Modigliani & Miller Approach on Capital Structure - Case Study Example

Financial Management Table of Contents Introduction 4 Part A 4 Existence of an Optimal Capital Structure 4 Modigliani & Miller Approach on Capital Structure 5 Assumptions 5 Empirical Implication of Modigliani & Miller Approach 5 Two propositions without taxes 6 Propositions with taxes: The trade-off theory of leverage 6 Applicability of Miller’s Theory in Real Situation 6 Trade-off Theory of Optimal Capital Structure 7 Pecking Order Theory of Optimal Capital Structure 7 Part B 8 Investment Appraisal Techniques 8 Payback Period 8 Benefits 8 Drawbacks 8 Discounted Cash Flow (DCF) 9 Benefits 9 Drawbacks 10 Comparison between Payback Period and Net Present Value (NPV) 10 Evidence 10 Decision 11 Conclusion 11 Reference List 12 Appendices 14 Appendix 1 14 Appendix 2 14 Introduction The relationship between the firm value and capital structure are the topic of debate, both empirically and theoretically. Throughout, the debate has gained its attention if there exist a favourable capital structure or not for a particular firm. Whether the quantity of the debt usage is immaterial to the value of individual firm, is also the part of the debate (Hatfield, Cheng and Davidson, 1994). The most favourable capital structure signifies the finest debt to equity ratio that maximises the value of the firm. The optimal/favourable capital structure offers stability between the ideal ranges of debt to equity, therefore minimising the cost of capital of the firm. Debt financing in general provides the lowest feasible cost of capital due to the reason of the tax deductibility. The long and short term ratio of debt of a firm should be considered while investigating the capital structure (Titman and Wessels, 1988). Investment appraisal is defined as a means of considering if an investment plan or project is valuable or not. It assess the degree of anticipated returns received for the altitude of the expenditure made and estimates the future benefits and costs over the life of the project. There are numerous types of methods of investment appraisal, for example payback period, discounted cash flow (net present value), internal rate of return, profitability index and accounting rate of return (Sangster, 1993). Among these methods, any two will be discussed in detail for better understanding of the decision making process. The paper aims at demonstrating the understanding of differing viewpoints on whether an optimal/favourable capital structure exists for individual firms. Further, two different investment appraisal methods will be compared by taking into account their benefits and disadvantages and deciding which one is more beneficial for formulating the investment decision. Part A Existence of an Optimal Capital Structure One of the controversial topics in the premise of finance has been the capital structure theory. The model of ‘Modigliani and Miller’ is regarded as very useful in this context (Bradley, Jarrell and Kim, 2009). In the mid 1970s, the universal academic view was that the most favourable capital structure entails balancing the debt’s tax advantage against the current value of the bankruptcy costs. As soon as this universal view become widespread in the business, that time only Miller offered a fresh challenge by demonstrating that under particular conditions the tax benefits of the debt financing or funding at the industry level is precisely counterbalanced by the debt’s tax disadvantage at the individual level. After that there has been developed a growing theoretical literature endeavouring to reconcile the ‘model of Modigliani and Miller’ with the theory of most favourable/optimal capital structure (Bradley, Jarrell and Kim, 2009). The general outcome of this effort states that if there is a considerable leverage-related cost, for example, agency debt’s cost and the bankruptcy costs, and if the earnings from the equity are not taxed, then the tax rate of marginal bondholders will be fewer than the business/corporate rate, and then there exist a positive total tax benefit to the corporate debt funding/financing. The favourable capital structure of the firm engrosses the trade off among the debt’s tax advantage and different leverage-related prices or costs. The consequence of these expansions of the Miller’s approach is the identification that the continuation/existence of optimal capital formation/structure is basically an empirical matter to decide whether the different costs which are leverage-related are economically important enough to manipulate the corporate borrowing’s costs. The Miller approach as well as its hypothetical extensions have enthused several studies that offer evidence or proof on the continuation of the leverage-related prices or costs (Bradley, Jarrell and Kim, 1984). Modigliani & Miller Approach on Capital Structure Assumptions The model of Modigliani & Miller involves five assumptions which are: no taxes; financing of debt does not entail any effect on the earnings before interest and tax; transaction price/cost for selling and buying securities as well as the cost of bankruptcy is nil; the borrowing cost is same for companies as well as for investors; and there is evenness of information which signifies that the investors are required to behave rationally and it also means that they will use the similar information which the corporate use. Miller’s approach also explains that if the investor buys stock of the leveraged company, it would rate him on the similar scale as purchasing the stock of unleveraged company (Casamatta, 2003). Empirical Implication of Modigliani & Miller Approach The empirical implication of Miller’s model is based on his assumptions. It presents situations under which the financial decision of the company or firm does not have any effect on its value. The empirical implication of this approach includes two types of propositions, which are as follows: Two propositions without taxes Proposition 1: With the hypothesis of ‘neutral or no taxes’, it has been projected that the company’s capital structure does not have an impact on the company’s valuation. Further, it proposes that equity as well as debt shareholder have similar priority (Miller, 1977). Proposition 2: It describes that the financial leverage of the company is in the straight proportion to the price of the equity. The major difference between these two propositions is that the proposition 2 believes that the debt shareholders have benefit or control as far as the claim of earnings is concerned. In this manner, the debt cost diminishes (Miller, 1977) Propositions with taxes: The trade-off theory of leverage Miller’s approach presumes neutral/no taxes but in fact, this does not happen. Most of the countries take tax from the companies. The interest which is given on the borrowed resources is in general tax deductible. However, the case is not similar with the dividends paid/compensated on equity. The hypothesis of trade-off describes that a company can take benefit of its prerequisite with debts provided that the bankruptcy’s cost surpass the cost of the tax benefits (Miller, 1977). Applicability of Miller’s Theory in Real Situation Evidence from the developed markets signifies that the firms or companies in the developed countries do not think about the deductibility of tax on the interest payment as a major factor when deciding on the suitable debt amount. It has been analysed that the credit rating and the probable bankruptcy costs or the financial distress are more influencing factors. This signifies that the firms in the developed countries, for example, the UK or US make an effort to balance the likely costs and also the debt’s benefits (Puxty and Dodds, 1991). In support of trade-off hypothesis of Miller, it is noted that the instability of earnings as well as cash flows augments the threat of the financial distress, thereby having an impact on the financial decision of the companies. Maintaining a debt to equity ratio is not regarded as a key issue by the firms when they are making decision on whether to raise capital stock. Around 10% of the companies in the developed countries categorises the free cash flow problem as an important issue (Puxty and Dodds, 1991). The companies in the developed markets do not agree that the adjustments in the common stock’s price as well as the current share’s valuation are the key issues when they are making the financing decisions (Puxty and Dodds, 1991). Trade-off Theory of Optimal Capital Structure The hypothesis dealing with the difficulty of communal relations of cost-benefit connected with initiating overseas capital into firm in the perspective of the optimization of capital structure in the firm is known as trade-off hypothesis/theory of optimal capital structure (Stohs and Mauer, 1996). In relation to this theory, it is presumed that the worth of assets as well as total capital which is invested in firm is stable and with this hypothesis, the most favourable capital structure is explored which would give the maximum company value. As per this theory, the firm that make use of overseas capital has its price/value shaped by depending on tax benefits and also on financial problems stemming from the threat of insolvency, which accompanies the utilisation of the foreign capital (Stohs and Mauer, 1996). The trade-off hypothesis of capital structure states that optimal capital structure exists only when subsidiary/marginal tax benefit’s value from the additional debt is equivalent to the marginal price of financial difficulties’ cost ensuing from additional debt (Stohs and Mauer, 1996). Pecking Order Theory of Optimal Capital Structure Pecking order hypothesis presumes that optimal/most favourable capital structure does not exist. It further describes that the companies favour internal financing; and only in that situation when there is no sufficient internal or interior cash flow for the activity financing, they arrive at foreign capital. As a final resort, they commence their own external financing, such as conducting stock issuance. Preference of the internal capital mainly results from the enthusiasm to neglect financial market as well as to manage the company’s resources. It has also been found that acquiring foreign capital through the firm does not impact its value, because the positive/affirmative effect of the financial leverage is eradicated by the negative information which is related to debt and financial situation of the company (Vasiliou, Eriotis and Daskalakis, 2009). Part B Investment Appraisal Techniques The different techniques of investment appraisal are considered as the main area in most of the businesses and it helps in making decision related to the investment in particular project. Among the various methods, two of them will be taken into consideration and highlights will be provided on how they assist in making decisions relating to investment. Payback Period Payback period is referred to the simple method for measuring an investment through the span of period it takes to pay off. This technique is usually used for the small businesses. It depends on probable cash flows as well as presents a measure whether a business is liquid or not. A project which have shorter payback period is regarded as beneficial (Groppelli and Nikbakht, 2006). Benefits The advantages of payback period are that it is uncomplicated to calculate and understand and it is valuable in definite situations, such as hastily changing technology and recuperating investment condition. It favours fast return and thus helps in the company growth. It maximises liquidity and minimises risks. The payback period technique is most pertinent to companies which are facing cash flow problems. It is good in quickly changing markets. Further, this technique focuses more on the cash flow and not on accounting profit (Groppelli and Nikbakht, 2006). Drawbacks There are certain drawbacks of the payback period method such as it does not take into consideration returns after payback period and also ignores the project profitability, which is one of the main drawbacks. The managers of the company find it difficult to set up a targeted period of payback. It also disregards the periods of cash flows and is considered as subjective technique because it provides no perfect investment signal. It is considered as an approach of short term and does not take into consideration the future worth of money (Groppelli and Nikbakht, 2006). Discounted Cash Flow (DCF) Discounted cash flows is considered as one of the most important and valuable technique while making the investment decisions. It is used to assess the prettiness of investment opportunity (Moyer, 2004). The analysis of DCF makes use of projections of upcoming free cash flow and then discounts them in order to reach at net present value (NPV), which is utilised to appraise the prospective for investment. If the cost arrived at by means of analysis of DCF is more than the present value of investment, then the opportunity is considered as good one (Moyer, 2004). The analysis of discounted cash flow symbolizes the net/total present value of the proposed cash flows accessible to all the capital providers and total of the cash required to invest for the purpose of producing the anticipated growth (Moyer, 2004). The notion of the valuation of discounted cash flow relies on the belief that the asset or business’ value is intrinsically based on the capability to produce cash flows usually for the capital providers. DCF depends more on fundamental prospect of business rather than on the factors of public market or the historical precedents. An analysis on DCF capitulate the entire business value including both the equity and debt. The discounted cash flow technique of valuation entails projecting free cash flows over the period of horizon, computing the terminal amount at the period’s end as well as discounting the anticipated free cash flows and the terminal value by making use of the discounted rate in order to reach at the net present value (NPV) of overall anticipated business’ cash flows. Benefits Theoretically, the method of discounted cash flow is considered as the most preferable technique of valuation. It is regarded as forward looking as well as relies more on future probability rather than on historical outcomes. This technique is more internal looking, depends on the primary expectations of asset or the business, and is not influenced more by unpredictable external factors. The analysis of discounted cash flows lays emphasis on the cash flow creation as well as is less influenced by assumptions and accounting practices. This method permits expected operating tactics to be featured in the valuation. It also allows dissimilar business components to be appreciated separately. A carefully proposed DCF help the investors to get a clear picture of the inexpensive companies against the expensive peers (Moyer, 2004). Drawbacks The accurateness of valuation established using the discounted cash flow technique highly relies on the superiority of the assumptions regarding discount rate, terminal value, and free cash flows. As an outcome, the valuations of DCF are usually articulated as different values, in spite of a particular value by making use of various values for main inputs. The terminal value over and over again signifies a large part of entire discounted cash flow valuation. In such cases, valuation is dependent on terminal value assumptions in spite of operating postulations for the asset or business (Moyer, 2004). Comparison between Payback Period and Net Present Value (NPV) The comparison is shown between the payback period and the NPV because the DCFs signify the NPV and the discounted rate is also used to reach at the NPV. The payback period computes the time within which the original investment is recovered. The criteria for rejection or acceptance are a benchmark determined by the company. If the payback period is equal to or less than the benchmark, the company will choose the project or plan, otherwise will refuse it. The main dissimilarity between the net present value and the payback period is that the method of payback period is not concerned about the cash flows especially after the payback period and it also take no notice of the future rate of money. Whereas, the net present value takes into consideration the future rate of money as well as concerned about the entire cash flows until the existence of the plan or project (Ross, Westerfield and Jordan, 2008). Evidence The chosen investment appraisal methods are applied in practice in order to assess the viability of the project. The net present value (discounted cash flows), and the payback period is applied in the Tesco Plc and Walmart Inc to observe whether the techniques are viable or not to make the investment decisions. The Total Cash Flows of the Tesco Plc which is arrived from the operating, investing and financing activities is positive for the first and fifth year only (See Appendix 1). The cost of capital is assumed as 10% and the discounted cash flow (DCF) arrived is also positive in the first and fifth year only. Total DCF of the Tesco Plc is £397.04. Due to the negative cash flows in the second, third and fourth year, the NPV computed is also negative i.e. -£152.96 (See Appendix 1). The Total Cash Flows of the Walmart Inc is positive in the first, second, and fifth year. Therefore, the DCF arrived is also positive in the first, second, and fifth year. Total DCF of the Walmart Inc is £1491.54 and the NPV arrived is £291.54 (See Appendix 2). The payback period of Tesco Plc is 1.5 and that of Walmart Inc is 3.7. Irrespective of the negative NPV and less amount of DCF of Tesco Plc, its payback period is less than that of Walmart Inc (See Appendix 1 and 2). It shows that NPV or the DCF technique is more beneficial while making the investment decision because a project with negative NPV or less amount of DCF is not accepted, as in case of Tesco Plc, while its payback period is beneficial and it does not make any sense. Therefore, the DCF technique should be preferred more than the payback period method. Decision It has been analysed that the net present value (discounted cash flow) technique is better and is preferred more than payback period method because it takes notice of the future rate of money and is also concerned about all the cash flows until the continuation of the project. Whereas the payback period ignores both the aspects which are considered as very important while choosing the project. It has also been analysed that all the problems are endured by NPV (DCF) and because of this it is regarded as the best technique to analyse, measure, and choose projects of big investments. Conclusion The paper is designed to provide view and evidence on whether optimal or most favourable capital structure subsist for the individual companies as well as to focus on the two different investment appraisal methods. The theories on the capital structure which is presented above do not clarify the notion of capital structure in an adequate way. This is because Miller’s and trade-off theory explain that capital structure exists, whereas, the pecking order hypothesis explains that it does not exist. Therefore, further research is still required in this direction. The different techniques of investment appraisal assists in the decision making process. The assessment of the cash flows needs carefulness due to the reason that, if the inference of cash flow is wrong then net present value will be misleading. An analysis of DCF treats a firm as a business in spite of just a stock price as well as it requires one to think about entire things that will have an impact on the performance of the company. Among the two techniques, the DCF method is more preferable than payback period technique because it takes notice of the future rate of money and is also concerned about all the cash flows. Reference List Bradley, M., Jarrell, G.A. and Kim, E.H., 2009. On the Existence of an Optimal Capital Structure: Theory and Evidence. The Journal of Finance, 39(3), pp.857-878. Casamatta, C., 2003. Financing and Advising: Optimal Financial Contracts with Venture Capitalists. Journal of Finance, 58, pp.2059-2086. Groppelli, A.A. and Nikbakht, E., 2006. Finance. New York: Barron’s Educational Series, Inc. Hatfield, G.B., Cheng, L.T.W. and Davidson, W.N., 1994. The determination of optimal capital structure: The effect of firm and industry debt ratios on market value. Journal of Financial and Strategic Decision Making, 7(3), pp.1-8. Miller, M.H., 1977. Debt and Taxes. Journal of Finance, 32, pp.261-275. Moyer, S.G., 2004. Distressed Debt Analysis: Strategies for Speculative Investors. Florida: J. Ross Publishing. Puxty, A. G. and Dodds, J.C., 1991. Financial Management: Method and Meaning. London: Chapman and Hall. Ross, S.A., Westerfield, R. and Jordan, B.D., 2008. Fundamentals of Corporate Finance. New Delhi: Tata McGraw-Hill Publication. Sangster, A., 1993. Capital investment appraisal techniques: A survey of current usage. Journal of Business Finance and Accounting, 20(3), pp.307-332. Stohs, M.H. and Mauer, D., 1996. The determinants of corporate debt maturity structure. Journal of Business, 69(1), pp.279-313. Tesco Plc., 2009. Value travels: Annual Report and Financial Statements 2009. [online] Available at: < http://www.tescoplc.com/files/pdf/reports/annual_report_2009.pdf.> [Accessed 14 April 2015]. Tesco Plc. 2010. Tesco PLC Annual Report and Financial Statements 2010. [online] Available at: [Accessed 14 April 2015]. Tesco Plc. 2011. Annual Report and Financial Statements 2011. [online] Available at: http://www.tescoplc.com/files/pdf/reports/tesco_annual_report_2011.pdf. > [Accessed 14 April 2015]. Tesco Plc. 2012. Annual Report and Financial Statements 2012. [online] Available at: http://www.tescoplc.com/files/pdf/reports/tesco_annual_report_2012.pdf.> [Accessed 14 April 2015]. Tesco Plc. 2013. Tesco PLC Annual Report and Financial Statements 2013. [online] Available at: https://files.the-group.net/library/tesco/annualreport2013/pdfs/tesco_annual_report_2013.pdf. > [Accessed 14 April 2015]. Titman, S. and Wessels, R., 1988. The determinants of capital structure choice. The Journal of Finance, 43(1), pp.1-19. Vasiliou, D., Eriotis, N. and Daskalakis, N.P., 2009. Testing the pecking order theory: The importance of methodology. Qualitative Research in Financial Markets, 1(2), pp.85-96. Walmart., 2013. Walmart 2013 Annual Report. [online] Available at: < http://c46b2bcc0db5865f5a76-91c2ff8eba65983a1c33d367b8503d02.r78.cf2.rackcdn.com/88/2d/4fdf67184a359fdef07b1c3f4732/2013-annual-report-for-walmart-stores-inc_130221024708579502.pdf> [Accessed 14 April 2015]. Appendices Appendix 1 (Source: Tesco Plc, 2009-2013) Appendix 2 Note: The values of Wal-Mart are multiplied by 0.66 to convert them into pound. (Source: Walmart, 2013) Read More