 in the last 12 months to a low of Sh5.35.
The concept of optimal capital structure has drawn a great deal of attention both in finance theory and practice although it remains one of the great unsolved problems of modern corporate finance. The two founding professors of capital structure theories, Modigliani and Miller, initially developed the capital structure irrelevant proposition. In this theory, they hypothesised that in perfect markets, it does not matter what capital structure a firm adopts. According to this theory, the market value of a firm is determined by its earning power and by the risk of its underlying assets and its value is independent of the way it chooses to finance its investments or distribute dividends.
The real world is far from the perfect market of MM theory and the capital structure is both relevant and a major determinant of the value of the firm and hence the price of a company’s shares in the stock exchange. In the real world there are taxes, transaction and bankruptcy costs, differences in borrowing costs for companies and investors, information asymmetries and effects of debts on earnings. These are significant assumptions in MM theory that do not hold true in the real world. When these assumptions are taken into account, the capital structure adopted by KQ has important implications for its share price and hence market value.
The subsequent MM Trade-Off Theory of Leverage recognised the importance of a certain level of debt. It assumes there are benefits to leverage, or incur debt, within a capital structure up and until the optimal capital structure is reached. The theory recognised there are tax benefits from interest payments because interest paid on debt is tax deductible. Thus holding debt effectively reduces a firm’s tax liability, which has a positive impact on its share price because of the interest tax shield. Although in the case of KQ the debt tax shield saves Sh1.4 billion in tax liability, the risk and cost of holding excessive debt overshadows the tax benefit.
After the optimal capital structure is achieved, any further increase in debt has a negative impact on the share price, a flight path that KQ has taken in the last financial year. Whereas the airline industry is characterised by high gearing, with debt typically exceeding equity, negative equity is less common. Though there is no rule of thumb as to what is the optimal structure of a particular firm, contemporary literature in financial statement analysis points the optimal value of the debt-to-equity ratio is deemed to approximate one. This implies liabilities equal equity and the maximum acceptable debt-to-equity ratio is considered to be 1.5-2 or less. Besides, the debt to asset ratio expressed as a percentage is considered desirable at mid-30s to the low of 40s.
Looking at KQ’s statement of financial position, its long term debt increased from Sh31.4 billion to Sh50 billion and then shot to Sh104 billion from 2013 to 2015. In the same period, it’s debt-to-equity ratio rose from the theoretical optimal of 1.01 in 2013 to the watch-list level of 1.78 in 2014 before signalling red at (17.47) in 2015. Such a major increase in the level of debt, without corresponding increase in equity carried significant risks and was bound to create financial instability. Perhaps a fact that is now clearer with the value of hindsight.
It may therefore be appropriate to make a capital call on the shareholders, partly because the capital structure, holding other factors constant, is less than optimal and more significantly and immediate, because the firm is technically insolvent and faced with bankruptcy. The two major shareholders, the National Treasury that owns 29.8 per cent and KLM that owns 26.7 per cent will need to consider making major capital injections to rescue the airline.
It is also worth exploring the extent to which the pricing of KQ was informed by its capital structure. Airline tickets are perishable goods, with the product expiring at a point in time. Secondly, capacity is fixed well in advance and can be augmented only at relatively high marginal costs. These two factors create the potential for very large swings in the opportunity cost of sale, because the opportunity cost of sale is a potential foregone subsequent sale. Any empty seats on a flight are foregone sales once a flight is airborne. This and the increased competition in routes previously dominated by KQ called for more dynamic pricing. Faced with high interest obligations, KQ may have been constrained in using dynamic pricing or yield management optimally, making its pricing more sticky and higher, compared with other carriers.
The negative equity of KQ means the firm’s creditors, who may now hold the right to appoint receivers, liquidators and administrators to protect their interest, are critical partners to its continued operations. Furthermore, excising such rights would be counter-productive and may further depress KQ’s realisable value. A debt restructuring would be an amiable alternative, perhaps lengthening the maturity of debt and leases to reduce the level of financing costs. This will give the firm the flexibility to re-strategies on the how to recover business operations.
The prospects for recovery are positive going forward. KQ has been awarded the best business class and best cargo airline in Africa three years in a row. Besides, the management’s determination to achieve better altitude is promising, and the skill set both in management and board leaves little doubt on the ability to turn around the firm. But it is clear tough choices will need to be made. Often times shareholder rescue packages and creditor restructuring plans come with stringent terms and conditions, and rightly so.