Corporate Finance Theory and Transaction Cost Theory - Research Paper Example

Corporate Finance Theory and Transaction Cost Theory Goal of Corporate Finance Corporate finance, as the name suggests, concerns itself with the monetary decisions that are made by different business organizations and includes the analysis and tools utilized for making the decision. The main objective of the Corporate Finance theory is to maximize the shareholders’ wealth and to achieve the same, it is necessary to maximize the value of the firm. In this regard, three decisions are mainly to be taken by the companies; these are, investment decision, financing decision and dividend decision. Investment decision concerns with the identification of the area or sector in which investment can generate highest return by bearing a standard risk; the financing decision on the other hand focuses on areas from where the company should obtain finance, what the cost of capital should be and lastly the dividend decision which concerns with the company’s payment of dividends to the investors. Decisions like the amount of dividend to be paid to the investors or whether the company would like to reinvest the amount for future return, form parts of dividend decision. At first the company management will conduct a financial analysis of the company and the present market scenario. The management will review the cash flow, the company’s earning in previous quarters and its current capital investment in the market (Quiry et al, 2011, p.19-57). They would review and advise changes that should be made in the company policies to generate more return. The company on its part would review the situation based on the financial analysis report and consider whether it would make changes in the present financing mix or acquire more debt. The company needs to decide whether they would pay dividend to the equity investors or retain the earnings for their future use. Situational analysis is also an important tool. The company management should make a robust plan so that they can face the probable situations that can arise in the future which can be financial as well as non-financial. Financing mix is yet another important decision that should be made by the managers of the organization. The managers have to make sure the cost of capital to conduct an effective analysis. The mix should be based on the limit of cost of debt and the cost of equity. The managers are levied with the great task of finding the best source of finance for the company in the present situation. Apart from the source of finance, there is also the need of working capital which is important for the day to day operations of the company. The managers have to make sure what should be the sources of the working capital of the company and what would be its current assets and current liabilities. Capital Structure of the Companies Capital structure of a company means the source of finance for its business. The financial sources are needed for two different purposes; the long term and the short term needs of the company. The company management is endowed with the responsibility to take the decision regarding the ideal financial mix for the company. Under long term financing plans, the companies have to take decisions about the debt equity mix that should be obtained and when the dividend should be paid to the shareholders or either it would be paid at all (Damodaran, n.d., p.5-20). For the short term financing, the company needs to decide what would be the sources of financing and what would be the ratio of current asset and current liabilities. Since the need of financing is different for each company and varies according to their business strategy and product, each opts for different type of financing. A company in the software industry would need more working capital for operation while a company in the manufacturing industry would need long term finance. A businessman or entrepreneur going for a risky business venture has to seek finance from the venture capitalists or the angel investors as s/he would not get the needed finance from the general equity investors or the banks, as the chance of getting success is dubitable. It proves that each business venture has its own unique needs of finance. There is also the difference in the criterion of assessing the investment decision of the companies. The small companies mainly assess the payback period criteria for assessing an investment whereas the larger companies use the capital asset pricing model or the present value model for assessing an investment. The firms mainly look after the firm risk rather than assessing the project risk when they assess a project. Researchers have found that the financial flexibility and the credit rating factors get greater importance when a firm decides the capital structure it needs to opt for as these are important factors for getting investment for the future(Graham and Harvey, 2000, p.9-13). There are some basic factors which should be taken in account by the finance managers in time of fixing the capital structure of the company. The characteristics of the assets, the tax payable by the company are some of the basic factors which should be considered when fixing the capital structure. The management of the firm have to take these factors and then they have to fix the capital structure of the company (Robert H. Smith School of Business, n.d., p.2-16). Closed Mutual Funds A company needs finance for improving its business activity and the main goal of corporate finance is to make the most efficient utilization of the available fund. Mutual fund is an important resource of finance for business organisations as it provides a large pool of money to the managers. It is such a resource where funds from investors get accumulated at a place from where it is further invested in companies by Mutual fund investors to generate the highest return.. Mutual funds are of two types, open ended mutual funds and close ended mutual funds. In an open ended mutual fund, the investors have the option of sell the shares at his or her desire. Unlike the case of closed mutual funds, there is no such restriction which can hold the investors from selling their shares till the maturity. There are many types of funds like bond funds, money market funds, growth stock funds etc (Investment Company Institute, 2007, p.3-9). The close ended mutual funds are the positive one for the corporate industry. When the investors invest in such a corporate bond fund, then the corporate can have the money till its maturity and can use it efficiently. The capital which is supplied from the mutual funds is perfectly elastic and it provides the management of the company to identify the net present value which is positive of the opportunities (Berk and Green, 2002, p.3). When a company is growing gradually year after year then the closed mutual fund is a major source of getting finance. The investors of the closed mutual funds would naturally like to invest in a company which shows a steady growth as this will give them the highest return from the equities. If the investors have got high return from the stocks they would certainly invest in the stocks for the future also assuming that the stock is a high growth stock. If the mutual fund managers continue to invest in the stock then the concerned company get that fund which is necessary for continuing their operations. So the closed mutual funds is an effective option for getting finance for the companies whose performance has been good in the past years and still shows steady growth curve. Transaction Cost Theory The transaction cost is incurred when a monetary transaction take place. A transaction cost doesn’t only mean the buy or sales cost but also the other costs associated with the transaction. The cost includes the cost of the information of the transaction. A buyer has to search about the product which is available in the lowest cost, so that he or she can buy the product in a reasonable price. There would be the bargaining cost which is also associated with the total buying process. The bargaining cost is there because the two parties involving in the transaction want to go in an acceptable agreement. There is the cost of making sure that the two parties will stick to the contract throughout the period. Transaction cost may also include the cost of transportation as it is also associated with the buying process. So there is the enforcement and the policing cost associated with that transaction. These are the costs known as transaction cost which is not the direct cost of the product but the costs are associated with the transaction of the product from the seller to the buyer. The market is imperfect. So for overcoming this market imperfection some cost is incurred for exchanging the goods and services which is known as the transaction cost. The theorists who are dealing with the transaction cost assert that the cost of a product consists of the two components. One is the transaction cost and the other is the production cost. The production cost is the cost for manufacturing the product, the distribution cost of the goods or the services associated with the product. On the other hand the transaction cost of the product includes the cost of the information regarding the product pricing, the cost regarding the coordination of the people who are associating with the transaction, the cost of the contract associating two parties (Appalachian State University and York University, 2011). There are two type of costs are there associated with the company. The costs are the inside costs of the company which is known as the bureaucratic cost and the other type of cost is the transaction cost which is external. The transaction cost theory implies that when the inside cost of the company which means the bureaucratic cost of the company is more than the outside cost that is the transaction cost then the company is not going to the right direction but when the transaction cost of the company is more than the bureaucratic cost of the company then the company is tend to grow because it means the company is able to perform the inside activities cheaply so there is more probability that the company will able to have profit (Businessmate.org, 2011). In his research paper Williamson have defined for the five types of costs the transaction cost is arising generally. The two human factors which are in the transaction costs are the opportunism and bounded rationality. There are three environmental factors also exists which are asset specificity, small numbers trading and the uncertainty (Aubert and Weber, 2001, p.5). Reference Aubert, B. and Weber, R. (2001). Overview of Transaction Cost Theory. Transaction Cost Theory, The Resource-Based View, and Information Technology Sourcing Decisions: A Re-Examination of Lacity Et Al.’s Findings. Retrieved on January 2, 2012 from http://www2.hec.ca/gresi/documents/cahier0108.pdf. Appalachian State University. and York University. (2011). Transaction Cost Economics. Retrieved on January 2, 2012 from http://www.istheory.yorku.ca/transactioncosteconomics.htm. BusinessMate.org. (2011). What is Transaction Cost Theory? Retrieved on January 2, 2012 from http://www.businessmate.org/Article.php?ArtikelId=182. Berk, J. and Green, R. (2002). Introduction. Mutual Fund Flows and Performance in Rational Markets. Retrieved on January 2, 2012 from http://www.bankingemba.com/rp100.pdf. Investment Company Institute. (2007). A Guide to Understanding Mutual Funds. Retrieved on January 2, 2012 from http://www.ici.org/pdf/bro_understanding_mfs_p.pdf. Quiry, P. et al. (2011). Corporate Finance: Theory and Practice. 3rd Ed. United Kingdom: John Wiley & Sons Ltd. Graham, J. and Harvey, C. (2000). The Theory and Practice of Corporate finance: Evidence from the Field. Retrieved on January 2, 2012 from http://jfe.rochester.edu/99431.pdf. Robert H. Smith School of Business. (No Date). Capital Structure. Financial Management. Retrieved on January 2, 2012 from http://www.rhsmith.umd.edu/faculty/Gphillips/courses/bmgt640/Capstr.pdf. Damodaran, A. (No Date). The Debt Equity Trade Off: The Capital Structure Decision. Retrieved on January 2, 2012 from http://people.stern.nyu.edu/adamodar/pdfiles/ovhds/ch7.pdf. Read More