The Utilization of the Various Financial Instruments - Essay Example

?Research and Critical Evaluation on the M&M (Modigliani and Miller) Models Introduction: The paper focuses on the various financial decisions of an organization relating to the modes of finance with a critical emphasis on the MM hypothesis. The paper also focuses on the nature and the utilization of the various financial instruments used by the organizations and their effective role in achieving the objectives of the organization. The paper focuses on both the proposition of the MM hypothesis and interprets which method will be beneficial for the organization. The paper also includes subjects of other modes of financing the organization and the relation between the capital structure and MM hypothesis. The paper presents the elementary propositions of the Miller-Modigliani approach and after presenting their models, put forward a categorical analysis and criticism with respect to optimization for shareholders’ returns in the context of arbitrage scenario (Chandra, 2002, pp.411-412, 417-418). Financial Decision Making in Achievement of Specified Business Objectives Financial Decision Making The financial decisions taken by a business firm to meet financial objectives must also fulfill the goals of specified business objectives. Finance is considered to be the lifeblood of a business concern. Hence management of the financial resources for an organization must be conducted in a manner as to satisfy the organizational goals. The gamut of financial decisions focus on key activities like planning, organizing, directing the capital requirements and the usages of the funds incorporated in a business organization. These financial activities must be pursued in order to meet key financial objectives like achieving a strong rate of return on the amount of capital invested. The business must target at achieving such levels of profits as would not only help in meeting the amount of investments made but also for helping the business to accumulate funds for the future. However, organizations must not only focus on achieving huge profits to augment the capital value of the stakeholders but must generate a holistic view in bettering the economic position of the firm (Joseph, 2005, pp.170-172).. The short term financial needs of a firm center on acquiring of short-term business assets in meeting the short-term liabilities of the concern. This aspect is known as the management of working capital, which is conducted to take care of the current solvent position of the concern (Chandra, 2002, pp.4-5). Maximizing Shareholder Value Most business organizations render importance to the issue of augmenting the value of the owners and shareholders of a business firm. The value of the owners or shareholders of a business firm reflects on the market value of the total amount of stock possessed by such. Market value of the stocks refers to the price quotes of such while being traded in stock exchanges. Wealth of the shareholders is maximized by the business organization through the augmentation of the present value of some future returns expected by the owners. Future returns depend on the accrual of dividends or of future sale proceeds of company stocks. The present value of such future income is calculated based on a specific rate of discount accounted on receiving cash dividends in the future period (Moyer, McGuigan, & Kretlow, 2008, p.5). Financial Strategy A business organization to perform effectively must formulate an adequate financial strategy to satisfy the business goals. An effective financial strategy drawn by any concern revolves around accomplishing two specific business needs. Firstly it endeavors to cite the sectors from which the firm can draw in adequate amount of funds to meet its business needs. Secondly, it sets guidelines for the proper management of such funds within the organization to generate an efficient financial structure. The business organization must also look forward in maximizing the return on the investments made and in minimizing the rate of risks adhered to it (Bender & Ward, 2008, pp.4-6). The strategic role of financial management measured against the set business objectives evolves based on some salient features. Management of financial capital earns strategic importance in being able to acquire funds at reduced costs. Another strategic role of financial management concerns the effective utilization of the funds procured. Finally to serve future needs or in meeting contingencies a part of the funds acquired must be set-aside as reserves. This practice helps in the curtailing the risks associated with business (Gupta, 2007, p.297). Financial Risk Management Strategy Financial risk management strategy operates based on some key goals. Firstly, the business organization must look at acquiring profits, which would help it survive in the competitive business world. Secondly, the business organization must set adequate debt to equity financial ratio to reflect solvent position of the concern. Thirdly, the business organizations must formulate a perfect tax structure, which would meet both business and auditing needs. Further in the fourth case the business organizations must make feasible investment decisions to reduce the element of risk involved in such. (Youngberg, 2010, pp.57-58). Models of Financial Management-Discussion and Evaluation Modigliani and Miller Model The ‘Modigliani and Miller Model’ was designed by Franco Modigliani and Merton Miller. This model is better known as the M and M model after the initial of the two founders. The ‘Modigliani and Miller Model’ was propounded by the theorists in their paper on capital structure of a firm. This model endeavors to study the relationship amongst the components of capital structure and the cost incurred in raising the required capital. However, the valuation done through the model goes the same as that done through the Net Operating Income model of a firm’s capital structure. The proposition given by the Modigliani Miller model states that the cost incurred in raising the capital of the firm remains the same or is rather independent to the changes in the capital leverage factor reflected by the changing debt to equity ratio of the firm. To depict the same in a computed fashion it states that the weighted average amount of the company’s ‘cost of capital’ remains unaltered with corresponding change in the debt to equity ratio. Thus the value of the firm also remains the same without getting fluctuated. The Modigliani and Miller Model operate based on certain propositions, which can be underlined as follows. Firstly, it observes that the factors like cost incurred by the firm in raising the required capital and the value of the firm are both independent to the alterations brought about in the firm’s capital structure. The second proposition that the Modigliani Miller Model observes is that the rate of capitalization gradually increases to balance the effect of the funds accumulated through the use of debt instruments. In the third proposition the model states that the rate of interest charged while making investments is free or independent to the mode of investment financing modes. The Modigliani Miller Model other than the stated propositions also follows some particular assumptions, which can be mentioned as follows. Firstly it assumes that the capital market is a perfect one where information is easily accessible, transactions conducted are free of charge, and the securities available are divisible into infinitesimal proportions. Moreover, the capital market to be perfect notes that it is free of the cost of bankruptcy occurred in a firm. The second assumption held by the model observes that the managers and investors operating in the financial markets are of rational nature. The rationality of the investors is ascertained in the process where they make efficient combinations of the risk involved with the return anticipated for the investments made. Again, the rationality of the managers is ascertained in the process where they work for the betterment of the position of the shareholders. In the third assumption the model holds that the expectations of the investors operating in the financial markets anticipate same thoughts or reflect same expectations about the future earning power of the business firm. The fourth assumptions holds that individual firms based on their potential of taking business risks can be grouped into separate classes having the homogeneous population. Finally, in the fifth assumption the model erases the occurrence of any tax element in the economy and holds the business environment free of tax (Khan & Jain, 2007, pp.19.11-19.12; Chandra, 2002, p.417). Modigliani and Miller Model without Taxes The Modigliani and Miller Model analyzed the capital structure of the firm assuming a situation which is free of any type of taxes based on corporate or personal income. To elucidate the model two firms are chosen pertaining to the same risk class. The first firm chosen has a leverage factor, which means that it’s capital funding activities consist of drawing funds from external sources. The second firm chosen depends on ownership funding and is thus free from the leverage factor. Further a required rate is taken on the returns for the firm, which is devoid of the leverage factor while depending on ownership funds. These events are conducted for a business situation free of tax expenses. However for the sake of explanation a firm is chosen which conducts its capital funding operations through both amounts received from proprietors and as well as from outside sources. Thus finally two firms are obtained viz. one conducting combined capital funding from both external and internal sources while one depending wholly on ownership funds. Using the proposition given by the model it can be stated that the weighted average figure computed for the cost of raising the capital is free of the leverage factor of in the capital structure for the first firm. For the second firm the weighted average figure for cost incurred in raising the capital equals to the equity capital of the firm. It is because the firm is devoid of external funds. Again in the situation where the business environment is free from tax pressure cost incurred in raising equity capital for the two firm one depending on combined capital structure and the other dependent solely on proprietor’s funds amounts the same. The Modigliani Miller proposition thus identifies that in a no-tax situation even if the amount of debt is increased the benefits accruing from availability of cheap capital would be balanced by increase of risk concerning ownership funds keeping the computed value of the concern the same. In the arbitrage condition where the market is devoid of taxes and the two stated firms are operating with mixed and ownership capital the investors would work to equate such. The investors in order to create the same market value of both the firms would continue a process of purchasing shares of the low value firm and sell those of the high value firm to equate their market valuations (Brigham & Ehrhardt, 2008, pp.608-609). Modigliani and Miller Model with Taxes and Bankruptcy Costs Modigliani and Miller in a correction paper published five years after their original paper on capital structure introduced the concepts of Corporate Taxes and cost related to the bankruptcy factor. The incorporation of corporate taxes causes the earnings on capital invested to be taxed, which creates an additional factor relating to payment of interests. However firms in this situation, which is dependent on external funds or on a combination of ownership and external funds is found to be better off than those solely depending on ownership sources. It is because increased incidence to external funds helps create a shield to the taxable expenses and hence increases the value of the firm. Thus this theory suggests of shifting the dependence from ownership funds to totally on external debt funds to increase market value of the firm. Further the introduction of the bankruptcy cost adds to the model of capital structuring. Costs associated to bankruptcy are of two types viz. direct and indirect. Direct cots like legal expenses are easily visible while indirect costs are like decline of market share or loss of goodwill. These bankruptcy costs are found to increase with the rise in the cost of raising capital. To set off the effects of increasing cost of bankruptcy a capital structure is created with optimum amount of debts. This helps the amount of tax savings to marginalize the effect of increased bankruptcy costs (Schaefer, 2002, pp.55-57). Critical evaluation of The MM hypothesis: According to the theory presented in the MM hypothesis, company size, tangible assets and the overall profitability of the organizations have no significant impact on the formation of the capital structure in an organization. Companies favor debt financing accounts for small and lesser complex capital structure in comparison to the companies favoring equity financing. In case of the debt the source of the origin of capital is limited than the equity financing scheme. Companies operating with the debt financing module are much more prone to financial risk as they are largely controlled by the entrepreneurs who aim at profit maximization within a short frame of time. Companies operating with MM model in the capital structure attribute to complex capital structures and are less prone to the financial and economic crisis. Under the MM model it has been found that the shareholders of the organizations remain under the control and abides by the decision framed by the companies. Capital structure plays an important role in the company and is determined by the company size and the volatility. However this factor does not guide the capital structure formation of the company. However the MM model has been criticized as under the model there is no provision for the optimum capital structure. MM hypothesis specified that a debt level is set by the company when the optimum capital structure increases its trade-offs which are affected by the factors such as corporate taxes, the cost for bankruptcy and agency. In the model the value of the target debt ratio is practically zero and it incorporates various factors based on the tax and the cost factors. According to the model when the ratio of the internal and the external Cash flow and the dividends is out of the proportions there is a fluctuations in the debt ratios and the fluctuations occur on the expected return on equity also. The overall study of the market reveals the fact that most of the organizations prefer to have a less complex capital structure as they have the opportunity to invest the liquid assets in various corporate projects and it also reduces the exposure of the risks with the external equity financing. The less complex capital structure provides them with the opportunity to accept less debt which has lesser risk factors associated. Comparison between traditional financing and MM The basic difference between the two modes of financing is in the number of the source of the capital, In case of traditional financing methods there is a single source of capital income whereas in case of MM hypothesis there is multiple source of capital income. Traditional financing mode has no effective tax shield effect and there is no provision of deducting tax on a regular basis. The profit accumulated in the traditional financing modes cannot be kept by self and needs to be distributed among the financial providers. In case of the MM financing it consists of an effective tax shield and it deducts the tax on a regular basis. The profits realized need not to be distributed among the financial providers. Debt financing and traditional financing: Debt financing originates when the companies takes money from other sources. The idea of debt financing appears to be a good one for meeting up the expenses of the short term projects. Debt financing can be achieved from a bank or various debenture holders. There is an inherent risk associated with the mode of debt financing. The interest rate associated with such modes of financing can be very high and generally an asset is kept as security by the debt financer. In presence of large capital structure maintained by the company and large shareholders the debt financing can appear to be a cheaper option in maximizing the value of the company. It is important to critically the final benefit arising from the debt financing as the final profit realized will be lesser than the profit realized without considering any debt. The option of debt financing leads to an increase of the cash flow from the shareholders and the debt holders because of the saving they gain on the tax transfer. Larger amount of debt financing gives rise to lesser return on equity and it becomes a danger indicator for the company. Certain sector of the industry is benefitted by the huge amount of debt financing. Equity financing comprises of the other source of finance. It is a form of share capital which is invested in the business for gaining long term return for the share capital in return for the share of the ownership. The raising of money in the equity financing is very demanding and requires a lot of time and dedication. The investors of the equity finance have a similar interest in the business process with that of the entrepreneur. Often the equity financers assist in strategy and decision making process of the business. The traditional financing comes from the internal source of the business. The act of traditional financing usually is to be completed by an investor’s or company’s own equity, collateral funds, mutual funds which are considered to be very risky at business. The responsibilities of the traditional financing generally lie with the investor or the investing companies. Issuing of the stocks however does not cost much to the company and it only results in the decrease of the shareholders value. In case a company is facing financial problems issuing of the company’s stock is a good method of raising money for the purpose. Mix of Debt financing and Equity financing, balance of cost & risk Certain organization adopts a mixed approach towards their financing and encounters certain level of advantages and disadvantages with each of them. The mixed financing method approach used by the organization should be done during the initial stages of the fund raising as it helps the firms in achieving a balance point of the cost and risk. However some firms opt for part debt financing and part equity financing in their capital structure. Firms with large capital structures are generally recommended to use debt financing as the major proportion in their financing activity. (Pratap & Rendon, 2003, pp.13-45) Decision and interest from financial controller: The shareholders value in the organization largely depends on the decision regarding the financing methods. The firm with a complex capital structure will benefit the shareholders from the equity financing approach. The benefits of the shareholders and that of the financial controller’s lies in close integration and the financial controllers should be careful in finding out whether the decision taken will increase the value of the shareholder and have an effect on the share of the firm. (Schwert, 1989, pp.15-53), Maximize shareholders’ value Shareholders value in the organization can be maximized by the efficient capital structure. Reducing the Debt financing cost is a major way adopted by the medium sized capital structure firms. Other than the use of debt financing for cutting the cost increasing the value of the shares with that of the equity financing of each of the shareholders also adds substantial value for the shareholders viewpoint. Conclusion and recommendation: The importance of the MM model in financial management cannot be ignored. It has a significant role to play in the business sectors. The appropriate use of the MM model can help in optimizing the debt equity ratio, business risks and leveraging of the business. The effective use of the MM hypothesis will enable the company in appropriate financing which would in turn affect the overall operation of the organization. The study conducted above also enables to draw the conclusion that the effectiveness of the debt financing is much more than that of the traditional equity financing. The critical analysis of the MM model helped to identify the shortcomings associated with the MM model. The Modigliani-Miller Model reflects the picture of a classical economy with no taxes where the weighted average cost of capital structure remains the same for cases where the firm is financed by debt or equity. However, the above case earns justification only in hypothetical circumstances and not in real world affected by tax and interest costs, which affects the market value of the firm. Further, the suggestion framed in the modified Modigliani-Miller Model states of taking increased resort to debt funds to counter the incidence of taxes. However, in context of the real world taking increased resort to debt funds weakens the solvency ratio of the company and makes it amenable to bankruptcy. Thus, the Modigliani-Miller Model must be revised in the context of fluctuating tax and interest rates, which affects the cost of capital of the firm. References Chandra, P. (2002), Financial Management, Tata McGraw Hill. Joseph, R. (2005), Business Policy And Environment, Anmol Publications PVT. LTD. Moyer, R., McGuigan, J., & W. Kretlow (2008), Contemporary Financial Management, Kentucky:Cengage Learning. Bender, R., & K. Ward (2008), Corporate Financial Strategy, Butterworth-Heinemann. Gupta (2007), Business Studies, Tata McGraw-Hill. Khan & Jain (2007), Financial Management, Tata McGraw-Hill. Brigham, E., & M. Ehrhardt (2008), Financial management: theory and practice, Cengage Learning. Pratap, S. and S. Rendon. (2003). “Firm Investment in Imperfect Capital Markets: A Structural Estimation.” Review of Economic Dynamics . Vol. 6, No.5, pp.13–45. Schaefer, O. (2002), Performance Measures in Value Management.: A model based approach to explain the CVA and EVA Measures, Erich Schmidt Verlag GmbH. Schwert, W. 1989. “Why Does Stock Market Volatility Change over Time?” Journal of Finance. Vol. 44, No,11, pp.15–53. Read More