Capital Structure Decisions Evaluating Risk and Uncertainty - Coursework Example

Financial Management By Lecturer’s and M&M formula M & M theory refers to a financial theory that states that the firm’s market value is entirely determined by its power with regards to earning as well as the ultimate underlying assets’ risk, and is often independent of how it chooses to distribute dividends or finance its extensive investments. A firm can mainly choose between the three modes of financing that includes; issuing of shares, spending or even borrowing profits. The theorem seems to get much more complex, but the fundamental thought is that, under some definite assumptions, there is no much difference on whether an organization finances itself with either equity or debt (HAAG, 2000). Generally, there is often an ultimate increase in leverage (D/E), while the WACC remains constant. Where; refers to the needed return rate on equity cost or equity Is the required return rate on debts or borrowings, while Refer to the rate of debt-to-equity. With taxes, the formula that can be used for the entire computation can be taken as follows; Where; - value of the levered firm. - Value of the unlevered firm. - tax rate (); x - debt value (D) The case study here is the Aguia Company; that has an overall debt of £12 million, equity of £72 Million, and the tax of about £6 million; while they are trading there shares at £8 million pounds/share. The estimation of what the ultimate share should be at the equilibrium price can be for Aguia can be computed as follows: Vg =Vu + Dt where the ungeared Company is the same in every aspect to the geared company expect for its capital structure. Vg = profit before Interest / WACC Vu = Vg = Earning in an ungeared Company / KU KU = the cost of equity in n ungeared Company. Therefore, Dt = £14m * 35% (tax rate) = £4.9m For the Pomba Company; Dt = £10m * 35% (tax rate) = £3.5m These results can be summarized in the table below so as to bring in some sort of comparative nature between the two Companies: Aguia Pomba Debt £100 million £30 million Equity £72 million £30 million Corporation Tax rates 35 % 35% Regular Profits £6 million £2 million TR £14 million £10 million Dt £14m * 35% (tax rate) =£4.9m £10m * 35% (tax rate) =£3.5m This hence means that, there is a greater advantage of levering this firm, given that the entire corporation can deduct the payment of interests. Therefore leverage often lowers the overall tax payments (ARTIKIS, 2007).The payment of dividends is hence non-deductible. Generally, a higher proportion of debt-to-equity translates to a higher needed equity return, simply because of a much higher risk involved for the equity-holders within a firm with debt. The formula generally a derivative of the weighted average cost of capital theory. These propositions can always be true with regards to the assumptions that; the transaction cost does not exist, while the corporations and individuals borrow capital at equal rates. These results may seem irrelevant in one way or the other but the entire theorem still remains under study simply because it denotes something that is very essential. This is has to do with the aspect of capital, whereby the capital structure tends to precisely matter because of violation of one or more assumptions. It informs on where to seek for the optimal capital structure determinants and how such factors may impact on that best possible capital structure (AGARWAL, 2013). Trading of shares in a perfect market: What an investor should do if shares are traded in a perfect market: If both Companies (Aguia and Pomba) trades there shares within the ultimate range of a perfect market, a rational investor has to put various factors into dire consideration, while the Companies’ share prices on the other hand tend to be affected in one way or the other. This is mainly because of occurrence of this aspect of perfect competition. Perfect market competition is often taken as the directly opposite perspective of a monopoly, since it dwells on a situation whereby there are no single firm suppliers of a specific service or good, hence leading to harmony with regards to prices simply because consumers often have a number of alternatives thereby increasing the rate of competition within the market niche. On the other hand, perfect competition ensures that there are numerous sellers and buyers, and prices tend to reflect on demand and supply. Also, customers tend to have various alternatives if the product or service they would like to buy happens to be extremely expensive or falls short in terms of the quality. This allows new firms to enter the market easily, hence generating additional rate of competition. Companies only earn enough profit that keeps them remain in business, because targeting much higher or usurious profits will enable other Companies to storm into the market through the act of pulling back the profit levels to the minimum value. Perfect competition is comprised of four main characteristics that includes; a large number with regards to small firms, sell of identical products by all the firms, perfect sense of resource mobility or aspect of freedom regarding the entry and exit into and out of the industry, and finally the aspect of perfect knowledge on the prices and technological advancements. These four main features mean that a specified perfectly competitive company or firm has the inability of exerting any form of control over the entire market. The larger number of such small firms that all produces identical products indicates that a greater number of the perfect alternatives exist for the produced output by any specified firm. This hence makes the ultimate demand curve to be perfectly elastic for a competitive firm’s output. Perfect knowledge can be taken to mean that all these firms operates within the same stands, such that buyers are well conversant about all the possible perfect alternatives for a specified good or service and that enterprises actually do manufacture identical products. Having dwelled on issues that relates to stock and money market, the firm itself should be the main point of consideration by the investor. Though is thrives under a narrow scope, there are broader issues that should be put into consider. They include; management, earnings, liability, competition, government regulation and fraud. This analysis can be duly made based on various arising issues. For instance, each quarter of investors often waits curiously for the announcement of the company earnings that will either fail to meet up the expectations. The investor’s reaction is usually dictated to a greater extent by the extent of such a miss. When there is a much smaller shortfall, the effect would not probably be essential enough to necessitate to a large decline or mass sell-off of the stock price. However, in a situation when the firm has a track record of exceeding the analyst’s estimates before sudden miss with regards to the mark, this has the possibility of signalling future company troubles. Regardless of how smaller the shortfall is, you might wish to do investigation on the basic reasons behind it so as to try and identify any looming problems with such a stock. What should happen to the share prices of both companies? The larger shortfall with regards to earnings as related to the expectations, the more the negative reactions from the investor, and the resulting growth in price declines. This is mostly true for the momentum hoards that have been witnessing chains of positive earnings. History shows that once such stocks have single negative earnings, the rate of decline can be massive and swift. In such a case, the best thing is to dispose such an investment as soon as possible. At times, a company might announce earnings as exceeding the estimated consensus and, consequently, offers a warning that they might not have the ability to meet the projected expectations within the next quarter. This is often termed as a "downward guidance" (DIXIT & PINDYCK, 1994). Over a period of time, firms have become adept towards the investor expectations and managing analyst. Hence, downward guidance is usually a sole way of a firm to offer advance warning in such a manner that does not surprise the market analysts especially when there is a shortfall with regards to earnings. When a sole firm offers a downward guidance, the analysts tend to work towards lowering their ultimate earning so as to make it simple for a firm to attain these reduced expectations. On the other hand, when a single company gives out an announcement of buying another firm, the normal market reaction will be the aspect of lowering the buyer’s prices and increasing the value of the acquired firm. The basic reasoning is normally on the fact that the one who acquires is deliberated to be paying a lot. Based on the involved companies, there might be a number of questions whether the expected union might be allowed to occur from a narrow perspective, if there are compatible corporate cultures, and if there is the element of the earnings’ dilution. In the long-run most stocks eventually witnesses some sort of decline with regards to the prices. It is typical for a rising stockpile to pose at some point. As long no news accompanies this sort of decline, investors might wish to utilize such short-term declines so as to add them up to stock investment situation (HAAG, 2000). So, the decline should entirely be related well to the ultimate industry as well as the accompanying trading volume. The key element is to ensure whether the company’s changes in one way or the other. Finally, it can be ascertained as well that investors usually hate seeing that the shares’ value reduces over a certain time period, especially when there seems to be no or indefinite contributing elements towards this decline. As the ultimate prices decline, some of the investors can consider that the entire market is a little more knowledgeable and hence enters into a certain awkward mentality that is characterized by selling of their shares and lowering of the prices. Some others often take what is referred to as the contrarian approach. This has to do with the aspect of believe in the claim that most sellers are often overreacting. Such kinds of investors usually add up to their situations especially when a drop in prices is realized, hence taking advantage of the bargaining price. Many professional investors generally view a slow but steady reduction in the stock prices as the excellent opportunities for carrying out probable transactions. Their ultimate reasoning is the fact that if real problems or challenges existed with the entire firm, the hurry of investors to dispose off or sell would significantly force the prevailing price to shoot down sharply within a very short time period. Instead, they usually theorize that price declines are as a result of money managers who sell their stake within the company so as to raise money, hence causing most of the investors to follow suit in turn. Capital structure Decisions: Capital structure generally refers to the manner in which a firm finances its main assets through the aspect of combining debt, equity or even hybrid securities. A corporations capital structure can hence be termed as the structure or composition of its ultimate liabilities. For instance, a company that sells 80 billion USD in debt and 20 billion USD in equity can be taken as being 80 percent debt-financed and 20 percent equity-financed (ROBB & ROBINSON, 2010). The firms debt ratio to the total financing as per this example can be taken as the corporation’s leverage. In the real sense, capital structure might be of high complexity and tends to include various sources. Gearing proportion on the other hand refers to the ratio of the employed capital by the ultimate firm which emerges from the business surrounding, for instance through the aspect of taking short term loans. Debt often appears in the form of long-term payable notes or bond issues, while equity on the other hand can be mutually classified as a preferred stock, retained earnings or a common stock. The short-term debt that includes working capital needs can also be considered as the main capital structure segments. Generally, a firms proportion of both long and short-term debt is often put into consideration during the capital structure analysis. When people are referring to the capital structure concept they are likely making reference to a corporations debt-to-equity proportion, which offers greater insight into the intensity of the company’s risks. A company that is heavily thriving on debt finances poses great risk since it is extremely highly levered. Modigliani and Miller established a very efficient and effective capital Structure specifically within a perfect market. Perfect market is characterized with several qualifications that include the bankruptcy cost, perfection information, uniform interest rates, minimal or no taxes, as well as failure of financing decisions to impact on the entire investment. A firm can mainly choose between the three modes of financing that includes; issuing of shares, spending or even borrowing profits. The theorem seems to get much more complex, but the fundamental thought is that, under some definite assumptions, there is no much difference on whether an organization finances itself with either equity or debt Under these entire conditions, Modigliani and Miller came up with two major findings. They ascertained the Company’s value is largely independent of its main capital structure (ROBB & ROBINSON, 2010). In addition, they also ascertained that the equity cost for an unleveraged company is equal to the equity cost of a leveraged firm plus the financial risk’s added premium. This can be taken to mean that, increase in leverage, while the individual’s risk burdens is transferred between various investor classes, the total risk is majorly conserved hence leading to creation of no extra value. Their main analysis was entirely extended to encompass the impacts of risky debts and taxes. Under a more classical tax scheme, the `tax interest deductibility makes the aspect of debt financing to be of a much greater value in that; the capital cost decreases as there is decrease in the debt proportion within the capital structure. The most favourable structure would then be in apposition whereby it lacks any form of equity. If there is a capital structure irrelevance within a perfect market, then the existing imperfections in the real situation should be the main cause such relevance. With regards to the capital structure theory, trade-off concept often works towards allowing for the existence of the bankruptcy cost. It reiterates on the fact that greater advantage can be realized through debt financing and that of financing cost with debt (BIERMAN, 2003). There is an ultimate increase in marginal benefits as the debt decline increases, whereas there is also an increase in the marginal in such a manner that a company that optimizes its general value will often focus on trade-off especially when selecting the amount of equity and debt to be utilized for financing. Empirically, it might ascertain the rate of Debt/Equity between various industries, but not within a single industry. Pecking Order Theory on the other hand often tries to recapture the asymmetric information costs. It explains that firms usually put their finance sources into greater priority in accordance to the least resistance, hence preferring to increase financial equity as a final resort. The aspect of internal financing is initially used. Debt is hence issued especially after depletion (MILLER, 2001). Equity on the other hand is usually issued when it seems that it is no longer reasonable for issuance of any debt anymore. Agency theory is also deemed as being very essential in this segment. It is generally concerned with problem resolution that often exists within agency relationships. This is mainly between the principals (including the shareholders) and the principals’ agents (for instance, the company executives) (ROBB & ROBINSON, 2010). This theory mainly dwells on two major problems. These include the problems that often arise when there is a conflict between the principal’s and the agent’s objectives and goals. The other problem that arises is when both the agents and the principals have varying attitudes towards the risks and uncertainties. Because of such varying risk tolerances, agents and principals might be both inclined towards taking different actions. Signalling theory on the other hand is essential for behavioural description especially when two varying parties (organizations or individuals) have accessibility to varying information (LÖYTTYNIEMI, 1991). Usually, a single party should choose on whether and even how to fuel communication. The other party on the other hand must select how to make the signal interpretation. Signalling theory often holds an outstanding position within an array of management schedules, including that of strategic management, human resource management and entrepreneurship. While the utilization of the signalling theory has recently gained momentum, its main tenets have often turned out to be blurred as applied to the entire organizational concerns. It also upholds that businesses often adhere to a hierarchy of financial sources hence preferring internal finances when there is availability, whereas debt is usually preferred more than equity when there is need of external financing. The kind of debt that a firm selects can thus act as a main signal of its financial requirements. There is also a greater argument that equity can act as a less preferred entity for raising capital simply because when managers the aspect of issuance of new equity by the managers makes investors to believe that their thoughts are linked to the firm’s value, hence making firms to take advantage of such a valuation. Due to this, investors often place a much lower value towards the fresh equity issuance. The other main aspect that should be put into dire consideration is on the Myers capital structure. This is where the capital structure decisions can on the other hand be referred to as the capital puzzle model mainly because of the primary factors that tends to influence them (HAAG, 2000). These factors can be taken to include the business risk, Company’s tax exposure, financial flexibility, management style, growth rate, as well as the prevailing market conditions. Business risk involves the aspect of debt exclusion, hence igniting basic risk to the entire companys functionalities. The greater the risk, the lower the rate of optimal debt proportion (MAW, 1968). The aspect of company’s exposure, on the other hand, has to do with debt payments that are often considered to be tax deductible. So, if a firm has got a higher tax rate, hence using debt as the ultimate means of project finances, it is often attractive simply because the debt’s tax deductibility payments tend to protect some taxable incomes. Financial flexibility essentially refers to the companys ability of raising capital in worse scenarios. It should often emerge unsurprising that companies usually have no greater challenges with regards to raising capital especially when there is a remarkable sales growth and stronger earnings. However, with the firms stronger cash flow during good times, the aspect of raising capital is very simple. Companies have to make greater efforts of being prudent while raising such capital during good times, but not stretching some of its capabilities further. Lower debt levels of a company translate directly to greater flexibility levels. Moreover, management styles often range from being aggressive towards being conservative. The more the level of the Company’s conservative nature, the lesser the level of inclination to the use of debt towards profits increment (LÖYTTYNIEMI, 1991). A very aggressive management might try to quickly grow the company by use of essential debt amounts so as to increase the ultimate growth of the firms earnings/share. On the other hand, firms that are often within their cycle’s growth phase usually finance such a growth and development through debts. The main conflict that emanates with this technique is that, the growth firms’ revenues are typically unproven and unstable. So, higher debt pack is usually inappropriate. Finally, market conditions on the other hand can have essential effect on a firms capital-structure situation. This is often applicable suppose a company has to borrow capital for setting up a new plant. If the entire market is in a struggling mode, it means that investors are restricting companies capital accessibility simply because of various market concerns whereby the interest rates might be much higher than what a Company is willing to pay. In such a situation, it is sensible for a firm to wait for the market conditions to return to the normal conditions before it tries to source out for such funds (HART, 1994). Generally, all these concepts and prevailing factors are very cognitive towards the concept of Capital structure. This is the basic reason why capital structure decisions are often referred to as the capital puzzle models. Reference List: ARTIKIS, G. P. (2007). Capital structure. [Bradford, England], Emerald. http://public.eblib.com/choice/publicfullrecord.aspx?p=306208. AGARWAL, Y. (2013). Capital structure decisions evaluating risk and uncertainty. Singapore, Wiley. http://site.ebrary.com/id/10683274. BIERMAN, H. (2003). The capital structure decision. Boston, Kluwer Academic Publishers. DIXIT, A. K., & PINDYCK, R. S. (1994). Investment under uncertainty. Princeton, N.J., Princeton University Press. HAAG, S. (2000). M&Ms: the lost formulas. [S.l.], Simon & Schuster. HART, O. (1994). Capital structure decisions of a public company. [Roma], Banca dItalia. LÖYTTYNIEMI, T. (1991). Essays on corporate capital structure decisions. Helsinki, Helsinki School of Economics and Business Administration. MAW, J. G. (1968). Return on investment; concept and application. [New York], American Management Association, Finance Division. MILLER, R. M. (2001). Paving Wall Street: experimental economics and the quest for the perfect market. New York, Wiley. ROBB, A. M., & ROBINSON, D. T. (2010). The capital structure decisions of new firms. Cambridge, Mass, National Bureau of Economic Research. http://papers.nber.org/papers/w16272. Read More