Definition of capital structure
Capital structure has been defined as financial company mix that is a function of company long term debt (Harper & Endres, pp.30-1), specific company short term debt, company common equity (Casson, pp.327-8) and company preferred equity (Kor et al, pp.1188-9). Capital structure has been identified as mechanism or processes through which a company meets its financial obligations. Some authors (Rosenbaum & Pearl, p.4, p.6; Conner & Prahalad, pp.477-8; Hennings, p.108) however identify capital structure to be company’s debt-to-equity ratio which provides basis of financial risks that the company is likely to face (Harper & Endres, pp.31-2). Theories on capital structure provide that if a company is financed by more debts (Kor et al, pp.1190-3), it becomes riskier. Highly Risk Company is highly levered. The measure for debt financing is gearing ratio. Different types of capital interfere with debt and equity as measures of capital structure for instance preference shares that have fixed return which qualify them to be debt as opposed to equity based on their impacts on economic effects. Existence of convertible debt into equity tends towards equity (Foss et al, pp.1165-8). Financial models and theories affirm capital structure has no influence on company value measured in terms of debt and equity (Rosenbaum & Pearl, 2009, pp.5-8; pp.14-16). Sources of debts include issue of bonds or long term payable notes. A company use of equity is based on capability to utilize her common stock, and retained earnings. Capital structure includes short-term debts for instance working capital (Harper & Endres, pp.33-5). As a result, it can be said capital structure refers to processes through which a company finances her assets via equity, debt and hybrid securities. Some authors however pose capital structure as composition of company liabilities. For example if a company sells USD 30 million in equity and USD 70 million in debt, the company is said to be 30% equity-financed or 70% debt-financed (Casson, pp.330-4). 70% debt-financing denotes company’s leverage. This predisposes use of gearing capital in form of external financing through financial loans (Kor et al, pp.1191-3).
This essay reports on the competitive advantage of capital structure of the Google Inc relative to Microsoft.
The capital structure of Google Inc satisfies Modigliani-Miller theory and as well as framework of Google Blue Ocean strategy. Capital structure of Microsoft conforms to Modigliani-Miller Theorem but is aligned to red Ocean Strategies. Google Blue Ocean strategy is structured to exploit new market spaces whose competitive advantage is not known in order to make competition irrelevant (Chan & Mauborgne, pp.1-5). Google use of Modigliani-Miller theorem to develop a capital structure was meant to manage competitiveness of companies in the same line of specialization for instance Microsoft that have adopted red ocean strategies. Microsoft Capital structure is based on Red ocean strategies through investment in known market spaces to competitors and clarity in understanding of market competitiveness, customer value expectations and purchase behavior of the customers which results into competing firms adoption of mixed approaches like market focused strategies and customer focused strategies through competitive exploitation of values of PESTLE, SWOT and PEST analysis. Google Blue Ocean Business Strategy (Chan & Mauborgne, pp.11-2) has resulted into adoption of business competitive advantage through exploitation of market spaces that competitors don’t exploit. The incapacity of competitors to use Blue Ocean business strategy lies in incapacity of adequate academic literature on mechanism of creating a Blue Ocean Strategy and mechanism it improves enterprise bottom line. This has kept financial analysts guessing on feasibility of Google investments. Google use of blue Ocean strategy resulted into creation of new market demand (Chan & Mauborgne, pp.16-7). Use of Blue Ocean Strategy contributed into improved returns on opportunities and returns on opportunities and was structured on four action model (figure 1).
Source: Adapted from Chan W. Kim, and Renée Mauborgne, (2005) Blue Ocean Strategy, Havard Business School Press, p.18
Integration of Midigliani-Miller theorem into Blue ocean strategy made it possible to achieve irrelevance of mode of Google financing based on its book value (Kor et al, p.1194). This contributed into Google capital structure that was relevant to capital structure that it adopted. As a result, Google was positioned to manage her bankruptcy costs, agency costs, taxes and creation of financial information asymmetry. Microsoft seeks to achieve financial information symmetry. Through Midiglaini-Miller theorem (Harper & Endres, p.36), Google was able to achieve optimal capital structure which minimized her debt hence enhanced value of Google (Vise & Malseed, p.34). Capital structure for Google is designed to manage perfect capital market conditions that are characterized by healthiness of transaction, lack of bankruptcy costs or availability of perfect information that make it possible for companies to access credit facility at equivalent rates hence decisions on investment are not a function of financial component of production (Casson, p.338). As a result, the value of Google is independent of capital structure and cost of equity, for instance, in a leveraged company is equal to cost of equity for unleveraged company (Forbes.com, Appendix). This contributed into a scenario where as leverage increases, conservation of total risks results which translate into loss of value creation. The Microsoft scenario was reverse. As a result, based on classical tax system, Google debt deductibility of interest results into valuable debt financing (Hennings, p.114) compared to Microsoft.
Google capital structure is based not on trade off theory which integrates bankruptcy costs to be part of capital structure (Auletta, 45; Chan & Mauborgne, p.22). Microsoft capital structure is structured on trade off theory. This could have created environment for Google tax benefits of debt. Failure to adopt trade off theory in her capital structure is based on financial distress that is associated with costs of debts (Forbes.com, Appendix).
The Google revenue in terms of equity-debt ratio has been stable. The Google revenue as at fourth quarter of 2009 was calculated at USD 23.651 billion (Forbes.com, Appendix), with operating income of USD 8.312 billion and a profit of USD 6.520 billion. Google total assets were calculated to be USD 40.497 billion, total equity at USD 36.004 billion (Rosenbaum & Pearl, pp.27-9). The Google employees were determined to be 24, 400 at the end of the fourth quarter of 2010 (Forbes.com, Appendix). Capital structure of Google includes total assets and total equity of her subsidiaries which include YouTube, Doubleclick, On2 technologies, Grand Central, Picnik, Aardvark and AdMob (Forbes.com).
Stock exchange registration
The Google Share Capital was registered on Nasdaq Stock Exchange on August 19th 2004 with a total of 19, 605, 052 shares that were issued under Initial Public Offer (IPO) at USD 85 per share (Forbes.com, Appendix). This was done under symbol GOOG. The IPO raised USD 1.67 billion. This positioned Google to a USD 23 billion and competitive market capitalization (Forbes.com, 2011).
The Google Shareholders
Google currently has over 318 million shares. 40% of current shares are controlled by large corporations and mutual funds (Forbes.com, Appendix). The founders of Google have control interests. The main shareholders that have high control interests for Google stocks (table 1).
Google Stockholder voting powers
Pecking order Theory has been implemented to manage Google stakeholder voting powers (Forbes.com, Appendix). Google has class A and Class B stock structure (Forbes.com, Appendix). This has resulted into class B having ten votes for every Class A share. The dual class structure (Class A and Class B) tends to sustain Google stability and independence (Forbes.com; John). Microsoft has a mono-class structure where stakeholders have equal voting powers.
Google Capital ownership
The growth of Google has been achieved through Acquisitions of businesses that satisfy Google business philosophy and business model (Chan & Mauborgne, pp.45-6). Google market share and capital has been attributed to acquisition just like Microsoft market share growth. Google has exploited the values of Pecking order theory (Hennings, p.1112; Auletta, pp.31-4; Battelle, p.12) with objective interest of managing costs associated with asymmetric information. Microsoft utilized pecking order theory to achieve symmetric financial information. Pecking order theory adoption has made Google to prioritize on her primary sources of financing which are internally pooled from internal; financing to equity (Brandt, pp.5-7). Thus, Google has integrated law of least effort into pecking order theory which has formed basis for preferred foundation for enhancing her equity. Google uses internal financing which is subsidized by issuance of debt alternatively, equity is issued. Google, through pecking order theory (Chan & Mauborgne, p.49), has established a hierarchy of financing which is absent in Microsoft. Internal financing if prioritized. Microsoft is commonly financed externally through debts and equity which make Microsoft riskier to investors. Precedence is allocated to debt as opposed to equity. Debt and equity are adopted whenever external financing is required (Stross, pp.35-6). Google equity as a form of external financing is adopted through share issuance which increased number of external ownership. Google, through its Blue Ocean strategy (Chan & Mauborgne, p.22; p.26) of investing in unknown market spaces without competition, doesn’t use pecking order theory through issuance of new equity to make investors believe Google is overvalued which could make investors place a lower value to equity issuance. Microsoft uses pecking order theory through new equity issuance to make investors believe Microsoft is highly valued.
Credit rating, ratios and Google capital structure
Google has a very high credit rating. Google has attained Aa2 credit rating which is the third highest investment grade (Auletta, p.19). Microsoft has not achieved Aa2 credit rating. The high credit rating of Google has been driven by Google integration of agency theory into its Blue Ocean strategy. Google utilizes three forms of agency costs to enhance her capital structure. Google utilizes Asset substitution effect as integral component of its capital structure (Forbes.com, Appendix). As ratio of debt and equity increases (D/E), Google is positioned to undertake risky projects even when the NPV is negative (Foss et al). This is fundamental in transfer of debt from debtholders into the shareholders in the event the Google value decreases. Capital structure of Google doesn’t suffer from under-investment problems like case of Microsoft. This has resulted into a scenario where there is no build up of debt risks that could be translated into debtholders as opposed to shareholders (Auletta, p.16; p.18). The Google capital structure is not based on positive NPV although Google has capacity to increase her capital value. Microsoft capital structure tends to positive NPV compared to Google. Google has sustainable free cash flow to her investors which has build strong relationships through stability of her value. The capital structure is derivative of managed leverage on Google financial structure (Forbes.com, Appendix).
The Turnover of Google is easy hence fast capacity to translate her non-cash assets into cash assets (Forbes.com, Appendix). Google has a strong Days Sales Outstanding (DSO). The Google DSO (Forbes.com, Appendix; Foss et al) measured in terms of average collection period (Harper & Endres, p.35, p.38) is lower than Microsoft. DSO (Hennings, p.117; Stross, p.41; Battelle, p.12) is based on Google outstanding receivables. The DSO is calculated by dividing outstanding receivables (Harper & Endres, pp.34-7; Hennings, pp.111-5) by total sales within a given period (Casson, p.335-9; Kor et al, pp.1202-8; Harper & Endres, pp.35-6) whose value achieved is multiplied by number of days within the period. Google doesn’t suffer from Higher DSO. High DSO (Harper & Endres, pp.37-8; Kor et al, pp.1208-9, Conner & Prahalad, pp.479-50) may provide possible inadequate analysis on Google open account credit terms (Forbes.com). Google manages her DSO to minimize cash flow problems that might affect her operating capital. Google has a high Days Payable Outstanding (DPO) as a result, Google doesn’t incur cash shortage. The DPO of Microsoft is low. Google has a sustainable Days working capital which is a function of Google DSO and DPO (Chan & Mauborgne, p.32). The Capital structure of Google (Harper & Endres, pp.36;Battelle, p.51;Stross, pp.25-8) based on asset turnover provides basis for Google efficiencies in use of assets to generate sales revenue (cf. Forbes.com, Appendix). The asset turnover of Google is a function of different ratios. The main rations that form asset turnover for the Google (table 2)
The asset turnover elements measure staff productivity, motivation and performance and mechanism they impact on growth of sales and profitability. This has made it possible for the Google to manage her debt coverage through capacities for production of sufficient revenue that meets her monthly debt payments (Hennings, pp.118-20; Forbes.com, Appendix). This has made it possible for Google to access credit facilities and forms basis for Google to initiate new projects. This demonstrates Google has sustainable Return on Assets (ROA) which illustrates sustainability of Google to generate Google investments and assets (Forbes.com, Appendix).
The Google and Microsoft ROA have provided stability for her Return on Equity (ROE) which forms basis for determination of rate of return (RoR) on ownership interests and control. Microsoft and Google ROE have been used to indicate profit earned on every dollar unit. This has made it possible for benchmark analysis of industries that have invested in the same line of business as Google like Microsoft to be conducted. Google and Microsoft have employed Du Pont Formula as a strategic profit model (Casson, pp.340-4). The Du Pont theorem implementation has provided basis for Google and Microsoft to manage their capital structure. Du Pont Theory has made it possible for the Google and Microsoft to break down their ROE into three categories (Forbes.com, Appendix). The division of ROE has made it possible for the Google and Microsoft to track capital growth of different ROE segments. For instance, rise in net margin results into more revenue hence rise in ROE, in the event Asset Turnover rises, sales revenues increase which rise ROE. Rise in financial leverage gives implication of use of debt financing as opposed to equity financing. As a result, increasing debt proportion on Google capital structure provided basis for increasing ROE (Kor et al, pp.1192-5). Microsoft increase of her debt proportion result into decrease of ROE.
Google has sustainably managed her financial leverage benefits (Randall, Forbes.com, Appendix) as opposed to Microsoft. This has made it possible for the Google to manage risks of defaulting on interest payments. Reliance on debt has effect of contributing into risk of creditors seeking increasing risk premiums which gradually lower ROE (Harper & Endres, p.39). Google’s debt contributes into ROE (Hennings, pp.117-9; Casson, pp.344-5; Forbes.com, Appendix). This occurs since Google ROA exceeds interest rate on the debts (Kor et al, pp.1216-17, Hennings, pp.114-5; Rosenbaum & Pearl, p.22-4). The Google capital structure further integrates cash flows which integrates non-cash assets. The stability of Google Average rate of return (ARR) is structured on time value of money (Forbes.com, Appendix) which is different from Microsoft. Time value of money, based on Google capital structure doesn’t include NPV or IRR (Internal rate of return). This is because ARR cannot be adjusted towards risk management that could fit long term financial forecasts. Google adopted this position in order to enhance value of her liquidity hence capacity to meet her maturing short term financial obligations (Foss et al). As a result, Google cannot be exposed to problems of insufficiency to manage loses which reduces costs of financing her business activities. The high Google liquidity position of Aa2, has contributed into stability of her capital forecasts and expected future cash flow analysis. Google has achieved this due to management of her net working capital which has provided opportunity for Google to have a safety cushion to her creditors (Forbes.com, Appendix).
The Google solvent ratio demonstrates capacity for Google to fund her long term business obligations (Conner & Prahalad). Sustainability of a high solvency ratio has ensured Google cannot default payments. Throughout the history of Google, the solvency ratio has been greater than 20%. The Google current liability/Equity provides framework for measuring her Debt-equity proportion (Forbes.com, Appendix). Google doesn’t utilize debt versus capital investment, hence is unleveraged which reduces risks. Microsoft is leveraged which increases risks. The Google debt ratio has never been less than one due to non-reliance on equity finance (Conner & Prahalad, pp.481-5). Microsoft debt-ratio goes below one due to reliance on equity finance. The Google debt ratio is greater than one hence implication that external Google financing is based on equity. Due to low debt/equity ratio, Google is lowly leveraged which has made Google to be highly liquid (Forbes.com, Appendix) compared to Microsoft. Thus, long term risk burden of Google is minimal hence a boost to investors. Google doesn’t require a high ratio because of its liquidity and capacity to borrow capital at short notice. The Google quick ratio or the Google acid test ratio is measure of its liquidity (Harper & Endres, pp.33-5). The liquidity of Google is structured to manage scenarios that might predispose use of cash burn rate (Forbes.com, Appendix). Google invests into habitual financing of projects that don’t impact on its book value in order to ensure its Business model satisfies Blue Ocean strategy through integration of neutral mutation hypothesis. Neutral mutation hypothesis is backed by Google market timing hypothesis which results into creation of new demand and creates capital value (Forbes.com, Appendix) through historical cumulative timing of market demand variations. This is indifferent in Microsoft.
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Brandt L. Richard, “Inside Larry and Sergey’s Brain”. 2009
Casson, Mark, “Entrepreneurship and the theory of the firm”, Journal of Economic Behavior and Organization 58, 327-48, 2005
Chan W. Kim, and Renée Mauborgne, “Blue Ocean Strategy”, Havard Business School Press, 2005
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Harper, D. A., and Endres, A. M., “Capital as a layer cake: A systems approach to capital and its multi-level structure”, Journal of Economic and Behavior Organization 74, 30-41, 2010
Hennings, K. H., “Capital as a factor of production”. In: Eatwell, J., et.al. (Eds.) The New Palgrave: A Dictionary of Economics Vol. 1. Reprinted in Bliss,C., Cohen, A. and Harcourt, G.,(Eds.), 2005. Capital Theory. Cheltenham: E. Elgar, 108-22, 1987
Kor, K. Y., Mahoney, J. T., and Michael, S., “Resources, capabilities and entrepreneurial perceptions”, Journal of Management Studies 44, 1188-1212, 2007
Rosenbaum, Joshua; Pearl, Joshua “Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions”. Hoboken, NJ: John Wiley & Sons, 2009
Stross, Randall: “Planet Google: One Company’s Audacious Plan To Organize Everything We Know”. Free Press. Web.
Vise, David and Malseed, Mark: “The Google Story”. Delacorte Press. Web.
List of Appendices
Table 1: Google 2010 price changes
|PRICE/VOLUME||High||Low||Close||% Price Chg||% Price Chg vs. Mkt.||Avg. Daily Vol||Total Vol|
|Moving Average||5-Days||10-Days||10-Weeks||30-Weeks||200-Days||Beta (60-Mnth)||Beta (36-Mnth)|
Table 2: Comparative data 2010 and 2009
|CHANGES||YTD vs. |
|Curr Qtr vs. |
Qtr 1-Yr ago
|Annual vs. |
Table 3: Growth changes in the last 5 years
|GROWTH RATES||5-Year |
|R² of 5-Year Growth||3-Year |
|CHANGES||YTD vs. |
|Curr Qtr vs. |
Qtr 1-Yr ago
|Annual vs. |
Table 4: Google liquidity
|SHORT-TERM SOLVENCY RATIOS (LIQUIDITY)|
|Net Working Capital Ratio||54.56|
|Quick Ratio (Acid Test)||3.9|
|Liquidity Ratio (Cash)||3.50|
|Average Collection Period||46|
|Working Capital pS||98.71|
|Free Cash-Flow pS||18.75|
|Financial structure ratios|
|FINANCIAL STRUCTURE RATIOS|
|Altman’s Z-Score Ratio||9.68|
|Financial Leverage Ratio (Assets/Equity)||1.3|
|Total Debt/Equity (Gearing Ratio)||0.15|
|LT Debt/Capital Invested||3.4|
|LT Debt/Total Liabilities||10.3|
Table 5: Valuation ratios
|Tobin’s Q Ratio||2.65|
|Current P/E Ratio – LTM||23.40|
|Enterprise Value (EV)/EBITDA||11.02|
|Enterprise Value (EV)/Free Cash Flow||24.60|
|Price/Tangible Book Ratio – LTM||5.45|
|Price/Book Ratio – LTM||4.55|
|Price/Cash Flow Ratio||21.2|
|Price/Free Cash Flow Ratio – LTM||25.7|
|P/E Ratio (1 month ago) – LTM||23.0|
|P/E Ratio (26 weeks ago) – LTM||21.0|
|P/E Ratio (52 weeks ago) – LTM||26.0|
|5-Y High P/E Ratio||56.2|
|5-Y Low P/E Ratio||13.9|
|5-Y Average P/E Ratio||34.9|
|Current P/E Ratio as % of 5-Y Average P/E||67|
|P/E as % of Industry Group||64.0|
|P/E as % of Sector Segment||68.0|
|Current 12 Month Normalized P/E Ratio – LTM||25.0|
Table 6: Figures per share
|PER SHARE FIGURES|
|LT Debt pS||3.75|
|Current Liabilities pS||31.26|
|Tangible Book Value pS – LTM||113.20|
|Book Value pS – LTM||135.38|
|Capital Invested pS||148.36|
|Cash pS – LTM||35.20|
|Cash Flow pS – LTM||29.13|
|Free Cash Flow pS – LTM||23.97|
|Earnings pS (EPS)||26.31|
Table 7: Operating ratios
|Free Cash Flow Margin||20.45|
|Free Cash Flow Margin 5YEAR AVG||18.56|
|Net Profit Margin||29.0|
|Net Profit Margin – 5YEAR AVRG.||26.0|
|Return on Equity (ROE)||18.4|
|Return on Equity (ROE) – 5YEAR AVRG.||17.2|
|Capital Invested Productivity||0.62|
|Return on Capital Invested (ROCI)||17.9|
|Return on Capital Invested (ROCI) – 5YEAR AVRG.||17.2|
|Return on Assets (ROA)||14.7|
|Return on Assets (ROA) – 5YEAR AVRG.||15.4|
|Gross Profit Margin||69.2|
|Gross Profit Margin – 5YEAR AVRG.||66.9|
|EBITDA Margin – LTM||40.9|
|EBIT Margin – LTM||37.0|
|Pre-Tax Profit Margin||0.0|
|Pre-Tax Profit Margin – 5YEAR AVRG.||33.1|
|Effective Tax Rate||21.2|
|Effective Tax Rate – 5YEAR AVRG.||24.1|
Forbes.com, “Balance sheet”. Web.
Forbes.com, “Cash flow”. Web.
Forbes.com, “Income statement”. Web.
Forbes.com, “Ratios and returns”. Web.