Corporate Finance and Different Approaches - Research Paper Example

Corporate finance Table of Contents Table of Contents 1 Introduction 1 Modigliani & Miller Theorem for Capital Structure 2 Net Income Approach 6 Net Operating Income (NOI) Approach 8 Traditional Approach 9 Capital structure of BMW and Bybox Holdings Limited 11 Conclusion 13 Introduction Capital is the lifeline of business. A business may have plans for expansion but such plans can materialize only if it has the necessary financial back-up. If there is dearth of finance, then even a well drawn up business strategy cannot be executed. A business desiring to establish itself as a market leader must first of all chalk out the financial benefits arising from this initiative and then the manager has to decide the ways of raising the necessary finance. Finance can be raised from various sources like equity and debt. If the company has cash surpluses then it can plough back the retained earnings for financing the investment plans. These sources of finance differ in various ways in terms of obligation, tax system and the cost of issue (Lumby & Jones, 2003, pp.380). The cost of debt is low as compared to the cost of equity. Therefore inclusion of more debt in the capital base lowers the overall cost of capital of the business and raises the value of the firm. However, the capital structure theory propounded by Miller and Modigliani states that frictionless market is characterized by no taxes, nil transaction costs relating to the raising capital or bankruptcy, the level of debt used by the business in the capital base does not impact its value. This is commonly referred to as “capital structure irrelevance” theory. The issue of cheap debt instead of raising costly equity raises the return demanded by the equity investors thus keeping the weighted average cost of capital (WACC) of the company same. But in the real world, altering the mix of debt and equity in the capital structure impacts the taxes that the company has to pay, thus influencing the value of the firm (Rajan & Zingales, 1998). The theories of capital structure explain the link between the cost of capital, capital structure and company valuation. Important theories include Net Income Approach, Net Operating Income Approach, Miller & Modigliani (MM) approach and Traditional approach (Jain & Khan, 2005, pp. 16.26). Modigliani & Miller Theorem for Capital Structure Franco Modigliani and Merton Miller are highly esteemed for their contribution to the theories of financial economy. Both won the noble prize for their concept of capital structure. Their theorem on capital structure is known as MM theorem. This theorem states the relationship between cost of capital, capital structure and the valuation of a company. The cost of capital and the valuation of the company are influenced by the capital structure. The capital structure of any company includes only two types of capital i.e. owned capital or equity and loaned capital or debt. In order to maintain the leverage, cost of capital and value of firm; it is important to construct the capital of company properly. MM approach closely resembles the net operating income approach and both the approaches challenge the traditional view of capital structure. Modigliani Miller theory opines that the value of any firm remains unaffected with the changes in debt and equity. According to this theory, it is not possible to form an optimal mix of capital that includes equity and debt therefore any choice of capital mix incurs the same cost of capital. “The independence of cost of capital argument is based on the hypothesis that regardless of the effect of leverage on interest rate, the equity capitalisation rate will rise by amount sufficient to offset any possible saving from the use of low cost debt” (Thukaram. p.517). This theory considers that the cost of capital is nothing as compared to the capitalisation rate which is based on the equity of that firm. This theorem is also known as the irrelevant principle of capital structure. Before stating such theory, Modigliani and Miller assumed certain conditions under which this theory is applicable. This theory holds certain assumptions. These are mentioned below. 1. The market is efficient where investors are rational and they are free to buy and sell stocks. They can also borrow and invest it without any restriction. 2. The DP Ratio (dividend payout ratio) is 100 percent. 3. There are no corporate taxes. 4. As the market is perfect, the information is also perfect and all the investors’ expectations are same. 5. No bankruptcy and transaction cost are involved. 6. The value of the firm is independent of the capital mix. 7. All the firms are classified as “equivalent risk class or homogeneous risk class”. This means that the returns are associated with the same class of risk (Khan & Jain. p.15.10). The theory includes two types of situations. The first situation states the value of the firm when no taxes are levied. It states that “Assuming that there are no taxes paid, the value of a firm is independent of its capital structure. In other words, if a firm does not pay any taxes, then free cash flow is independent of leverage (Ramesh. p.76)”. Here the value of the levered firm (VL) and the value of the unlevered firm (VU) are equal i.e. VU = VL (Krannert School of Management. n.d). The theory that doesn’t take taxes into consideration has three basic proportions. Firstly, the cost of capital and the value of firm are constant for any ratio of capital mix. The second proposition is that cost of equity and the cost of capital are equal. This proposition states that increase in the debt-equity ratio will lead to the increase in the return on equity. As risks are related to the equity holders of a company with debt, the increasing leverage affects the cost equity (Megginson. p.407). Therefore the equation will be: r1 = r + (r – rd) D/E. This equation shows that the return on equity (r1) is dependent on the debt equity ratio or the leverage of the firm (D/E). The last proposition is that the investment cut-off rate is independent of the way financing is conducted and hence the weighted average cost of capital is equal to the cost of equity (WACC=r1). Modigliani and Miller have explained the concept of arbitrage in order to develop the theory. According to them, arbitrage occurs when two identical assets like stocks of unlevered and levered company are sold at different prices. In such a condition; the arbitrageurs play an important part. They buy the low priced stock and then sell it in a different market where they get higher prices for these low priced stocks. Primarily, the arbitrage process involves the operation of balancing. While valuing the two identical firm i.e. levered and unlevered, arbitrage process balances the value of both firms and makes it equal. The investors who hold the stocks of higher valued firm will sell their stock and will buy the stocks of lower valued firm. This will bring down the prices of high valued firm and increase the prices of low valued firm; thereby making both the firms equal (Brigham & Ehrhardt. p.607). The above theory is called irrelevant as some of the assumptions are irrational. The absent of corporate taxes is illogical because it is an important factor as the financial charges like interest is deducted before the payment of tax. Later, Modigliani and Miller formulated their theory which includes the existence of corporate taxes. Except the taxes, all the other assumptions have remained unchanged and they have brought some changes in their theory. The proposition 1 is modified after adjusting the taxes and the equation now stands “VU = VL + (tax rate*value of total debt).” The proposition 2 is also changed and the equation is “r1 = r + (r – rd) D/E*(1 – tax rate)”. The MM theorem forms the basis of modern financial structure of corporate. The theory is formulated with such assumptions that seem to be irrelevant in the financial world. This theory creates a condition where the financial decisions related to its capital mix of the dividend policy do not affect the value of the firm. The assumptions of this theory mainly deal with the systematic information and “Modigliani Miller theorem that suggests there is no systematic relationship between the financing decision and the value of the firm” (Leland & Pyle. 1977). Joseph E. Stiglitz, in his paper “Why Financial Structure Matters” analysed the reasons of MM theory is important, in spite of the fact that optimal capital mix depends on tax rates. He explained that the firms may differ in the way the treat their clientele, but they never differ in a marked way from the one predicted by the MM theory (Stiglitz(a) 1988). The MM theory has proved very helpful while making decisions for financial structure and dividend policy. Modigliani Miller’s theory argued that if any firms financial decisions influences the overall cost of capital, this theory will explain the necessary condition by means of which it can be overcome. When Modigliani Miller modified the theory and included the corporate tax, he pointed out that the differential treatment of tax of debt and equity did matter in the corporate financial policy. Initially Joseph E. Stiglitz was confused with this theory and he decided to test it. He in his article, “Modigliani, the Modigliani-Miller Theorem, and Macroeconomics” commented that “As I worked on the problem, the first result was to show that the Modigliani-Miller theorem was far stronger than they had realized” (Stiglitz(b). n.d). This theory deals with taxes, and states that in the presence of corporate taxes, the debt capital has a particular advantage as the tax is deducted after the interest paid on total debt capital. This causes a decrease in leverage and the overall cost of capital. In this case the value of the levered firm will become higher than the unlevered firm. Therefore, in order to increase the value of the firm, the financial decision makers have to consider the capital structure. Net Income Approach As per this approach, by minimizing WACC the business can increase the firm’s value and raise the market price of its equity. This can be done by employing more debt in the capital base. It is mainly based on the assumptions- The cost of raising debt is cheaper than the cost of issuing new equity. The corporate taxes are nil. Investors risk perception is independent of the firm’s debt mix. (Palanivelu, 2007, pp.432; Batyabal & Sharma, 2008, pp. 157). The studies conducted by the researchers show that alterations in the capital base effects the cost of capital thereby impacting the firm’s value. The table below shows that an increase in the debt-equity ratio lowers the cost of capital- Financing mode Weight (W) Cost of capital (K) (%) W*K (%) WACC (%)   Equity 0.6 11 6.6     Debt 0.4 5 2 8.6               Equity 0.4 11 4.4     Debt 0.6 5 3 7.4   From the above table it is clear that raising the debt-equity ratio of the company lowers the WACC. In the first case, when the weight of equity in the capital base is 60% and that of debt is 40% the WACC is 8.6%. In the second case, when the debt-equity ratio is reversed i.e. the weight of equity is lowered to 40% and that of debt is increased to 60% the WACC falls to 7.4%. A low discounting rate raises the value of the firm (Groppelli & Nikbakht, 2006, pp.243). This is in line with the net income approach which states that a rise in the debt-equity ratio lowers the discount rate thereby raising the firm’s value. Net Operating Income (NOI) Approach According to this theory the WACC and the firm’s value remains constant with any changes in the financial leverage. This is due to the reason that the low cost of debt is off-set by an increase in the return required by the equity investors (Kuhlemeyer, 2004). NOI approach as advocated by David Durand states that the firm’s value depends on the net operating income and risk associated with it implying that the leverage used by the firm does not influence the business risks or net operating income. The use of varying levels of debt and equity merely changes the income distribution between debt and equity. Source: (Kuhlemeyer, 2004). The above graph shows that as the debt-equity ratio increases the benefits arising from the use of high debt component is wiped out by the rise in the equity capitalization rate thus nullifying the benefits accruing from increase in the debt (Bose, 2006, pp.69; SatyaSekhar, 2009, pp. 147). Traditional Approach According to the traditional approach of capital structure it is possible for the management to increase the firm’s value by using judicious amount of debt. Here the company management thrives to minimize the cost of capital and maximize the firm’s value. This approach also holds that the amount of debt employed by the company impacts the valuation of the business and that of its shares (Grant, 2003, pp.48). Source: (Kuhlemeyer, 2004). The theories discussed above show that there exists a link between the capital structure of the business and its value. The debt mode of funding is cheap as compared to equity and it does not dilute the ownership of the business. Moreover, the interest costs are allowed as tax deductible expense that helps the company in lowering the tax burden (Pinteris, 2003). The use of equity does not entitle the business to any tax benefits as the dividend cost is not allowed to be treated as a business expense. In the evaluation of an investment plan the management discounts the forecasted cash flows using the required rate of return. Only, if the expected return is more than the required rate of return or the costs that the business has to pay to the providers of funds, the business plan is accepted. The cost of finance in turn depends on the source of funding. Like a company relying heavily on equity has a high cost of funding and the company using optimal amount of debt has a low cost of capital. If the firm is able to employ the right mix of debt and equity in the capital base the overall cost of capital goes down thus softening the selection criteria of business proposition. This means that merely a business strategy is not enough to ensure success; the use of optimal sources of finance is an important barometer of a financial viability of an investment. Capital structure of BMW and Bybox Holdings Limited The long term liabilities of BMW have increased significantly over the last eight years. In 2001 the company reported long term liabilities of £48.930 million that fell marginally by approximately 10 percent in the year after to £43.495 million. After this the long term liabilities of the company increased nearly threefold to £90.611 in 2005. In the following year this amount fell by more than thirty percent to £59.728 million. After this there has been a steady rise in the long term liabilities of BMW with the company reporting long term liabilities of £146.655 million in 2008. The company reported shareholders funds of £197.812 million in 2001which increased thereafter to £223.023 million. This amount fell significantly in the following year to £97.006 million. The shareholders funds maintained an uptrend thereon. This amount increased sharply to £826.306 million in 2008. From this it can be inferred that in the company’s capital structure the debt component is limited whereas equity is high. This indicates that the company is relying more on equity for funding its business activities. Bybox Holdings Limited had long term liabilities of £0.032 million in 2005. In the following year the company increased its debt exposure by nearly seven times to £0.229 million. A company generally raises debt for financing the investment plans. As raising equity is a costly and time consuming process the firms prefer to use the debt mode of funding for financing investments. This is also evident from the sharp rise in the debt position of Bybox Holdings Limited to £0.658 million in 2007. But care must be taken to maintain debt at ideal levels. An injudicious use of debt raises the cost of capital for the business. This is because the businesses that are highly leveraged are given a low credit rating by the credit rating agencies, thereby pushing up the debt costs (Kronwald, 2010, pp.9). This can be one of the reasons for the reduction in the debt component of Bybox Holdings Limited in 2008 to £0.457 million. However the equity component of the company has moved up steadily over the years. The total equity of the company was £2.081 million in 2005 which increased by more than fifty percent to £3.765 million in 2008. This shows that the percentage of debt used by the company was low initially but kept on rising thereafter and reached the peak level at 19.40 percent in 2007, following which the company reduced it significantly to 10.82 percent in 2008. As compared to debt the percentage of equity employed by the company has always remained high. The proportion of equity was fairly high at 90.68 percent and 98.49 percent in 2006 and 2005 respectively. However, there has been a decline in the equity mix of the company in 2008 and 2007 suggesting inclusion of higher debt in the capital base. An analysis of the capital structure of BMW and Bybox Holdings Limited shows that both the companies have limited proportion of debt in their capital base. The amount of debt has increased rapidly over the years for both the companies as is evident from the rise in the percentage of debt in the capital mix. However both the companies place more importance on debt as reflected from the financial statements. Conclusion The most important business decision is to determine the composition of the capital mix. The capital structure of a company includes debt and equity. The ratio of debt and equity is a very important factor which determines the leverage, profitability and the value of a firm. Therefore to construct and maintain the optimal financial structure is the foremost task of policy makers of a firm. When a business decides to invest in projects it needs to acquire the fund from different sources. In such situations, determining the proportion of debt and equity is important. In this paper three theories of capital mix have been explained and each of them states its theory for financing. Generally, in case of a risky project, the use debt increases the risk, as firms are liable to pay the interest before deducting the tax even if the firm incurs a loss. In this case the use of equity is considered to be safe. The MM theory which included corporate tax explains that the levered firms get the benefit of tax shield as interest is paid before the tax deduction. Less use of equity capital helps to decrease the cost of capital and the value of firm increases. These theories help to determine the equilibrium where the cost of capital becomes least and the leverage is decreased. Reference Batyabal, S. Sharma, P.O. 2008. Ugc-Net/jrf/slet Commerce. Upkar Prakashan. Bose, C.D. 2006. Fundamentals of Financial Management. PHI Learning Pvt. Ltd. Brigham, E.F. & Ehrhardt, M.C. 2008. Financial management: theory and practice. Vol.12th Cengage Learning. Grant, L.J. 2003. Foundations of economic value added. John Wiley and Sons. Groppelli, A.A. Nikbakht, E. 2006. Finance. Barron's Educational Series. Jain, K.P. Khan, Y.M. 2005. Basic financial management. Tata McGraw-Hill. Khan, M.Y. & Jain, P.K. 2004. Financial Management: Text, Problems And Cases. Tata McGraw-Hill. Krannert School of Management. No date. Capital Structure Without Taxes,The Modigliani-Miller Propositions. [Online]. Available at http://www.krannert.purdue.edu/faculty/Rau/mgmt610w/ftp/CapitalStructure/MMNoTaxes.pdf. [Accessed on June 9, 2010]. Kronwald, C. 2010. Credit Rating and the Impact on Capital Structure. GRIN Verlag. Kuhlemeyer, A.G. 2004. Capital Structure Determination. Pearson Education Limited. Available at: http://www.google.co.in/url?sa=t&source=web&cd=5&ved=0CCUQFjAE&url=http%3A%2F%2Fwps.pearsoned.co.uk%2Fwps%2Fmedia%2Fobjects%2F1670%2F1710247%2F0273685988_ch17.ppt&ei=6yoPTJWQBY-_rAeFweHFCQ&usg=AFQjCNH4XAgBMUAt39rKEXqiPWcrmXGx7Q [Accessed on June 9, 2010]. Leland, H.E. & Pyle, D.H. May 1977. Informational Asymmetries, Financial Structure, And Financial Intermediation. The Journal of Finance, Vol, Xxxil No. 2. Lumby, S. Jones, C. 2003. Corporate finance: theory & practice. Thomson Learning. Palanivelu, R.V. 2007. Accounting for Management. Firewall Media. Pinteris, G. 2003. Benefits and Costs of Debt. 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Prentice Hall. http://books.google.co.in/books?id=OzkX7v7wQBEC&pg=PA432&dq=net+operating+income+approach+of+capital+structure&hl=en&ei=bCsPTJqWFI6xrAfftNTUCQ&sa=X&oi=book_result&ct=result&resnum=10&ved=0CFcQ6AEwCQ#v=onepage&q=net%20operating%20income%20approach%20of%20capital%20structure&f=false http://www.google.co.in/url?sa=t&source=web&cd=5&ved=0CCUQFjAE&url=http%3A%2F%2Fwps.pearsoned.co.uk%2Fwps%2Fmedia%2Fobjects%2F1670%2F1710247%2F0273685988_ch17.ppt&ei=6yoPTJWQBY-_rAeFweHFCQ&usg=AFQjCNH4XAgBMUAt39rKEXqiPWcrmXGx7Q http://books.google.com/books?id=RRVOz34gpPcC&pg=PA323&dq=Lumby,+S+and+Jones,+C+(2003)+Corporate+Finance:+Theory+and+Practice&lr=&cd=3#v=onepage&q&f=false Lumby, S and Jones, C (2003) Corporate Finance: Theory and Practic Read More