Financial Management - the Capital Puzzle - Essay Example

Financial Management Table of Contents Application of the M&M Approach 3 2. Share Traded In a Perfect Market 4 3. Capital Structure Decisions Often Referred To As ‘The Capital Puzzle’ 7 Modigliani-Miller Capital Structure Theory 8 Trade-off Theory 10 Pecking Order Theory 11 Agency Theory 11 References 13 1. Application of the M&M Approach Aguia and Pomba are companies that have same business operating characteristics. On the financial ground, Aguia comprise of debt and equity but Pomba only equity. The aspect is to derive equilibrium price of Aguia’s shares through the M&M proposition assuming the rate of cost of capital for all-equity to be 10%. M&M Proposition I: £ Million Aguia (Levered) Pomba (Unlevered) EBIT 6 2 (Less) Interest 1.44 - EBT 4.56 2 (Less) Tax (35%) 1.596 .7 Net Income 2.964 1.3 VU = EBIT (1 – tC) / ru = £ 2(1-.35)/ .10 = £ 13 million VL = VU + t C B = £ 13 + .35 * 12 = £ 17.2 million M&M Proposition II: re = ru + (B/S) (ru – rb) S = VL – B = £ 17.2 – 12 = £ 5.2 re = .10 + (£ 12 / £ 5.2) (.10 – .12) = .10 - .046 = 0.054 re = Dividend/ Value of Equity Dividend = 72 *0.054 = £ 3.8 Hence the equilibrium price of the Aguia share P1 = Po (1+Ke) – D1 = 8 * (1.054) – 3.8/20 = £ 8.24 per share (Ogilvie, 2009) 2. Share Traded In a Perfect Market Perfect market is the market place in which the organisations are the price takers, as the price of share derived are based on the demand and supply of share in the marketplace. Furthermore, the investors relatively have significant information about the stocks traded in the security exchange and firm have freedom to entry and exit in the market. Additionally, share of both companies Aguia and Pomba if traded in a perfect market, investors get significant choices to make preferred investment plans. Moreover, the capital structure of Aguia, which compose of both equity and debts and Pomba of all equity finance, will significantly affect the decisions of the investor prior to investing the share of any of these two companies. In the general context, stock investor’s takes there investment priority based on the strong fundamental aspects and strong balance sheet of the company. Moreover, the strength of the balance sheet will be evaluated not only based on the working capital adequacy or the positioning of asset but also the capital structure. Capital structure also plays a fundamental role. Additionally, the capital structure of the company will provide signal to the investors regarding the valuation of the company in the marketplace. For instance, company readily makes the decision to exchange part of debt in respect of the equity. This will likely increase the value of the firm and reduce the possibility of risk, as it will provide the signal in the market that the firm debt capacity have significantly increased. Furthermore, in the context it can be affirmed that the leveraged and unleveraged firm have different feature, characteristics, advantage, and disadvantages. For instance, having capital structure with debts involves obligations to payback interest. On the other hand, equity involves high cost and return to satisfy the shareholders. Moreover, in the case of perfect market investor’s will be in a position to analyze the market and the share prices with the available information. This can be done with the assistance of various technical analytical tools to identify the risk and return trade off in taking investment decision (Masulis, 1980). Correspondingly, if share of Aguia and Pomba is traded in the perfect market it will significantly influence the share prices of these companies because the businesses are identical in its characteristics and operation but the capital structure of the company is un-identical. In the general context, investors or the shareholders are likely to have the perception that with the extrinsic use of debts in the capital structure of the business will have an adverse impact over the valuation of stock. In this regard, it can be concluded that with the increase in interest than the earning per share shareholders will decrease and lower the value of share. In the similar context, Buigut & et. al. (2013) in their study to measure the relationship of capital structure and share prices revealed the fact that debt, equity and gearing ratio are the key determinants of the share price for a company. Moreover, gearing ratio and debt portion in the capital structure will have positive impact over the share prices; on the other hand, equity structure will unconstructively affect the prices of the share. Besides, having the availability of necessary information in the hand, investors will be able to make rational decision over which security is highly profitable. Technical tools such as Relative Strength Index (RSI) and moving average indicators significantly help in taking sound investment decision. In this regard, various available mechanisms to measure and compare the performance of the company will help the investor to determine where the securities are overpriced or underpriced and reduce the associated risk. Besides, the available indexes will also reflect the security profitability position in the long period and short run prospect through enabling the investors about the most risky security. Besides, various chart and tables also indicates and navigate the positioning of Aguia and Pomba securities in different scenarios. However, capital structure of the company is not the only determinant of pricing of the share but also other forces such as future prospect of investment, trend, market position, and economy among the other factors inclusively derive the movement of share prices of company. Moreover, the different market indicators along with the performance will significantly help the investors to take the rational decision, which could make investors to either invest in stock of Aguia or Pomba or rather in both the securities. Nevertheless, the effect of considerable change in the price will be highly affected through the demand and supply of Aguia or Pomba securities, as the demand of any of this security rises above its supply the movement of the price of security will correspondingly be raised (Gitman & et. al., 2008). 3. Capital Structure Decisions Often Referred To As ‘The Capital Puzzle’ Researches of corporate finance reveal that Capital structure decision is one of the major fundamental issues that are being faced by the executives as well as by the management level of a corporate organisation. The capital structure of an organisation represents the combination of common stock, debt and preferred stock that are used for long term financing for the organisation. Generally, debt capital and equity are considered as the two major form of long term funds for a company. Capital structure therefore shows the way a company finances for the various activities and operations through utilising various sources of funds. The capital structure of every organisation varies on the basis of certain factors including the size of the organisation, its type, asset structure, company growth, profitability, liquidity and risk involved in the company. However, the corporate finance is referred to as the specific area of finance that are concerned with the various financial decisions made by the corporation as well as the tools and analysis that are used for making various decisions. The overall discipline may be divided into short term and long-term decisions as well as techniques along with its primary goal of maximizing the corporate value besides managing the financial risk of the company (Myers, 1984). The main reason for managing the capital structure of a company is to combine various financial sources for maximizing the shareholders wealth as well as reduce the cost of capital of the company. Therefore, it is the responsibility of financial manager to design a capital structure provides optimal results for the success of the company. The capital structure decision made by the manager is considered significant because the values of the company are being affected and it involves the trade-off between the return and risks of the company. Increase in the debt will result in enhancing the risk of the company as well as the expected return. More the risk, higher is the debt and this may result in decreasing the price of stock of the company, while on the other hand the expected return of the stock price is increased. Therefore, rationale behind the optimal capital structure decision is to establish a balance between the return and the risk (Barclay & Smith, 2006). However, there are various theories of capital structure decisions that have led to justified results. There are researchers who opined that neither the capital structure nor the dividend policy influences the corporate value. Whereas, others argue that main focus of the financial manager is to make stable tax shield of higher debt against the possible higher costs of the financial distress. Majority of the researchers are in favour with the idea that the financial decisions are generally interrelated with the signalling effects. This is represented by the decrease in the price of stock with respect to the offerings of the common stock and increase in the price of stock with respect to the leveraged re-capitalization. There are four major theories in the corporate finance that highly influences the capital structure decisions. However, the conflict between these theories in making capital structure decisions is considered as the capital puzzle. The theories are Modigliani-Miller capital structure Theory, Trade-off theory, Pecking order theory and Agency theory (Myers, 1984). Modigliani-Miller Capital Structure Theory The MM theory is considered as the oldest and the first theory related with the capital structure decisions. As per the theory, it is stated that the value of a corporation is not being affected by the capital structure decisions. Rather the market value of a company is ascertained according to the earning power as well as the risks associated with various assets of the company. Therefore, the corporate value does not depend upon the way a company chooses for financing the investments or allocate dividends to its shareholders. However, the MM theory is based on certain assumptions that include: There should not be any transaction cost There should not be any bankruptcy cost Tax should not exist Scope of selling the assets at market value in case if the company suffers from bankruptcy Using the debts does not affect the Earning Before Interest and Tax (EBIT) The borrowing costs for the investors and the company should be equal Both the investors and the corporations should have access to the similar information Therefore, the value of the corporation is determined on the basis of the real assets and not on the securities and dividends that it issues to its shareholders. However, the theory is not applicable for the real world corporations because in real world there are transaction costs, taxes, difference in the borrowing costs and bankruptcy costs. As per the theory, the weighted average cost of capital of the corporation is constant even with the changes in the capital structure of the company. Thus, the company will not gain any tax benefit from the interest payments, irrespective of the ways it borrows and therefore there will not be any changes to the weighted average cost of capital. As WACC is not benefited due to the increased debts, the stock price of the company is not influenced by the capital structure. For this reason, the capital structure decisions are considered irrelevant to the stock price of the company (Luigi & Sorin, 2015). Trade-off Theory According to the Trade-off theory, it is stated that a corporation should borrow only when the marginal value of the tax shields over further debts are compensated by the rise in the current value of the potential costs of financial distress. A corporation is considered to have debt to a certain limit and the tax shields from the further debts are equivalent to the cost of financial distress. This however results in the cost of bankruptcy and therefore generates the agency costs, which arises due to the existence of doubt in the creditworthiness of the company. There are various factors included in the trade-off theory while determining the capital structure decision of a corporation. These factors include the cost of financial distress, agency cost and taxes. The optimal debt is considered to be achieved only when the tax shield would reach the highest amount of cost of financial distress. As per the trade-off theory, the profitability of the corporation and the capital structure are positively interrelated to each other. The theory also states that the profitable companies would use more debts as they possess the possibility of lower risk of bankruptcy and high burden of tax. However, Luigi & Sorin (2015) argued that inverse correlations exist between the financial leverage and profitability of corporation. Generally, in short run the companies have a fixed investment and dividends and thus if the debt financing is made the primary mode of external financing, the variations in profitability would be negatively correlated with the variations in leverage (Luigi & Sorin, 2015). Pecking Order Theory According to the Pecking order theory, it is assumed that the main goal of any company is to maximize the wealth of the shareholders. The theory thus states that there is an existence of hierarchy in selecting the financial source by the company. A corporation will not choose external financing rather it will prefer internal financing from the retained earnings of the company. However, if the corporation requires external financing, it may opt for the securities having minimum risks. Constant dividend policies should be possessed by companies based on which it will provide a steady amount of dividend payment to its shareholders. However, the amount of dividend payable to the shareholders does depend upon the profit or loss earned by the corporation. As a result of the fluctuations in the profitability, dividend policies and investment opportunities, it will be beneficial for the company to make use of the portfolio of investment in order to predict the insufficiency of cash. One of the major problems for the capital structure decisions is the unequal distribution of information between managers and investors. Thus according to this theory, the financial manager of a corporation will make capital structure decisions based on maximizing the wealth of the shareholders (Luigi & Sorin, 2015). Agency Theory As per the agency theory, the management of a company is considered as the agents of the investors and shareholders. For , there are certain costs that are incurred by the company for performing various controlling activities of the company known as agency costs. Thus, the theory states that the capital structure decision of a company is based on the agency cost that consists of the costs of equity issue as well as the cost of debts. As a result of the existence of conflict of interest between the managers and the owners of a company, the agency cost exists (Luigi & Sorin, 2015). Therefore, due to the conflicts of interest among various theories, the capital structure decisions are generally considered as the “Capital Puzzle”. References Barclay, M. J. & Smith, C. W., 2006. The Capital Structure Puzzle: The Evidence Revisited. Journal of Applied Corporate Finance, Vol. 17, No.1, pp. 16-17. Buigut, K. & et. al., 2013. The Effect of Capital Structure on Share Price on Listed Firms in Kenya: A Case of Energy Listed Firms. European Journal of Business and Management, Vol. 5, No. 9, pp. 29-35. Gitman, L. J. & et. al., 2008. Fundamentals of Investing. Pearson Higher Education AU. Luigi, P. & Sorin, V., 2015. A Review of the Capital Structure Theories. Journal, pp. 315-320. Masulis, R. W., 1980. The Effects of Capital Structure Change on Security Prices. Journal of Financial Economics Vol. 8, pp. 139-178. Myers, S. C., 1984. The Capital Structure Puzzle. The Journal of Finance, Vol. 39, No. 3, pp. 575-592. Ogilvie, J., 2009. Financial Strategy. Elsevier. Read More