Accounting and Finance - Assignment Example

Assignment Accounting and Finance of the of the Contents Question 3 Question 2 4 Decision of a rational investor and effect on share prices 4 Decision of a rational investor 6 Question 3: Why capital structure decisions often are referred to as ‘the Capital Puzzle’? 8 Introduction 8 Discussion 8 Conclusion 12 References 14 Question # 1: Vg= Vu + Dt Vg=Earnings in an Pumba /KU + Dt Vg=2,000,000/1,300,000(w-1) + 4.9(w-2) Vg=15.384615m+4.9m Vg=20.284615m Equilibrium price per share = 20.284615m / 20m =1.014 per share W-1: Cost of equity= total dividends payable to shareholders Cost of equity= 2,000,000*.65=1,300,000 W-2: Dt=14m*.35=4.9m Question 2 Decision of a rational investor and effect on share prices A perfect market competition exists when the information is even across the market about the prices and risks associated with the decisions. A perfect market further pertains to a free or boundary less market for new entrants to become a part of it and existing ones to move away without any restrictions. In such a market, there is limited to no space of having control over the prices of products and usually, low prices to consumers are charged due to vigorous competition. Firms compete by price cuts and development of their offerings as unique or lucrative for consumers remaining in the same homogenous product market. In a perfect market, it is assumed that no taxes are imposed and interest rates are derived by the market demand and supply function (Layton, Robinson & Tucker 2012, p. 895). If we consider a perfect competition in the market, an investor would be indifferent of the capital structures followed by each firm. The M&M theory suggests that in a tax-free economy, capital structure becomes irrelevant to the value of the firm. Some assumptions that the theory makes include: Investors are concerned about the returns or future cash inflows. Hence, they expect the same whether the investment is made in bonds or equity. As a result, investors would make decisions based on the firm’s value. Debt and equity components are traded in perfect markets, such that the transaction costs, taxes and bankruptcy costs are nil. Competitors, in a perfect competition market cannot set their own price for similar product offerings. Moreover, investors do not bear the burden of transaction costs leading to their indifference to moving funds from one company to the other. The borrowing and lending is done at a risk-free rate Agency costs do not exist in perfect market conditions i.e. an assumption of integrity and loyalty is made regarding management to act in the best interest of shareholders at all times. Financing decisions do not have any impact on the value of the firm (McMenammin 1999, p. 457) But, when tax effects are added to the M&M theory, the following characteristics are found: On the inclusion of taxes, tax shield on interest makes debt financing more attractive for the investors leaving better cash flows for them to receive. The tax shield Reduces the cost of debt financing as the tax effect is eliminated as Kd(1-t) and The value of the firm is increased due to tax relief. Capital structure becomes relevant to the rational investors decisions. Hence, a summary and mathematical representation of these two scenarios provides that: Without taxes: Vg = Vu While, with taxes: Vg = Vu + tD Where, Vg is Value of a geared firm Vu is Value of an un-geared firm tD is tax shield Decision of a rational investor Keeping an eye on the above discussion, it can be concluded that investors would go for an geared company if they are interested in the investment returns. In the case provided, Aguia seems to be a more lucrative opportunity for the investors. Aguia, being a geared company will have lower cost of capital and have higher expected returns in future. Since, it was assumed and provided above that investors are only concerned about the future cash flows, a rational investor would prefer a geared firm i.e. Aguia over the un-geared firm i.e. Pomba, in our case. In addition, a rational investor can make decision on future prospects and plans of the management. Let’s assume that Pomba plans to switch toward debt financing, it might be a more attractive option compared to Aguia as it has higher profit margins comparatively. Hence, financing arrangements in a tax-paying economy do affect the decisions of the investors and their choice of investments. On the other hand, if we assume an investor having limited or no knowledge of financing arrangements and the tax effect, the decision of the investor will be altered. For people outside finance world with limited to no knowledge of the financial impacts would consider debts as an evil and a burden on their finances. Hence, the reality will be different in their perception of their future cash flows. They would prefer equity based financing arrangement and a company with more equity component in the capital structure. The tax shield on interest would make the geared company more attractive hence increasing the demand of its shares. In our case, rational investors would be interested in purchasing the shares of Aguia (geared firm) over Pomba (un-geared firm) in an attempt to pursue the tax benefits. This increase in demand for Aguia’s shares would bring an upward pressure to its shares. Hence, Aguia’s shares are expected to rise in prices in a perfectly competitive market with rational investors. This effect would mainly be due to the market functions of demand and supply rather than the growth of the firm. Question 3: Why capital structure decisions often are referred to as ‘the Capital Puzzle’? Introduction The capital structure can be defined as the use of different source of the funds by the company in order to finance and manage its overall operations. There are different sources of the funding which can be considered by the companies such as the long term debt, common equity, preferred equity and the short term debt. The debt usually comes in the form of the bond issues and the long term notes payable. When the company analyzes its capital structure it usually considers the long term debt and the short term debt. Similarly, the financial managers also have to consider that how much of the financial requirements should be met from debt and how much from the equity. Thus, the capital structure of the company is mainly the decision about the debt-to –equity ratio of the company (Myers, 2010, p.574). The capital structure decisions are referred to as the capital puzzle owing to the complexities involved in maintaining a suitable capital structure for the company. Discussion It is always difficult for the company to maintain a proper balance between the debt and equity. It is commonly believed that the use of the debt creates high risk for the company where is the finances obtained from the issuing of the shares are less risky. Those companies which finance their requirements using the equity are low levered as compared to the firms that use debt and are high levered. The capital structure decisions vary from organization to organization. However, it has been observed that most of the new firms rely on the debt financing. This is the major reason that most of the new firms are risky. The two major source of the capital structure are the debt financing and the equity financing. Both these methods have some advantages as well as disadvantages. An important advantage of the debt financing is that it allows the tax benefit to the organization. Higher the tax higher will be benefit to the organization. Similarly, the debt financing reduces the burden upon the managers as they will be less concerned about the stockholders due to which their efficiency will also increase (Rauh & Sufi, 2010, p.21). The disadvantages of the debt financing include the higher business risk as the cost debt financing is higher as compared to the equity financing. Similarly, due to high reliance on the debt financing the company loses the future financing flexibility. Furthermore, when the company obtains a debt then it has to make the fixed payments in the future to the lenders. Similarly, the fixed payments are tax deductible. Moreover, the failure of the company to make the fixed payments against the debt can be highly risky as it might create a default risk. Moreover, the firm may lose its control in case of the non-payments against the debt (Myers, 2010, p.574). Thus, debt creates an obligation for the firm which it needs to fulfill. An important measure which is used in order to decide the capital structure of the firm is the cost of capital. It comprises of different components of the financing such as debt, equity, preferred stock and the cost of the each component. The cost of debt is actually the market interest rate which the firm is willing to pay on its borrowing. It mainly depends on three components which include the firm’s tax rate, general level of interest rates and the default premium (Myers, 2010, p.574). The capital structure decisions are considered as the capital puzzle the company faces difficulty in managing the optimal capital structure. The financial managers face difficulty in deciding that how much and from which sources they should borrow. Similarly, the financial managers have to decide that what proportion of the debt, preferred stock and common stock should the company use. The major objective of the financial manager is to decide such a mix of debt and equity which might result in the maximization of the shareholder health or should increase the price of the share (Robb & Robinson, 2012, p.34). Thus, increasing the price of the shareholder is the major objective of company which it intends to achieve by maintaining a suitable capital structure. Though the maintenance of the capital structure seems to be a very easy task but it is very difficult to maintain such a capital structure which increases the stock price of the firm. The capital structure decisions are very risky and the financial manager has to be very cautious in deciding such capital structure which is viable for the company and at the same time increases the market price of the shares for the company. An important tool used by the financial managers in order to decide the optimal capital structure is the use of the WACC (Weighted average cost of capital). With the help of the WACC, the company can decide a suitable capital structure. WACC varies with the mix of the different securities in the capital structure (Robb & Robinson, 2012, p.34). The change in the mix of the different securities in the capital structure of the company will also change the WACC. Usually such mixture of the different securities are selected which result in the minimum WACC. The capital structure in which the WACC is minimum usually results in the higher stock price as compared to the capital structure in which the WACC is higher (Margaritis & Psillaki, 2010, p.621). Leverage is also an important term used in the capital structure. It means that using that sources of funds which have a fixed cost. Generally it is considered as similar to the use of debt in the capital structure. An important responsibility and which is complex too is to decide that how much leverage should be there in the organization. This is an important question which the finance manager must address. A higher debt in the capital structure of the firm might ensure a higher rate of return in the good economic times but at the same time it might increase the riskiness of the earning streams of the firm. Thus, an important feature of the capital structure decisions is deciding a tradeoff between the risk and the return is such a way that the market price per share increases significantly (Lemmon & Zender, 2010, p.51). The capital structure decisions are taken differently by the different firms. Most of the corporations have low debt to asset ratio. The change in the financial leverage affects the value of the firm. Furthermore, the capital structures of different industries are different. There are many companies which have a target debt ration and they remain within that target. The target debt ratio is dependent on many factors such as taxes, the type of the assets, financial slack and the operating income of the firm. The financial manager of the organization always strives to maintain the optimal capital structure at which the share price is maximized and the cost of the capital is minimized. The capital structure of the firm can be maintained effectively if it is evaluated on a constant basis. The financial manager of the company should analyze the capital structure of the company over time. The capital structure of the company should be compared with the competitors having the similar business risk (Lemmon & Zender, 2010, p.51). Similarly, in order to devise the optimal structure for the company the analysts also evaluate the corporate governance of the firm. Additionally, the industry in which the firm operates is also carefully analyzed by the firm. The analysis of the regulators under which the firm operates is also very important before deciding the capital structure of the firm. Usually it happens that the regulators place certain limitations on the capital structure of the company beyond which the company cannot exceed. The capital structure decisions are in really like a capital puzzle in which the company has to be very careful in deciding the different factors. The financial manager has to perform very difficult task. He has to devise such a strategy which not increases the value of the share price of the firm but also decreases the cost of the capital for the firm. Furthermore, the capital structure decisions are also very risky. Though there are some tools with the help of which the capital structure of the firm can be measured yet these tools do not ensure that adopted capital structure will be favorable for the company (DeAngelo et al., 2011, p.235). The capital structure decisions of the firm can also be affected by the many external factors such as by the role of the regulators and the economic condition of the country in which the firm operates. There are also many other risks that are involved in the decision of the capital structures which should also be carefully analyzed before deciding the capital structure of the organization. The capital structure of the organization is directly associated with the profits of the organization. The capital structure that the company decides will eventually decide the profitability of the company. The capital structure which has low risk will significantly increase the prices of the shares which in turn increase the profitability of the organization (Rauh & Sufi, 2010, p.21). Due to the complexities involved in the capital structure decisions, many of the companies take the opinion of the external analysts and financial experts before deciding a financial structure of the company. Most of the companies usually have the lower debt as compared to the equity. Therefore, there is a lower proportion of debt in the capital structure of the different companies. Conclusion The capital structure decisions are very complex and must be taken carefully. Most of new organizations fail due to the inefficient capital structure decisions. Therefore, financial managers along with the other external analysts and experts should develop such a capital structure which is favorable for the company. Thus, the capital puzzle can be solved by carefully selecting such a capital structure which is less risky and the cost of capital of which is lower. The lower cost of capital will increase the prices of the shares of the firm and the profitability of the organization will increase. The Miller and Modigliani theory is of paramount importance in understanding the effects of capital structure, taxes and interest effects on the decision making of investors. The theory also provides ample evidence on the effects of prices for such transitions in distributable profits or future cash flows for the investors due to changing market forces i.e. demand and supply functions. While making capital structure decisions, the main idea is to analyze the tax rules, interest rates and market conditions. Under perfect market conditions, the investment decision should be more inclined towards the debt financing option. The reason is stated explicitly by the Miller and Modigliani theory. References DeAngelo, H., DeAngelo, L., & Whited, T. M. (2011). Capital structure dynamics and transitory debt. Journal of Financial Economics, 99(2), 235-261. LAYTON, A. P., ROBINSON, T. J. C., & TUCKER, I. B. (2012). Economics for today. South Melbourne, Vic, Cengage Learning. Lemmon, M. L., & Zender, J. F. (2010). Debt capacity and tests of capital structure theories.pp.51-57 Margaritis, D., & Psillaki, M. (2010). Capital structure, equity ownership and firm performance. Journal of Banking & Finance, 34(3), 621-632. MCMENAMIN, J. (1999). Financial management: an introduction. London, Routledge. Myers, S. C. (2010). The capital structure puzzle. The journal of finance, 39(3), 574-592. Rauh, J. D., & Sufi, A. (2010). Capital structure and debt structure. Review of Financial Studies, hhq095.pp.21-28 Robb, A. M., & Robinson, D. T. (2012). The capital structure decisions of new firms. Review of Financial Studies, hhs072. Pp.34-39 Read More