Capital Structure Miller and Modigliani’s theorem was first published in 1958 and it was a groundbreaking model in corporate finance. The M&M theorem on capital structure claims that in an efficient market and in the absence of taxes, bankruptcy costs and asymmetric information, the value of a firm is unaffected by how it is financed. That is, how the firm decides to raise capital, whether it is by taking on debt or by using existing equity, does not affect the value of the company. Market Timing and Capital Structure Article by Baker and Wurgler (2002) discusses equity “market timing”, i.e. practice of companies to issue shares when they are relatively expensive and repurchase them when they are cheap. According to MM model costs of different forms of capital do not vary independently because the markets are efficient and integrated, but in practice companies use equity market timing. Analysis shows that equity market timing is successful on average and companies tend to issue new shares when investors are too enthusiastic about future earnings also managers admit using market timing. Paper by Baker and Wurgler deals with the problem how market timing affects capital structure. Fluctuations in market value have very long-run impacts on capital structure. It is hard to explain this result within traditional theories of capital structure for example pecking order. Pecking order should prevent managers from issuing new equity entirely. Managerial entrenchment theory of capital structure by Zwiebel (1996) is partially consistent with market timing theory, but practice shows that managers are exploiting new investors instead of existing ones. Capital structure is the cumulative outcome of attempts to time the equity market. Fluctuations in the market-to-book ratio have considerable and lasting effects on leverage. Paper shows that these results are most consistent with market timing theory. None of tradeoff, pecking and managerial entrenchment theories can explain impact on capital structure. All of earlier mentioned theories have some significant flaws. Market timing theory looks as best explanation of empirical results in the sense that capital structure is a cumulative outcome of attempts to time the market. It seems that some other theories also have some explanatory power, and in some particular circumstances might be more important than market timing theory to explain changes in capital structure. But authors proved that if we have to choose just one theory, market timing theory would win because it has most explanatory power. Capital Structure and Firm Performance Berger and Emilia (2003) used profit efficiency as a new approach to test the corporate governance theory.
Shivdasani, A., & Zenner, M. (2004). Best practices in corporate governance: What two decades of research reveals. Journal of applied corporate finance, 16(2/3), 29-41.
The estimates of cost of capital for equity 6.14% are making by using the capital asset pricing model (CAPM) to generate forecast of DDM and RIM. This method is defined by the sum of risk free rate plus beta that multiplied with a risk premium. Particularly, the beta, which is a quantitative measure of the volatility of company stock relative to the unstable of the overall market, found in JB HI-FI case at 0.56 (JB HI-FI financial statement 2016). It
Blair, Margaret M. (1995) Ownership and Control: Rethinking Corporate Governance for the Twenty-First Century. Washington, DC: Brookings.
There is no universal theory of the debt-equity choice, and no reason to expect one. In this essay I will critically assess the Pecking Order Theory of capital structure with reference and comparison of publicly listed companies. The pecking order theory says that the firm will borrow, rather than issuing equity, when internal cash flow is not sufficient to fund capital expenditures. This theory explains why firms prefer internal rather than external financing which is due to adverse selection, asymmetry of information, and agency costs (Frank & Goyal, 2003). The trade-off theory comes from the pecking order theory it is an unintentional outcome of companies following the pecking-order theory. This explains that firms strive to achieve an optimal capital structure by using a mixture debt and equity known to act as an advantage leverage. Modigliani and Miller (1958) showed that the decisions firms make when choosing between debt and equity financing has no material effects on the value of the firm or on the cost or availability of capital. They assumed perfect and frictionless capital markets, in which financial innovation would quickly extinguish any deviation from their predicted equilibrium.
Our comparison for leverage will be based on three different firms; Everglades, Kraft Heinz and Geico. Leverage can be broken down into three components; operating, financial and total. As we set recommendations and explain our expectations for these firms we have analyzed these firm’s organizations will have to acknowledge their variable/fixed cost, optimal debt and equity within the firm. Operating leverage is the relationship between the fixed cost and variable cost of a firm in the cost structure. There are two different levels of leverage that help us to understand the risk that a firm can have.
The results obtained from the cooperation of Modigliani and Miller in 1958, was an attempt to prove that the financial decisions should not be significant in the perfect conditions of the market, after being published the Modigliani and Miller theory became the main theory of the capital structure. In the M&M theory it suggested that the market is fully efficient, meaning that there are no taxes, however in the theory Modigliani and Miller included the taxes to be able to reflect their theories in reality, and the theory also suggested that there are no bankruptcy costs. There are three propositions that were published by Modigliani and Miller which are: • Proposition 1: A firm’s total market value is independent of its capital structure. Proposition 2: The cost of equity increases with its debt-equity ratio. Proposition 3: A firm’s total market value is independent of its dividend policy.
IPO is a method for companies to raise expansion capital, however, it is also used by insiders as a tool to maximise their personal wealth. According to the theory developed by Aggarwal et al. (2002), managers underprice IPOs on purpose to raise higher profit from selling stocks at the expiration date. The IPOs that are underpriced on the first day attract the attention of the analysts therefore generate information momentum and change the demanding curve of the stock. The generated information momentum change the share price to peak around the expiration date which allow the managers to maximise their personal wealth through selling shares.
Finding the perfect capital structure in terms of risk and reward can ensure a company meets shareholder expectations and protects a firm in times of recession. Capital structure refers to how a business puts its money to “work”. The two forms of capital structure are equity capital and debt capital. Both have their benefits and limitations. Striking that perfect balance between the two can mean the difference between thriving versus trying to survive.
Bibliography: Turnbull, S. (1997). Corporate governance: its scope, concerns and theories. Corporate Governance: An International Review, 5 (4), pp. 180--205.
Lazonick, W., & O'Sullivan, M. (2000). Maximizing shareholder value: a new ideology for corporate governance. Economy and Society, 29(1), 13-35. Retrieved from http://www.uml.edu/centers/cic/Research/Lazonick_Research/Older_Research/Business_Institutions/maximizing shareholder value.pdf
Solomon, J (2013). Corporate Governance and Accountability. 4th ed. Sussex: John Wiley & Sons Ltd. p.7, p9, p10, p15, p58, p60, p253.
The efficient market hypothesis has been one of the main topics of academic finance research. The efficient market hypotheses also know as the joint hypothesis problem, asserts that financial markets lack solid hard information in making decisions. Efficient market hypothesis claims it is impossible to beat the market because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information . According to efficient market hypothesis stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments . In reality once cannot always achieve returns in excess of average market return on a risk-adjusted basis. They have been numerous arguments against the efficient market hypothesis. Some researches point out the fact financial theories are subjective, in other words they are ideas that try to explain how markets work and behave.
The capital structure of a firm is the way in which it decides to finance its operations from various funds, comprising debt, such as bonds and outstanding loans, and equity, including stock and retained earnings. In the long term, firms seek to find the optimal debt-equity ratio. This essay will explore the advantages and disadvantages of different capital structure mixes, and consider whether this has any relevance to firm value in theory and in reality.
K, . N., ER, w., DAVID, K., PAUL, M., WALTER, O., & EVANS, A. (2012). Corporate governance theories and their application to boards of directors: A critical literature review . Prime Journal of Business Administration and Management (BAM), 2(12)(2251-1261), 782-787.
Financial theories are the building blocks of today's corporate world. "The basic building blocks of finance theory lay the foundation for many modern tools used in areas such asset pricing and investment. Many of these theoretical concepts such as general equilibrium analysis, information economics and theory of contracts are firmly rooted in classical Microeconomics" (Oaktree, 2005)