What Constitutes Good or Bad Capital Structure - Essay Example

What Constitutes Good or Bad Capital Structure ID 19714 Order No. 296025 Name] [Course Name] [Supervisor] [Any other details] 30 April 2009 Table of Contents: Introduction: In this short essay, the author presents some empirical theories on capital budget structure and presents an argument on the factors that could be deciding the structure of capital of a firm. In the end, the author presents some points for discussions. Empirical Theories of Capital Structure The core of Capital Structure theory begins with the theorem of Modigliani and Miller (1958; 268-272) which states that the Cost of capital for a firm (market value of firm) is independent of the capital structure of the firm. They also recommended that an ideal capital structure of a firm is with all debt with cheaper debt finance than higher cost & riskier equity but an optimal capital structure exists in which the terms of debt financing & such other real world problems of debt financing (like bankruptcy due to high debt) and tax savings of the debt financing are balancing factors (Modigliani and Miller. 1963. 441-442). Many theorists didn't like their theorems but finally did find evidence in their applicability in many cases. Stiglitz (1969. pp784) however emphasized that the theorem was framed with some limitations in mind pertaining to existence & distribution of risk classes, competitiveness in the markets and clarity of effect of bankruptcy on the validity of the theorem. Stiglitz (1969. pp789) proved that under given risk classes the primary objective of firm management is to maximize firm value and hence they shall tend to choose the most appropriate capital structure that can achieve maximum value of the firm given certain implying factors that vary from firm to firm. But what could be such implying factors Let us focus on another empirical generalization established by Borch (1969. pp6-7) regarding conflict of interest in firm capital structure. If an organization has started with a capital and have achieved value addition over the capital, the shareholders will expect dividend payments from the value addition. Payment of dividends to shareholders will conflict with the interest of creditors as the latter would like to continue with long term interest payments. Hence, the creditors will tend to establish certain terms of agreement that indirectly impacts the dividend policy of the management thus affecting the capital structure of the organization as non-payment of dividends may end up reducing shareholder interest and hence can reduce equity financing. Another factor that affects the Capital Structure is the rate regulation by regulatory commissions. Spiegal and Spulber (1994. pp424-425) proved that rate regulations generates an incentive for the regulated firms to increase their debt levels. Thus regulated firms tend to have high leverages than unregulated firms. Chaganti & Damanpour (1991. pp488-490) and Brav (2009. pp265) argued that the firm's ownership determines capital structure to a large extent. Institutional investors or managers tend to reduce debt to equity ratio whereas shareholders that are "sensitive" to changes in performance tend to increase debt to equity ratio. This may be described using agency theory that the owners willing to take higher risks to maximize shareholder value will tend to reduce leverage while the owners willing to take lesser risks to maximize shareholder value will tend to increase leverage. Balakrishnan and Fox (1993. pp7-8) related firm Capital structure with asset specificity in which the investments are made. They argued that the firm's leverage would be positively related to investments in tangible assets or redeployment of existing assets but would be negatively related to investments in intangible assets. For example, a firm investing heavily in R&D will be more inclined towards equity finance because the outcome of R&D is normally intangible assets that do not form promising collaterals for debt financing. Bondholders like mortgage financers prefer tangible assets as collaterals and hence disburse loans more easily against them. The other problem of tangible assets is that they can be easily valued through their book value but not very easily valued through market values because the market largely lacks specialist class asset valuators. Hence, many times the markets may assign high value to an intangible asset (say brand equity) but may fail to recognize true value of a real estate property owned by the company. Hence, Balakrishnan and Fox (1993. pp14) finally concluded that the firm leverage largely depends upon the internal investment decisions by the management. Hence, in nutshell the proposition of equilibrium by Modigliani and Miller in limiting debt financing appears to be true from many perspectives as a number of practical issues in debt financing limits the same in spite of tax benefits thus leading to an optimal structure. What factors decide the Structure of Capital of a Firm From the perspective of the author, an optimal capital structure does exists as a balance between factors tending to lower leverage versus factors tending to increase leverage whereby these factors largely depend upon the internal dynamics of the organizations and the options of financing available to the firm management. The factors may largely depend upon investment decisions in acquisition of assets, market opportunities, interest rates in debt financing, terms implied by creditors on the firm against a finance agreement, dividend payout policies, etc. A large implying factor of such an optimal structure is the agency control that maintains an equilibrium between conflicting decision making by different agents (say managers versus shareholders). However, author wishes to question the fact that investments in innovations do not qualify easily for debt financing. Tangible assets do not always form promising collaterals - we have witnessed what has happened in the mortgage market where the collaterals were probably one of the safest tangible assets that banks & financial lenders could have thought of - homes of people. Why wouldn't a creditor choose to finance a brand equity - specifically if the experts tangibly valuate its value-addition to the running business of a firm. Discussion Points: Modigliani and Miller (1958; 268-272) largely advocated for major component of debt financing in the capital structure. Also, they argued in another paper (Modigliani and Miller. 1963. 441-442) about optimum capital structure as a function of equilibrium between debt financing real world problems and the debt financing benefits (like taxation benefits). In the recent past (2006-2007) the interest rates of debt financing increased. The author wishes to discuss the implications that this on capital financing structures. Did companies reduce debt financing during this period This is the first set of discussion points proposed by the author. In the second set of discussion points, the author wishes to discuss on the conclusion by Simerly and Li (2000. pp45) that high leverage impacts firm performance positively during stable environments and negatively during trouble times. They claim that Modigliani and Miller (1958; 268-272) theorem of leverage being inconsequential is in a perfect world but their theory is applicable in the real world. High debt definitely boosts firm performance in good times but why should they reduce firm performance during bad times Are these authors pointing towards a relationship between high debt and bankruptcy during bad times This is the second set of discussion points proposed by the author. Brav (2009. pp268) argued that there is high change of high leverage in private firms due to two kinds of effects - level effect and sensitivity effect. In the level effect, they argue about equity being information sensitive instrument and debt being information insensitive instrument and also presented that private firms are less likely to trust information sensitive instrument. In the sensitivity effect, the author argued that private firms are more sensitive to changes in performance and hence prefer to hold high contingencies (like high cash) rather than investing in equity markets. The author wishes to argue that how these companies comply with the balancing theory of Modigliani and Miller. (1963. pp441-442) Holding debt money for longer will lead to serious implications on NPV leading to liquidity problems in the long run. How does private firms mitigate such risks This is the third set of discussion points proposed by the author. Conclusion: In this short essay, the author presented arguments on optimal capital structure after analyzing the empirical generalizations pertaining to the same. In the end the author presented few discussion points. Reference List: Balakrishnan, Srinivasan and Fox, Isaac. (1993). Asset Specificity, Firm Heterogeneity and Capital Structure. Strategic Management Journal, Vol. 14, No. 1. pp7-8. John Wiley & Sons. Retrieved on 30 April 2009 available at http://www.jstor.org/stable/2486546. Brav, Omer (2009). Access to capital, Capital Structure and the Funding of the Firm. The Journal of Finance. Vol. 64. No. 1. pp265, 268. Borch, Karl. (1969). The Capital Structure of a Firm. The Swedish Journal of Economics, Vol. 71, No. 1. pp6-7. Blackwell Publishing on behalf of The Scandinavian Journal of Economics. Retrieved on 30 April 2009 available at http://www.jstor.org/stable/3439158. Chaganti, Rajeshwararao & Damanpour, Fariborz. (1991). Institutional Ownership, Capital Structure, and Firm Performance. Strategic Management Journal, Vol. 12, No. 7. pp488-490. John Wiley & Sons. Retrieved on 30 April 2009 available at http://www.jstor.org/stable/2486521. Modigliani, Franco and Miller, Merton H. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review, Vol. 48, No. 3. pp268-272. American Economic Association. Retrieved on 30 April 2009 available at http://www.jstor.org/stable/1809766. Modigliani, Franco and Miller, Merton H. (1963). Corporate Income Taxes and the Cost of Capital: A Correction. The American Economic Review, Vol. 53, No. 3. 441-442. American Economic Association. Retrieved on 30 April 2009 available at http://www.jstor.org/stable/1809167. Simerly, Roy L. and Li, Mingfang. (2000). Environmental Dynamism, Capital Structure And Performance: A Theoretical Integration And An Empirical Test. Strategic Management Journal. Vol. 21. pp45. John Wiley and Sons. Retrieved on 30 April 2009 available at http://www3.interscience.wiley.com.ezproxy.liv.ac.uk/cgi-bin/fulltext/68502925/PDFSTART Spiegal, Yossef and Spulber, Daniel F. (1994). The Capital Structure of a Regulated Firm. The RAND Journal of Economics, Vol. 25, No. 3. pp424-425. Blackwell Publishing on behalf of The RAND Corporation. Retrieved on 30 April 2009 available at http://www.jstor.org/stable/2555770. Stiglitz, Joseph E. (1969). A Re-Examination of the Modigliani-Miller Theorem. The American Economic Review, Vol. 59, No. 5. pp784. American Economic Association. Retrieved on 30 April 2009 available at http://www.jstor.org/stable/1810676. End of Document Read More