The Methods of Financing the Resources - Essay Example

?Financial Management Table of Contents Part A 3 Importance of Capital Structure in Efficient Financial Management of Large Companies 3 Modigliani–Miller Theory of Capital Structure 4 Argument against Modigliani-Miller Theory 4 Cost of Capital 5 Importance of Cost of Capital in Efficient Financial Management of Large Companies 5 Capital Asset Pricing Model (CAPM) in Cost of Capital 6 Argument against CAPM 7 Existence of Optimal Capital Structure 7 Analysis of Optimal Capital Structure of BMW 8 Analysis of Optimal Capital Structure in Delta Airline and Southwest Airline 9 Part B 10 Significance of Dividend Policy to Investors in Large Companies 10 Dividend Policy Theories 10 Dividend Irrelevance Theory 11 Dividend Relevance Theory 11 Dividend Strategies and Policies Available to Large Companies 11 Significance of Dividend Policy in Share Valuation 13 Strategic, Practical and Operational Issues of Dividend Policies 14 References 16 Part A Capital structure in any large company discusses the method of financing the resources through the blend of debentures, equity, and other securities. The capital structure of an organisation is an arrangement or formation of the liabilities. The objective of capital structure is to combine the undying bases of capitals in such a way so that it can increase the value of common stock of an organisation. The capitals of an organisation which create fixed expenses in the form of long-term debt and equity capital can be mixed with shared equity in the percentage which is utmost suitable to the share market. Through capital structure this mix can be developed which in turn increases the value of common stock (Keown, 2003). Importance of Capital Structure in Efficient Financial Management of Large Companies Capital structure arrangement is much significant for large organisations in order to survive in the industry for long run. In balance sheet of every organisation there are two components, one is liability and the other one is asset. The liability can be referred as the blend of finance of an organisation which has been gathered from internal or external sources and been utilised for business purposes. The financial manager and other sponsors can select the funds which will be used for business after analysing the influential aspects of capital structure. In this way, capital structure can help to develop a strong balance sheet. An accurate capital structure efficiently raises the strength of large organisations to deal with the losses or fluctuations in the economy (Milken, 2009). Modigliani–Miller Theory of Capital Structure In capital structure of an organisation, the Modigliani–Miller theory develops the root of contemporary thinking. Modigliani and Miller had anticipated that a large organisation has a specific set of projected cash flows and when the organisation selects certain percentage of liability and equity to fund the resources, it distributes the cash flows within investors. Their theory states that unless there is lack of taxes, liquidation expenses and irregular information in effective market, the value of organisation is unaffected by the way it is funded. The two major principles of Modigliani–Miller theory is conjecture of taxation and no taxation. If there are no taxes, raising leverage will not provide any advantages with respect to value formation; and if there are taxes such advantages will accumulate, in case leverage is introduced or amplified, as per interest tax protection (Bloomsbury Information Ltd, 2009). Modigliani and Miller had addressed the issue of taxes in an organisation’s capital structure more precisely. They had stated that if interest expenses on liabilities are omitted from commercial taxes it can help to make additional profit by lessening of tax payments. The additional profit can be divided onto investors through higher returns. They also stated that an organisation can make greater ‘profit after tax’ by raising the debt–equity ratio and this extra profit would lead to higher overhead of the shareholders without increasing the value of company (Villamil, n.d.). Argument against Modigliani-Miller Theory The major argument against Modigliani-Miller theory is that it does not provide an accurate explanation of how organisations can fund their business operations. It only provides the reason for significance of financing in large organisations. Their theory of infinite financial leverage can boost economic and commercial activities, but on the other hand it can result in augmented complication, lack of transparency and higher threat and ambiguity in business activities (Luigi & Sorin, 2009). Cost of Capital Cost of capital in large organisations refer to the cost of funds and it is used for evaluating the companies because it can provide the minimum return which an investor can anticipate for investing wealth to the organisation. In financial management of large organisations, cost of capital plays a significant part in decision making (Modigliani & Miller, 2008). Importance of Cost of Capital in Efficient Financial Management of Large Companies Cost of capital is used as an assessing instrument for accepting a proposal for investment. Any large organisation opts for those projects that can provide reasonable return on investment and that are not below cost of capital. Through cost of capital, organisations can evaluate the financial performance and define the suitability of all investment prospects. Cost of capital is important in planning an organisation’s capital structure. Cost of capital is affected by the opportunities in organisation’s capital structure. A proficient financial manager constantly monitors the fluctuations of capital market and seeks to accomplish comprehensive and cost-effective capital structure for the organisation. Whenever an organisation needs extra funding, it is required to select those financial sources which can result in least cost of capital. The interest rate and dividend rate among others can impact on the section of sources needed to be considered in order to avoid the monetary risk (Modigliani & Miller, 2008). Capital Asset Pricing Model (CAPM) in Cost of Capital In assessing the cost of capital, Capital Asset Pricing Model (CAPM) is widely used in the field of financial management. CAPM provides large companies a strong and instinctive estimation about calculating risk and connection between anticipated return and risk. CAPM is developed on the basis of portfolio model of Harry Markowitz where investors choose a set at t – 1 time which generates profit at t. His model accepts that investors oppose risks and they only consider the mean and the variance of profit on investment. The following figure will describe the CAPM through portfolio model: Source: (Fama & French, 2004). In the above diagram, an investor who wants higher yield on point a must agree to take high unpredictability of market and if investors want lower unpredictability then they can make midway yield at point T which is much predictable. Portfolios above b are ‘mean-variance-efficient’ as they are safe for lending and investors can also capitalise on the predictable yield with variances (Fama & French, 2004). Argument against CAPM The CAPM is criticised on the grounds that there are no simple method of estimating the market regarding the growth rate of projected cash flow. In the CAPM pattern, risk does not arrive unswervingly into the calculation of cost of capital. In CAPM, the assumption is that organisations that are financed by debt are probably risk free and have low cost of capital, while in reality, organisations cannot upkeep much debt because it can lead to higher risk and as a result is expected to result in greater cost of capital. According to Modigliani-Miller theory, there are no adequate justification of risk in investment and how it fluctuates in reaction to fluctuations in other variables. Therefore, the main question of CAPM was how the risk and anticipated return on investment can be linked (Perold, 2004). Existence of Optimal Capital Structure The existence of optimal capital structure is essentially an experimental subject concerning whether or not, several expenses with relation to leverage are economically substantial to impact the outlays of commercial borrowing. The theory of Modigliani-Miller has stimulated and provided indication on the existence of optimal corporate structure (Bradley & et. al., 1984). For every organisation, there is an optimal capital structure which differs according to the industry. The optimal capital structure can change according to economics, money market, revenue tendencies, and opportunities. These aspects can determine the optimum point of capital structure for any organisation (Keown & et. al., 2009). Analysis of Optimal Capital Structure of BMW While appreciating a large organisation, it is significant to calculate how invested money was attained. To certify an optimal capital structure, an organisation should maintain a rational equilibrium between debt and equity funding. If an organisation is financed through equity, then it should relinquish a tax defence which can be gained by bearing debt. On the contrary, if an organisation depends severely on debt financing, then it can extinguish its worth after specific degree of debt. If an organisation has more debt compared to best debt level then it can suffer financial misery. The leverage is a better measurement for an organisation’s credit performance and liquidity can measure the capital structure and ability of a company to react to market incitement. The following figure will describe the leverage ratio of BMW along with other competitors in the year 2009: Source: (Standard & Poor’s, 2009). The automobile industry is highly sensitive with respect to any economic fluctuation. It can be observed that compared to other big companies in the automobile industry, BMW’s leverage was below the standard in 2009. It indicates BMW’s strong financial position to overhaul long-term debt (Ploen & Olesen, 2010). In contrast to BMW, Toyota maintains a negligible financial risk, and its optimal capital structure is considered by enormous liquidity which signifies its sensitivity towards market fluctuations (Standard & Poor’s, 2009). Analysis of Optimal Capital Structure in Delta Airline and Southwest Airline The aviation industry is considered as risky business from the investors’ point of view. The industry is highly competitive in nature which includes price competition. The aviation organisations need to bear high fixed expenses and low variable expenses which are also termed as high operating leverage. Therefore, organisations which conduct business in aviation industry tend to have lesser debt for funding the capital. Meanwhile, the capital structure of Southwest Airline is optimal in aviation industry with 87% of equity and 13% of debt throughout 2007-2009. In comparison with this, Delta Airlines had struggled to achieve optimal capital structure in the airline sector. Delta Airlines’ was observed to possess one of the highest cost structures in the aviation industry. In the year 2004, Delta Airlines had confronted with higher prospect of bankruptcy due to higher expenses on business operations (Moyer & et. al., 2005). Part B Dividend policy is the procedure used by large companies to ascertain the amount of dividend for the shareholders. In financial management, the profit is gained by deduction of costs from the income and a percentage of this profit is dispersed to the shareholders as dividends (Lee, 2009). Significance of Dividend Policy to Investors in Large Companies In large organisations, dividend is much significant than the revenue for the investors. The reason is that, dividend offers a method for investors to evaluate an organisation in the viewpoint of investment. For instance, a fixed deposit which has interest rate of 8% per annum can generate revenue of 4.8% per annum after tax deduction (supposing tax rate is 40%). In this context, a share which has dividend return of more than 4.8% can be more attractive for investors as revenue generator compared to fixed deposit. But investors also need to consider that dividend possesses higher risk compared to fixed deposit where its return cannot be assured. Dividend policy is significant for investors because it can help to assess an organisation by using share valuation model and dividend discount model (DDM). If the rate of DDM is bigger than usual share value, then investors will be attracted to purchase it (Finweek, 2006). Dividend Policy Theories Dividend policy was designed with the growth of commercial system itself. The appearance of dividend policy is determined by growing circumstances of financial market. In dividend policy, two major theories are dividend irrelevance theory and dividend relevance theory (Al-Malkawi & et. al., 2010). Dividend Irrelevance Theory In dividend irrelevance theory, it is considered that organisation’s dividend policy is free from share value and decision regarding dividend is an unreceptive residual. The concept of residual is made on the basis of distributing profit to retained earnings and dividends of shareholders. This theory depicts that value of an organisation is measured by the investment and the funding decisions in optimal capital structure. It also says that dividend policy is irrelevant in defining value of an organisation. Dividend Relevance Theory Dividend relevance theory does not support the theory of seamless capital market and coherent investors. It examines the performance of dividend allocations and their impact on organisational value. This theory assumes that dividend policy is a real-world method which signifies dividend as a dynamic decisional aspect. This theory also says that dividends are not only a way of issuing profit but also a measurement of investor’s wealth. Therefore, an organisation needs to develop an optimal decision policy which can exploit the wealth of investors (Barman, n.d.). Dividend Strategies and Policies Available to Large Companies Large organisations do not typically use dynamic control on the dividend policy. The board itself rarely acclaims a dividend but rather they act on behalf of approval of the Chief Executive Officer (CEO) or standing commission of the company (Gordon, 1961). If the revenue of an organisation increases, the administration does not inevitably increase the amount of dividend. If the administration is confident enough that the increased revenue will endure in future, only then it can increase the dividend amount. For large organisations, there are several dividend policies available which are: Stable Dividend per Share Policy: Several organisations use stable dividend per share policy as it is favourable for the investors. Stable dividend denotes low risk. In this policy, even if a company faced loss in a year it will provide stable dividend to evade negative implications to existing and new investors. By implementing this policy the investors will become more confident by finding the loss as temporary. Stable dividend policy is essential to develop securities in which financial organisations capitalise (Shim & Siegel, 1998). Constant Dividend Payout Ratio Policy: In constant dividend payout ratio policy, the profits are distributed through dividends by certain percentage. As the profit varies from year to year the amount of dividend will also vary accordingly. The major difficulty of this policy is that it can impact on the amount of dividend, if a company is facing losses. This policy is also unable to increase the market value of share as majority of investors do not prefer variable dividends (Shim & Siegel, 1998). Compromise Dividend Policy: The compromise dividend policy generally cooperates within the strategies of constant Dollar and proportion of dividend in order to provide low Dollar amount for each share along with percentage addition. It is a flexible policy but also can generate doubt in the mind of investors regarding dividend payment. This policy is appropriate for large companies whose income fluctuates significantly in every year (Shim & Siegel, 1998). Residual Dividend Policy: When organisation’s investment opportunity is unstable, then the administration needs to implement inconsistent dividend policy. In residual dividend policy, the amount of dividend relies on convenience of investment predictions in any year (Shim & Siegel, 1998). Significance of Dividend Policy in Share Valuation Dividend policies can determine the amount of dividend of investors. Therefore, it certainly effects the share price valuation. Thus, large organisations need to implement optimal dividend policy which can raise the share price as well as increase investors’ wealth. The significance of dividend policy in share valuation can be described by three models which are: Traditional Model: Traditional model was developed by Graham and Dodd which says that the market value of share can increase if an organisation announces dividends more than usual amount. It can be described by the following formula: P = m (D+E/3) (Where P = Market value of share, m = Multiplier, D = Dividend per share and E= Earnings per share). It denotes that if D increases, then it can certainly impact on P. Walter Model: Walter model asserts that when return on investment (r) is higher than cost of capital (k) the market price of share (P) will increase along with reduction of dividend payout ratio and when r is equal to k then market price of share will remain unchanged with dividend payout ratio. This model can be described by following formula: P = (D + (E-D) r/k)/k Modigliani-Miller (MM) Model: MM model of dividend policy denotes that the market value of share is not related with the dividend payout. The model describes that if the profit of an organisation increases then it can raise the market value of share; and rise in the number of share can result in low market value of a share. Therefore, investors will be unenthusiastic towards dividend policy of the organisation (Gohil, 2011). Strategic, Practical and Operational Issues of Dividend Policies The dividend policy of large organisations can be affected by several strategic, practical and operational aspects. The following graph will describe the major strategic, practical and operational issues which can impact on dividend policy of large companies: Source: (Shim & Siegel, 1998). Besides, these issues the large companies also face numerous problems for non-cash dividend alternatives which are shown in the following graph: Source: (ASA, 2010). References ASA, 2010. IFRIC 17: Full Value of Non-Cash Dividends. CPD Verifiable Articles. [Online] Available at: http://www.accountancysa.org.za/resources/ShowItemArticle.asp?ArticleId=1914&Issue=1091 [Accessed January 06, 2012]. Al-Malkawi, H. N. & et. al., 2010. Dividend Policy: A Review of Theories and Empirical Evidence. International Bulletin of Business Administration, 9, pp. 171-191. Bloomsbury Information Ltd, 2009. Understanding Capital Structure Theory: Modigliani and Miller. QFinance. [Online] Available at: http://www.qfinance.com/contentFiles/QF02/ggaq2mzt/16/0/understanding-capital-structure-theory-modigliani-and-miller.pdf [Accessed January 06, 2012]. Bradley, M. & et. al., 1984. On the Existence of an Optimal Capital Structure: Theory and Evidence. The Journal of Finance, 39 (3), pp. 857-878. Barman, G. P., No Date. An Evaluation of How Dividend Policies Impact on The Share Value of Selected Companies. Nelson Mandela Metropolitan University. [Online] Available at: http://www.nmmu.ac.za/documents/theses/GRAHAM%20PAUL%20BARMAN.pdf [Accessed January 06, 2012]. Fama, E. F. & French, K. R., 2004. The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, 18 (3), pp. 25-46. Finweek, 2006. The Importance of Dividends. Investment in Shares. [Online] Available at: http://www.africansea.org/asea/(S(c5ifa2ilg5uu3oyrqixwgf3t))/Library/The%20importance%20of%20dividends.pdf [Accessed January 06, 2012]. Gordon, R. A., 1961. Business Leadership in The Large Corporation. University of California Press. Gohil, P., 2011. Dividend Decision. Scribd. [Online] Available at: http://www.scribd.com/doc/33870723/Dividend-Policy [Accessed January 06, 2012]. Keown, A. J., 2003. Foundations of Finance: The Logic and Practice of Financial Management. Tsinghua University Press. Keown, A. J., & et. al., 2009. Financial Management: Principles and Applications. Pearson Education India. Luigi, P., & Sorin, V., 2009. A Review of The Capital Structure Theories. Universitatea Din Oradea, pp. 315-320. Lee, S. S. P., 2009. Dividend Policy. The Chinese University of Hong Kong. [Online] Available at: http://www.hkiaat.org/images/uploads/articles/Dividend.pdf [Accessed January 06, 2012]. Milken, M., 2009. Why Capital Structure Matters. The Wall Street Journal. [Online] Available at: http://online.wsj.com/article/SB124027187331937083.html [Accessed January 06, 2012]. Modigliani, F. & Miller, M. H., 2008. The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review, 48 (3), pp. 261-297. Moyer, R. C. & et. al., 2005. Contemporary Financial Management. Cengage Learning. Perold, A. F., 2004. The Capital Asset Pricing Model. Journal of Economic Perspectives, 18 (3), pp. 3-24. Ploen, R. R., & Olesen, M. K., 2010. Valuation of BMW. Aarhus School of Business. [Online] Available at: http://pure.au.dk/portal-asb-student/files/10730/Valuation_of_BMW.pdf [Accessed January 06, 2012]. Standard & Poor’s, 2009. Toyota Downgraded To 'AA' On Prolonged Profitability And Cash Flow Pressure; Outlook Negative. The McGraw-Hill Companies. [Online] Available at: http://www.autonews.com/assets/PDF/CA6129658.PDF [Accessed January 06, 2012]. Shim, J. K. & Siegel, J. G., 1998. Schaum's Outline of Theory and Problems of Financial Management. McGraw-Hill Professional. Villamil, A. P., No Date. The Modigliani-Miller Theorem. University of Illinois. [Online] Available at: http://www.econ.uiuc.edu/~avillami/course-files/PalgraveRev_ModiglianiMiller_Villamil.pdf [Accessed January 06, 2012]. Read More