Financial Policies and the Value of the Firm - Literature review Example

Financial Policies and the Value of the Firm Literature Review Irrelevance of Financial Policy Miller and Modigliani(1961) considered the matter of a firm’s dividend policy and its effect on current share prices. The effects of different dividend polices on current share prices based on assumptions of perfect capital markets, rational behaviour on the part of investors and perfect certainty. The assumption of perfect markets means that all traders have equal access to information and transaction costs such as brokerage fees and transfer tax which are normally associated with the sale and purchase of shares are non-existent. Rational behaviour indicates a preference for more instead of less and an indifference to the form that wealth takes – whether it is in the form of cash payments as dividends or increases in the market value of shares. Perfect certainty on the other hand indicates that investors have no doubt in relation to the investment and financial policy of the firm as well as the future levels of profitability of all firms. Stiglitz (1974) extends the argument that the financial policy of the firm is irrelevant to a multi-period model. The reason for this extension is to give consideration to a wider range of financial policies to include not only a debt to equity ratio but a dividend retention ratio, a debt maturity structure and possibly the holding of securities in other firms. While stressing the importance of financial policy on the value of the firm to students of finance, Stiglitz (1974) indicates that ‘if the conditions under which the “irrelevance” theorems obtain’ are considered to be realistic it results in a reduction in the tools that they require to function effectively. Stiglitz (1974) suggested that it is possible to place the decisions that a firm makes into four groups: i. the way in which investment is financed; ii. the way in which revenue is distributed; iii. the amount that should be invested in any particular projects; and iv. the projects that should be undertaken as well as the techniques that should be employed. The first two relates to the firms financial policy while the last two relate to its investment policy. Stiglitz (1974) highlights the fact that there is a relationship between both types of decisions which may not be obvious. Stiglitz (1974) also indicates that two different but still closely related propositions have been confused. While they assert that a firm’s financial policy does not affect its value. The first asserts that the individual does not prefer one financial policy over another and specifically to the debt to equity ratio implying therefore that there is determinate ratio for the economy as a whole while the second indicates that there might be some preference as there may be a determinate debt to equity ratio for the economy as a whole but the financial policy of a particular firm makes no difference. Stiglitz (1974) concludes that the first preposition is stronger because it indicates that the financial structure of the economy and therefore the firm is irrelevant while the second indicates its irrelevance in relation to the firm only. Stiglitz (1984) points out that the decisions that the firm makes are interrelated and so the decision to increase dividend and still decide to invest would suggest that additional capital needs to be obtained. If a loan is obtained to facilitate the investment then less would be available in the following period and to either retained earnings or dividends would decrease. If instead, shares are issued to facilitate the decision to invest then the amount distributed to shareholders in the following period would decrease if retained earnings is left unchanged. Stiglitz (1974) points to shortcomings in Baumol and Malkiel (1967) and Modigliani and Miller (1958) in their discussion of on how taxation impacts the optimal financial policy of the firm. Baumol and Malkiel (1967) and Modigliani and Miller (1958) observed that debt reduces the amount of tax that a firm is required to pay and this results in an increase in the firm’s value. In order to simplify his explanation Stiglitz (1974) used a “one-commodity” model – in which there is a single commodity input and a single commodity output in each period to determine the impact of alternative financial plans on its market value. Stiglitz (1974) indicates that the total value of the firm is the present value of bonds outstanding plus the value of equity. At the beginning and end of the period it is represented by the following equations respectively. Beginning equation: Vi(t) = Ei(t) + ? ?(t, ?) Bi(t – 1, ?) Ending equation: Vi(t) = Ei(t) + ? ?(t, ?) Bi(t – 1, ?) In the equations V represents the value of the firm with the bar or negative (-) sign indicating now or at the start of a period and the plus (+) sign indicating the end of the period. E represents equity, ? represents the price at t time of a bond which promises to pay $1 at time ?. and B debt. Bi(t – 1, ?) represents the number of bonds outstanding at the end of period t-1 which matures at time ?. The change in value between the beginning equation and the ending equation represents the change in the value of the firm which can either be negative or positive. Ross (1977) indicates that nothing fundamental such as the firm value will be altered by the financing decisions that the firm makes if individuals are able to issue shares in the same manner as firms. If so, they will be able to ‘undo any financial package that the firm issues in order to restore equilibrium.’ This, Ross (1977) indicates in his proof that the firm’s financial structure does not affect the firm’s value. Ross (1977) also points out that the discarding of theories that determine financial structure is ‘an unfortunate consequence’ of Modigliani and Miller (1958) insights. Modifying the M&M’s theory to take into account the realities of the world, Ross (1977) indicates that since interest payments on debts is deducted before tax is calculated this will have a positive impact on the value of the firm. This makes the financing decisions and therefore the financial policy which influences the financial structure of the firm relevant to firm valuation. Brennan and Schwartz (1984) indicates that since the classic work of Miller and Modigliani which was published in 1961 interest in valuing firms have been non-existent. Brennan and stresses (1984) the importance of valuing the firm and its importance to corporate finance theory. Firm valuation is of importance to various stakeholders including security analyst and investors as it is important in assessing risk, the rate of return that shareholders require and the influence that financial policy has on the firm value. The neglect of research on financial policy and firm valuation has been blamed on the increased focus on the capital asset pricing model (CAPM). Brennan and Schwartz (1984) criticises the CAPM model and indicates that the models were concerned only about the ‘valuation of individual cash flows’ rather than the value of the firm. However, they paused to indicate that the value of the firm is simply the value of the cash flows that it expects. Brennan and Schwartz (1984) while accepting the value of expected cash flows indicates that a useful model of valuing firms should be based on a description of the firm as it provides a ‘richer and more parsimonious than a mere summation of the values of a series of time dated cash flows, whose stochastic characteristics must be individually enumerated.’ Brennan and Schwartz (1984) further stressed the point that cash flows are a direct result of investment opportunities that are available to the firm and the managerial policies that are directed towards them. Using the Cox, Ingersoll, Ross (1978) model for partial differential equation for valuing assets, Brennan and Schwartz (1984) provided some desirable characteristics that a useful valuation model should consist of. They are: i. a valuation that spans multiple periods and takes risk into account within a theoretical framework that places importance on consistency; ii. a careful description of the firm noting variables which are capable of being quantified and that also ‘have clear empirical counterparts’; iii. a description of the firm’s investment opportunities; iv. a description of the different financing options that are available to the firm that is ‘consistent with the rational pricing of securities’ and takes into account the limitations imposed by prior covenants and loan agreements on financing strategies. v. providing a role for management to assess the effects of various financing options and investment strategies; and vi. a simple closed form valuation expression. Using the first five characteristics a general partial differentiation equation which ‘governs the value of all financial claims’ was derived. The equation was then applied to the claims relating to debt and equity in the particular firm using the relevant state variables – book values of assets; the book value of debt; and return on assets (ROA) and ‘describing their stochastic evolution.’ According to Brennan and Schwartz (1984) both the book value of assets and debt are controllable by the firm since they depend on the financing and investment decisions that are made by management. However, ROA depends on the investment policy and the profitability of the firm. Brennan and Schwartz (1984) suggests that the decisions that the firm’s management makes are constrained by loan covenants which places a limit on the debt to equity ratio and the maximum debt that the firm can have. Miller and Rock (1985).replaced Miller and Modigliani (1961) assumption that investors and inside managers have the same information in relation to both earnings and investment opportunities with one that indicates that managers know more than investors. Miller and Rock (1985) indicates that this replacement brings good news in that the effects of dividend and thus financing announcements are the implications of the decision model rather than the qualifications given to it in Miller and Modigliani (1961). Miller and Rock (1985) further states that in a world where people think rationally a firm’s dividend or financing announcements provide just enough information on its sources and uses of funds and thus allows the market to determine the unobserved price which is the firm’s current earnings. This estimate of the firm’s current earnings by the market leads to an estimate of the future earnings of the firm and this s essentially what the firm’s market value depends on. Miller and Rock (1985) indicates that the bad news is that there are consequences of allowing information asymmetry and dividend decisions may lead to the firm taking investment decisions that are not optimal. The Fisherian criterion for optimal investment is – invest in real assets up to the point where the marginal internal rate of return is equal to the appropriate risk-adjusted rate of return on securities. If the market takes announcements of dividends as a clue to future earnings then managers will be tempted to give false clues by paying more dividends thus resulting in increases in share prices or paying little or no dividend and thus engaging in less external financing. The model for valuing the firm that Miller and Rock (1985) suggests should equate the directors and the market’s valuation if earnings are single valued and the market is rational. The objectives of directors should be to maximise the wealth of shareholders given the firm’s earnings and dividends and so arrive at a valuation that is consistent with these variables. While it may be true that the financial policies of the firm if certain variables are not included in the model is irrelevant to the valuation of the firm. The fact is, however, that we live in a real world and this is of importance and so setting up models that do not reflect what really exist is not worth anything more than what it is inscribed on. Tax affects all firms and it has a positive impact on the firm’s profits after tax since interest payments that are used in connection with interest payments on loans are deductible from revenues before the tax is calculated. This result in a reduction in the tax payable by a percentage similar to the tax charged. Any future investment decision that the firm is likely to take will be influenced by past financing decisions. Therefore, if the firm used loans in the past to finance investments the covenants that are related to those loans will impact further financial decisions and will therefore have implications for the value of the firm. Since, firms that have debt financed investments are guided by covenants it means that they can be prevented from making optimal investment decisions. They may not be able to borrow any additional loans based on these covenants and so they are restricted to ether issuing shares n order to facilitate future investments or reduce the level dividends paid or the earnings held in reserves. All of these factors work together to influence the valuation that the market places on the firm. Impact of investment on financing According to Chava and Roberts (2008) the precise mechanism behind the relationship between financing and investment is largely unknown. Chava and Roberts (2008) pays specific attention to the role of debt covenants which require a minimum net worth or current ratio and the impact that violations have on investments. They believe that violation of covenants provides a unique opportunity to look closely at the interrelatedness of financing and investment. Chava and Roberts (2008) provides several reasons why violating debt covenants provide such an opportunity. They include: i. the motivations and rationalisations for including covenants in financial agreements and their usefulness in mitigating agency problems as they assist in the firm obtaining financing through ‘pledging state-contingent control rights that can result in the transfer of control when violations occur; ii. covenants exist everywhere in financial agreements and so it is not just the covenants themselves that are relevant but the potential violations of these covenants; and iii. Covenant violations take place even when there is no sign that a firm is facing financial distress. Covenants when violated can lead to creditors taking control of the company and this explains the pressure it places on management of firms. Therefore, while a particular level of debt may be optimal in order to achieve a higher market value, loan agreements tend to limit the amount of debt that a firm can borrow and rightly so. This normally helps to arrest the growth of the firm. However, no lender wants to be faced with increasing risks. Increasing risks may lead to higher interest rates and may further force the firm into bankruptcy. Analyst take note of these issues in their analysis of the firm and it is this information that investors rely on in order to make decisions relating to investments in shares. Impact of leverage on growth and thus market valuation Billett et al (2007) looks at the effect of the choice of leverage, debt maturity and covenants on the firm’s growth opportunities. Billett et al (2007) financial policy choices are important because they are determined by a combination of firm characteristics and the ‘contracting environment.’ Billett provides evidence to indicate that covenant protection increases with growth opportunities, debt maturity and leverage. That is as a firm grows there is increasing need for debt with longer periods to maturity and this calls for a higher level of commitment from the management by the creditors. These covenants are a prerequisite for receiving loans. Therefore, covenant has a negative impact which helps to stifle a firm’s growth. According to Billett et al (2007) covenants are used by long-term loan creditors (such as bondholders) to control conflicts between themselves and shareholders ‘over the exercise of growth options and suggests that these conflicts short-term debt and restrictive covenants serve as substitutes as serve the role of controlling these conflicts. Billett et al (2007) also points out that n deciding to introduce leverage into the firm (involves a tradeoff between the costs and benefits of debt financing. It is interesting that Billett et al (2007) point out that one cost of debt financing is the potential for conflicts between holders of bonds in the firm and shareholders of the firm. Bondholders are potential owners while shareholders are the current legitimate owners who stand to lose if any of the covenants are broken, whether it results in higher interest payments or bankruptcy leading to control of the firm by bondholders. On the matter of costs, Hennessy and Whited (2007) pointed to a wide array of costs including the direct legal costs associated with chapter 11 bankruptcy and other indirect costs. Hennessy and Whited (2007) indicate that these costs le between 2 and 10% and 10 and 20% respectively. These are also factors that will affect market valuation and growth opportunities. When growth is stifled the value of the firm will be affected as investors look for other promising alternatives. Growth and profitability are two of the necessary ingredients for increasing value. The suggestion has been made that a way of resolving these conflicts in firms which want to continue to maintain high levels of growth is to consider using more short term debt (Jensen and Meckling 2006; Myers ). However, this constitutes an aggressive financial strategy which has high risks but can also have high payoffs. The debt structure is sometimes seen as a signalling device and so short term debt indicates that the assets are of a high quality (Flannery 1986). Impact of taxation on financial policies and the value of the firm Brennan () points to the effects of various market imperfections in their analysis. Even though Modigliani and Miller () deals with the tax which is one of the imperfections in their model they have just looked at one aspect – its direct effect on corporations. Brennan () indicates that they have totally neglected how taxation affects individuals and rightly so since individuals are affected by the tax that dividend income attracts as well as tax on capital gain. However, in recent times the calls for removing this double taxation – that is not taxing people who receive dividends twice have resulted in changes in tax legislations to address this issue. However, while it is true that dividends is not the only way in which investors can benefit from their investments, selling shares on the market is affected by certain costs including transfer fees and brokerage fees which also affects the validity of the irrelevance theory. Therefore, Brennan () rightly points to the asymmetric tax treatment of income received in the form of dividends and that on capital gains from the sale of shares. Impact of firm coverage by analyst Chang et al (2006) points out that coverage of the firm by analyst affects firms financing decisions. Chang et al (2006) suggests that when only a few analyst cover a firm, the firm is less likely to issue equity and so is more likely to issue debt. However, when they do issue equity they do so in large quantities. Chang et al (2006) indicates that financial analysts play a significant role in ensuring that the asymmetry that exists between market participants and managers of firm are reduced. In doing so they gather information that is considered to be complex and which market participants may have difficulty understanding and break it down into information that is easier to comprehend. Additionally, they disseminate information that is not easily accessed but are obtained from their face to face discussions with managers. In other words they help to facilitate a better understanding of a firm. Therefore, if information is not available on a firm there will be little or no coverage and so the issuance of shares by such a firm may not be successful. More information on a firm is usually suggestive that something positive is taking place as it relates to the firm’s operations. Firms in which nothing is happening may tend to shy away from analyst. Impact of financial strategy on financial policy According to Weinraub and Visscher (1998) there are risks and returns tradeoffs in alternative working capital policies. Aggressive financial strategies are high risk and involves high return working capital investment. Strategies that involve lower risks and lower returns are referred to as moderate or matching in current assets are matched to short term loans while longer term assets as well as a portion of inventory are matched with longer term financing. Conservative financial strategies are those which involve much lower risks and returns than moderate or matching strategies. Firms apply different types of financial strategies in order to obtain certain results. All of these impact market value. Financial flexibility It is important that firms are financially flexible in response to variables n the environment. There is no point sticking one particular policy or one particular strategy. Gamba and Triantis (2008) indicates that recent surveys of firms in the United States and Europe suggest that ‘the most important driver of firms’ capital structure decisions is the desire to attain and preserve financial flexibility. This Gamba and Triantis (2008) indicate will prevent firms from becoming financially distressed in the event that they are faced with negative shocks, and to put them in a position so that they are able to obtain funds to invest when opportunities that are profitable arise. Debt covenants normally place limits on firms’ flexibility. References Baumol, W and Malkiel, B.G. (1967). The Firm’s Optimal Debt-Equity Combination and the Cost of Capital. The Quarterly Journal of Economics. 81(4), p. 547-578 Billett, M.T., King, T.D and Mauer, D.C. (2007). Growth Opportunities and the Choice of Leverage, Debt Maturity, and Covenants. The Journal of Finance, 62(2), p. 697-730. Brennan, M.J. (1970) Taxes, Market Valuation and Corporate Financial Policy. National Tax Journal, 23(4), p. 417-427 Brennan, M.J and Schwartz, E.E. (1984). Optimal Financial Policy and Firm Valuation. Journal of Finance, 39(3), p. 593-607 Chang, X., Dasgupta, S and Hilary, G. (2006). Analyst Coverage and Financing Decisions. The Journal of Finance, 61(6), p. 3009-3048. Chava, S and Roberts, M.R. (2008). How Does Financing Impact Investment? The Role of Debt Covenants. The Journal of Finance, 63(5), p. 2085-2121. Flannery, M.J (1986) Asymmetric information and Risky Debt Maturity Choice. The Journal of Finance, 41(1), p. 19-37. Gamba, A and Triantis. (2008). The Value of Financial Flexibility. The Journal of Finance, 63(5), p. 2263-2296. Hennessy, C.A and Whited, T.M. (2007). How costly is External Financing? Evidence from a Structural Estimation. The Journal of Finance, 62(4), p. 1705-1745 Miller, M.H and Modigliani, F. (1961). Dividend Policy, Growth, and the Valuation of Shares. The Journal of Business, 36(4), p. 411-432 Miller, M.H and Rock, K. (1985). Dividend Policy under Asymmetric Information. The Journal of Finance, 40(4), p. 1031-1051 Modigliani, F and Miller, M.H. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review, 48(3), p. 261-297 Ross, D.A. (1977). The Determination of Financial Structure: The Incentive-Signalling Approach. The Bell Journal of Economics, 8(1), p. 23-43 Stiglitz, J.E. (1974). On the Irrelevance of Corporate Financial Policy. The American Economic Review, 64(6), p. 851-866 Weinraub, H.J and Visscher, s. (1998). Industry Practice Relating to Aggressive Conservative Working Capital Policies. Journal of Financial and Strategic Decisions, 11(2), p. 11-18. Read More