Term Paper on "Capital Structure Generally"

Term Paper 7 pages (2932 words) Sources: 1+

[EXCERPT] . . . .

Capital Structure

Generally the capital structure of a company is much influenced by the practical influences like managerial shareholdings, corporate strategy and taxation. The investment strategy by firms necessitates managers to explore the methods of financing new investment. The managers practice three main preferences: utilization of retained earnings, borrowing through debt instruments or issue of new shares. Thus the retained earnings, debt and equity constitute the three primary ingredients of the capital structure of the firm. The first two ingredients show ownership by shareholders and the second ingredient shows ownership by means of debt holders. The financing policy, capital structure and firms ownership are inextricably linked in representing the ways the economic agents form and alter their asset acquisition behavior via firms and capital markets and impact their income levels and returns to asset holdings in the form of capital gains, dividends or direct remuneration,. (Company Financing, Capital Structure, and Ownership: A Survey and Implications for Developing Economies)

The basis of the modern interactions on the corporate capital structure stems from Modigliani and Miller. Their analysis condemned the traditional view of corporate finance that relates to the relationship between the weighted average cost of capital, the weighted sum of debt and equity costs or the minimum overall return that is essential on prevailing operations to satisfy the demands of all stakeholders. The traditional view is initiated with the hypothesis that debt is normally cheaper than equity as an avenue of investment finance. A firm therefore, strives to increase its debt relative to equity with a view to reducing its average cost of capital. But the process cannot be expected to continue persistently since actually enhanced levels of debt increases the possibility of default as a result of the fact that the debt holders and shareholders are demanding greater returns on their capital. (Company Financing, Capital Structure, and Ownership: A Survey and Implications for Developing Economies)

Contrary to the traditional view the Modigliani and Miller theorem begins with the hypothesis of a perfect capital market and makes use of a simple arbitrage mechanism to explore three popular propositions relating to the value of the firm, the behavior of the equity cost of capital and the cutoff rate for new investment. The Proposition I states that the market value of any firm is quite independent of its capital structure and similar is the case with the average cost of capital. Their Proposition II states that the rate of return necessitated by the shareholders increases proportionately with the increase of the debt-equity ratio of the firm. This indicates that the cost of equity increases so as to counteract exactly any benefit accrued due to the use of cheap debt. The Proposition III indicates that a firm will only be involved with the investments whose returns are at the minimum equal to the firms weighted average cost of capital that is the weighted sum of debt and equity costs or the minimum overall return that is required on existing operations to cater to the demands of all stakeholders.

Two major differences exist between the traditional view and the theory of Modigliani and Miller. Firstly, in the traditional viewpoint the value and cost of capital of a firm is interrelated to its capital structure, while the Modigliani and Miller represent them to be independent of each other. Further the Proposition II of the Modigliani and Miller theorem indicates a linear relationship between shareholder rate of return and firm leverage. As a result of this at low levels of debt the cost of equity increases faster under the theorem of Modigliani and Miller than that under the Traditional View. At higher levels of debt the default risk is enhanced and the cost of equity increases at faster rate under the traditional view than that under the proposition II of the Modigliani and Miller theorem. (Company Financing, Capital Structure, and Ownership: A Survey and Implications for Developing Economies)

Capital structure indicates the "relative mix of long-term debt and equity in the capital of a company." Most of the theories striving to explain the movement of capital structure concentrate on the value of debt as a source of tax shield for the firms. Unlike the dividend concerns the interest paid for long-term debt is normally deduced for the sake of corporation tax. The prevalence of the long-term debt on the balance sheet thus generates the valuable interest-tax shield for the company. The firm-specified importance of such tax shield enhances with the marginal tax rate of the firm, the interest which is to be payable on the long-term debt and the stimulation levels inherent in the firm. As the interest rate and the marginal tax rate are exogenous elements, the most correct method to make additions to the value of the tax shield is to enhance gearing. But this strategy exposes the firm to enhanced levels of financial risk as well as the agency costs of debt. The three primary theories that strive to represent the capital structure in the direction are "static tradeoff, pecking order and signaling." (Do changes in a firm's capital structure signal information to shareholders?)

The Trade off theorem of Capital structure envisages achievement of the optimum debt rationalization by a tradeoff among the costs and concerned with the returns of debt financing. Firms regard this ratio as a target debt ration, since this ratio will enhance the market value of a corporation. Such theorem of Myers is based on the fact that firms required adapting their capital structure to attain that ratio. However, an adaptation of the capital structure necessitates time and needs money. Thus it is possible to indicate that the present debt ratio temporarily differs from the target ratio. Thus the tradeoff theory envisages striving of the firms for maximization of the market value. Contrary to this the free cash flow theory presumes that there exist wide divergent interests of shareholders and stakeholders. This indicates that the decisions of the managers do not always maximize the market value of the firm. (Does Capital Structure really matter?) free cash flow refers to the balance of money after all the projects, particularly with positive net present values are being financed. The debt decreases the agency costs of free cash flow by declining the cash flow which is available for spending at the discretionary authority of the managers. Debt also inhibits the liberty of decisions since a firm is compelled to pay interest and payoff sometimes. There will always be a risk that a firm won't be able to pay interest and payoffs in afterwards. This risk stimulates the managers to lead and organize a firm in a more effective manner. Myers again propounded the pecking order theory in addition to the static trade off theory. This theory takes the hypothesis that firms prefers to choose a mode to finance such projects. The order of investment resources is confined by difficulties which are resulted by the asymmetrical information between the managers and prospective investors. (Does Capital Structure really matter?)

Such theory is based on the hypothesis that the firms prefer internal modes of financing the projects; the firms adapt their target dividend pay-out ratio to the prevailing investments resources; the internal resources of a firm are changing as a result of unforeseen variability of profits; when the firm require extra resources they normally prefer the secured modes of getting of funds, this implies that firms prefer debt over the convertible stocks and common stocks. The conclusions arrived at through such pecking order theory is that a firm does not require a certain target debt ratio. The target ratio is influenced by the way a firm finances projects in the past. The theory also accord due significance to the costs of asymmetrical information and costs of bankruptcy. While such costs prevail, a firm does not always prefer to finance projects with a positive net present value. The option of a firm to finance a project is not determined by the positive net present value but the mode in which a firm is able to finance their projects.

Baskin evaluated the applicability of this theory in 1989 and inferred that presently it is possible to entail pecking order behavior with a rational theoretical basis and there appears no longer any rationality to dissuade the manifest empirical evidence. Cornell and Shapiro during 1987 presumed that not only investors, but there are varied groups of non-investor stakeholders who have an interest in a firm and some of them exert important levels of influence in the financial policy of a firm. According to Cornell and Shapiro, the financial structure may also rest on the net organizational capital of a firm and on the nature of its stakeholders. The non-investor stakeholders constitute customers, employees and suppliers etc. And holds implicit claims which are non-written promises and rights, like the right to provide service to customers or job security for employees. It is still not certain as to the how the companies prefer to choose their capital structure. However, these theories do… READ MORE

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