Current Issues in Finance - Essay Example

?Current Issues in Finance Table of Contents Introduction 3 of Capital Structure 4 Critical Evaluation/Review 6 Theoretical Support to Evaluation/ Review 9 Conclusion 11 References 12 Introduction Capital structure represents the mix of debts and equities in raising the wealth required for the effective execution of a particular business process. With reference to the context, capital structure also helps to indicate the rights distributed to the investors of the firm (Neal, 2004). In today’s fiercely competitive era, the requirement of a well-planned capital structure has increased substantially for both small and large firms to mitigate the probable consequences of weak liquidity position. According to the theory of capital structure, the major features of the conception constitute with maximum return with minimum risk, flexibility in resource allocation, adequate liquidity, conservation of reserves, balanced capital flow and leverage, which accumulatively helps in assisting the smooth flow of finances stimulating the overall business operations. It is in this context that according to the theorem presented by Modigliani & Miller, there are various factors on which the managerial decision of configuring an appropriate capital structure is depended (Kumar & Sharma, 1998). The objective of this paper is to discuss about the importance of capital structure with reference to the financial configuration of a Hong Kong based real estate company named Henderson Land Development Company Pvt. Ltd. With this concern, the paper will also attempt to examine the utilisation and importance of capital structure from a generalised points of view narrowing towards its implications on the company. Modigliani & Miller’s theorem towards capital structure will also be taken into account for the purpose of this study. Description of Capital Structure Capital structure can be defined as the framework or planned method through which a company attempts to control its allocation as well as flow of finances in its operational process mitigating financial interruptions by a considerable extent. According to the theory presented by Modigliani & Miller, capital structure represents the general distinction between leverage and equity describing the conditions under which a firm’s value can prevail unaffected due to the financial decisions taken by the management (Villamil, 2005). It is worth mentioning that from a generalised point of view, it has often assumed that equity propositions and leverage functions of any organisation is highly affected with its financial decisions, both in the short-run and in the long-run as well. As stated by Baker & Martin (2011), “capital structure refers to the sources of financing employed by the firm” (pp. 1). It is in this context that there are various available options which are generally availed by organisations to accumulate the required amount of capital or funding for the smooth execution of its organisational operations in the long run. Contextually, the decisions, taken by the organisations in order to accredit its capital structure, have often been witnessed to have a crucial impact over its competencies and the financial risks probably faced by the firm in its long run performances (Baker & Martin, 2011). Although the capital structure related decisions taken by organisations have been frequently considered as one of the major reasons to face noteworthy consequences, especially in the post economic crisis period, the formulation of the capital structure has also been identified to have considerable positive impacts on a company’s financial affairs. Contextually, the major features of capital structure are identified as profitability, flexibility, control and solvency. Profitability can be defined as the process of utilising maximum resources in the business process engaging minimum cost which subsequently gives rise to the profit ratio. In the similar context, flexibility can be discussed as the process in which the capital structure can be altered according to the changes occurring in the business trends engaging minimum time and cost. It indicates that along with the alterations in the company strategies, such as expansion, collection of debts and equity as well as collection of required loans, its capital structure should also be changed effectively. Notably, this particular characteristic can be identified as a crucial phenomenon in the modern day concept of capital structure which allows the company to alter its business processes in a cost efficient manner involving minimum degree of financial risks and thereby augmenting the shareholder value (Denis & McKeon, 2009). Higher degree of control, which is regarded to be another feature of a reliable capital structure, indicates the strength of regulating a business efficiently with due consideration towards the smooth flow of finances and other resources. Solvency, as another significant feature of capital structure, refers to the ability of a particular firm to repay its long-term obligations and therefore effectually avoid the risks of bankruptcy and/ wind-up (Kumar & Sharma, 1998). With due consideration to the above mentioned facts, it becomes quite apparent that organisational decisions concerning its capital structure can have a strong impact over its long run financial viability and competency to deal with its short term as well as long term obligations along with preserving its strategic competencies. It is in this context that Miller & Modigliani, through their theorem of capital structure, proposed an optimal configuration to accumulate the required funds posing minimum impact on the financial risks faced by the organisation or likely to be faced in its long run performance (Baker & Martin, 2011). With this regards, the assumptions considered in this theorem states that when there are no tax imposed on the funds allocated, the firms are unable to attain benefits in terms of value creation or in terms of mounting leverage. On the contrary, with the imposition of taxes, the benefits of value creation and mounting leverage can be attained with the virtues of interest tax shield (Cohen, 2004). Critical Evaluation/Review The capital structure of Henderson Land Development Company indicates the involvement of a larger proportion of its reserves than securities. With due consideration to the company’s balance sheet for the year ended 31st December 2011, it is estimated that the company has been providing due significance towards its reserves in comparison to the shares with the intention to generate the required amount of equity. For instance, the total amounted equity held by the company was recorded as HK$ 115,126 million by the year end of 2011. This total equity value, comprised of HK$ 110,388 million, which amounted to almost 95.88% of the entire capital accumulated by the company. Notably, the remaining 4.22% of the entire capital accumulated, i.e. HK$ 4,738 million were gathered through shares including general shares, bonus shares, preference shares and equity shares as well. In the similar context, the reserves allocated for the capital structure included bank loans and other long term as well as short term debts, along with a proportionate share from the company profits (Henderson Land Development Company, 2011). From an in depth point of view, it can be identified that the company trends with respect to its capital structure decisions have been increasingly inclined towards the involvement of shares, reserves, and long term as well as short term loans. In this context, it becomes further apparent that the amount invested by the company from its own reserve is comparatively more than the shared capital involved. With reference to the capital allocation decisions of the company, it can be further noted that the capital structure of the Henderson is shifting its sole concern from reserves towards debts. For instance, the net debt involved in the capital allocation of the company in terms of reserves amounted to HK$ 44,818 million in the year 2010 which decreased by HK$ 36,890 million in the year 2011. Subsequently, a rise can be identified in terms of the share capital employed. Notably, in the year 2010, the company was identified to accrue a total amount of HK$ 4,352 million as its share capital which was increased to HK$ 4,738 million by the year end of 2011 (Henderson Land Development Company, 2011). Therefore, it becomes quite apparent that the conception of Henderson in allocating the required capital is in an alteration phase where an increasingly greater significance is being provided towards share capital in comparison to the reserves as the prime sources of funds. Notably, a large sized limited company is generally observed to issue shares in order to increase its funds for the business. The shares are fundamentally issued in two types, i.e. equity shares and preferential shares (Finance Reliable Resourceful, 2006). In this regards, it has often been noted that the advantages of issuing excess equity helps to increase the capital of the fund within a short span of time engaging minimum amount of risks, but certainly, raising a considerable percentage of obligations to be beard by the company. Furthermore, larger allocation of share capital also assists the organisation to reduce its tax liability and therefore gain the advantage of interest tax shield. On the contrary, the limitations of issuing excess share capital can also lead to various problems such as high dividend returns at the time of profits, restrictions in terms of Articles and Memorandum of Association also rises in respect of excess issuing of equity (Brigham & Gapenski, 1998). It is worth mentioning in this context that the organisation was observed to focus on accumulating a major proportion of its capital through its reserves, which can formally be treated as its capital reserves, owing to its traditional managerial approach concerning capital structure. It is in this context that similar to many other traditional organisations, Henderson also concentrated on enhancing its protection from huge amount of loan losses by primarily focusing on engaging greater proportion of reserves in comparison to share capital (Richardson, 2002). Furthermore, lending capital from bank helps company to develop its business process in the short run which can also be apparently witnessed in the case of Henderson. With due concern to the amount engaged by the company in terms of its borrowed loans in order to accumulate its total capital required, it is worth mentioning that in the current day phenomenon, excess amount of borrowed loans can reward significant advantages as well as incur noteworthy disadvantages towards the company’s financial viability in the long run. For instance, the advantages of borrowing bank loans assist the company to serve its debenture holders easily preserving the flow of organisational process. Furthermore, many companies, which tend to follow the traditional belief of capital structuring, also considers that repaying loans in the short term or in the long term basis is less riskier in comparison to the accumulation of dividends in order to pay the shareholders against their funds involved in the company’s capital. Contradictorily, the disadvantages of rendering higher significance to company reserves for accumulating the required capital can be identified as the necessity to pay interest charges as per the agreement irrespective of the circumstances faced by the organisation. On the contrary, engaging share capital renders the benefit to reduce the dividend promised on shares following the consent of majority of the board members (as per the company’s regulations and accounting standards), understating the circumstances faced by the company. Furthermore, these kinds of loans and borrowings are fundamentally raised with emphasis on company’s assets and thus in case of any accident, a risk persists that the assets kept as collateral for the bank loans will be overtaken by the financer or creditor (Pour, 2012). With reference to the context, it becomes quite apparent that Henderson is quite likely to face these types of dismissals in its operations owing to its larger emphasis over capital reserves rather than on accumulating share capital. However, the current trends witnessed with regards to the capital structuring decisions of the organisation, indicates that the decision makers of the organisation are shifting their sole consideration from capital reserves to share capital. This further explains the organisational concern to reduce its obligations towards short term and long term debts (Richardson, 2002). Theoretical Support to Evaluation/ Review With reference to the above discussion, it becomes apparent that the fundamental methods implemented by Henderson to collect the required amount of capital for its business process are majorly concentrated on loans or borrowings from banks and other financial institutions along with its company reserves including profit and shares. It has been observed in this regard that the company principally focuses on its long term objectives and therefore attempts to concentrate largely on its long term financial viability. However, the company also does not tend to avoid the requirement of its short term flexibility which can also be regarded as a vital reason for the decision makers to emphasise on the accumulation of capital reserves in the fund allocation process rather than concentrating on the aspects of share capital. With reference to the theorem of Modigliani & Miller, in its long run process, the company has to consider a few of the fundamental aspects related to the risks which can be raised along with the accumulation of loans with respect to its reserves and issuing of shares. It is worth mentioning that according to the Modigliani & Miller’s theorem, trading or accumulating capital through shares can significantly benefit the organisation in rewarding flexibility as it is assumed that securities such as preference shares, debentures and similar other financial products can be traded freely with minimum inclusion of time, cost and legal obligations. Whereas, the inclusion of capital reserves are quiet likely to increase the limitations of the company to acquire the required amount of fund on a short notice and therefore hamper its flexibility by a considerable extent (Baker & Martin, 2011). With reference to the company scenario, it becomes apparent that the Henderson majorly focuses on the accumulation of capital reserves in terms of borrowings and bank loans both in the short term and in the long term as well as in terms of profits attained by the company at the end of each fiscal year. From an overall perspective, the percentage accumulation of capital reserves is much higher than the share capital engaged by the company in its capital structure. However, the trend that can be noticed with regards to the capital structure decisions of the company indicates a shift in the company’s financial strategies from being concentrated on capital reserves towards a larger allocation of share capital. Therefore, with due consideration to the assumptions proposed by the Modigliani & Miller’s theorem it can be stated that the company needs to consider the significance of involving share capital as its major source of fund, without disregarding the virtues of reserve capital to obtain an optimal capital structure (Villamil, 2005). Conclusion Capital structure is the statement generally used by large firms in order to maintain the flow of finance effectually for the smooth continuation of its business process. Along with it, capital structure also helps to estimate the profit expected by the company with proper allocation of its resources along with rendering an in-depth understating of its financial strengths and weaknesses and thereby indicating its requirement of sources used for raising its capital. With this concern, the fundamental sources used by Henderson for accumulating the required capital are through the company reserves, shares, and bank loans. Relating the company approach with the theorem presented by Modigliani & Miller, it can be stated that the inclusion of a larger proportion of reserves in its capital structure is likely to benefit the organization with enhanced leverage and liquidity, but on the contrary, the company might have to witness the loss of interest tax shields in its long term operations. References Baker, H. K. & Martin, G. S., 2011. Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. John Wiley & Sons. Cohen, R. D., 2004. An Implication of the Modigliani-Miller Capital Structuring Theorems on the Relation between Equity and Debt. Citigroup. [Online] Available at: http://rdcohen.50megs.com/MM.pdf [Accessed June 05, 2012]. Denis, D. J. & McKeon, S. B., 2009. Financial Flexibility and Capital Structure Policy Evidence from Pro-Active Leverage Increases. University of Illinois at Urbana-Champaign. Henderson Land Development Company, 2011. Corporate Profile. About the Group. [Online] Available at: http://www.hld.com/en/pdf/investor/annual/2011/hld_annual_2011.pdf [Accessed June 05, 2012]. Henderson Land Development Company, 2011. Sustainable Future Annual Report 2011. Investor Information. [Online] Available at: http://www.hld.com/en/pdf/investor/annual/2011/hld_annual_2011.pdf [Accessed June 05, 2012]. Neal, D. A., 2004. Capital Structure for Entrepreneurs. Kauffman Foundation. [Online] Available at: http://www.entrepreneurship.org/~/media/Files/Resource%20Center/Communities/Entrepreneurship/Capital%20Structures%20for%20Entrepreneurs.pdf [Accessed June 08, 2012]. Pour, N. M., 2012. Identifying Different Sources of Finance to PLC Advantages and Limitations. Kensington College and Business &University of Wales. [Online] Available at: http://wales.academia.edu/NahidMohsenPour/Papers/454569/IDETIFYING_DIFFERENT_SOURCES_OF_FINANCE_TO_PLC_ADVANTAGES_AND_LIMITATIONS [Accessed June 05, 2012]. Richardson, D. C., 2002. World Council of Credit Unions Toolkit Series. Pearls Monitoring System. Villamil, A. P., 2005. The Modigliani-Miller Theorem. The New Palgrave Dictionary of Economics. [Online] Available at: http://www.econ.uiuc.edu/~avillami/course-files/PalgraveRev_ModiglianiMiller_Villamil.pdf [Accessed June 09, 2012]. Read More