(1) Introduction
There are three main capital structure theories which materialized from the reflections on the Modigliani and Miller (MM) Theorem (1958) first static tradeoff theory, Agency cost theory and Pecking order theory. This study is undertaken in Pakistan perspective.
The phenomena that developed by MM about market perfection under critics in gaze of mentioned theories.
The Pecking Order Model is component of capital structure was developed by Myers C.S et al 1984. It state that companies prioritize their source of financing in descending order (from retain earning to new stock ) internal funds are used first by retain earning, depreciation, and when that is used up, debt is issued, and when it is not sensible to issue any more debt, equity is issued as last resort. Due to Asymmetry of information “informational effect” the organization changes there behaviors toward capital structuring positive investment opportunities should be financed through available financial slacks or by debt financing is more valuable mix of capital structuring (Myers C.S et al 1984). Support sticky dividend policies to generate funds internally able to finance investment opportunities. This theory maintains that businesses hold to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required. According pecking order firm have not well defined optimal debt ratio due to asymmetric information firm adopt hierarchal order of financing preference the first priority internal financing if firms needed external financing by safe debt, risky debt equity financing is only used as lost resort Myers C.S et al 1984.
Every small, large corporation invests to maximize ...
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In SIVMED’s case, based on the definition of WACC, all capital bases should be included in its WACC. These include its common stock, preferred stock, bonds and long-term borrowings. In addition to being able to compute for the costs of capital, the WACC also determines how much interest SIVMED has to pay for all its activities. The value of the firm’s stock, which we want to maximize, depends of the after-tax cash flow. Hence, after-tax values for WACC are also needed. Furthermore, cost of capital is used to determine the cost of each debt, stock or common equity. Being able to analyze these will be essential into deciding what and how new capital should be acquired. Hence, the present marginal costs are ideally more essential than historical costs.
Their poor financial performance required them to use less traditional instruments to obtain financing. The capital acquired supported their growth until they reached a level of profitability in 1978. Subsequently, they continued to increase their net income and the quality of their balance sheet. With continued prospects for growth tempered by some regulatory uncertainty, they need to determine their optimal financial structure for the future. CAPITAL REQUIREMENTS MCI's capital requirements for the next 3 years are x,y and z. See Exhibit A for more information.
We defined several criteria to determine our choice – return, risks and other quantitative and qualitative factors. Targeting a debt ratio of 40% will maximize the firm’s value. A higher earning’s per share and dividends per share will lead to a higher stock price in the future. Due to leveraging, return on equity is higher because debt is the major source of financing capital expenditures. To maintain the 40% debt ratio, no equity issues will be declared until 1985. DuPont will be financing the needed funds by debt. For 1986 onwards, minimum equity funds will be issued. It will be timed to take advantage of favorable market condition. The rest of the financing required will be acquired by issuing debt.
The consistent high spending of capital equipment is the first reason why one would recommend reducing the debt to equity ratio. A company with higher levels of debt is less flexible in being able to adjust to new market demands and conditions that require the company to make new products or respond to competition. Looking at the pecking order of financing, issuing new shares to fund capital investing is the last resort and a company that has high levels of debt, must move to the equity side to avoid the risk of bankruptcy. Defaulting on loans occur when increased costs or bad economic conditions lead the firm to have lower net income than the payments on loans. The risk of defaulting on loans and the direct and indirect cost related to defaulting lead firms to prefer lower levels of debt. The financial distress caused by additional leverage can lead to lower cash flows available to all investors, lower than if the firm was financed by equity only. Additionally, the high debt ratio that Du Pont incurred also led to them dropping from a AAA bond rating to a AA bond Rating. Although the likelihood of not being able to acquire loans would be minimal, there are increased interest costs with having a lower bond rating. The lower bond rating signals to investors that the firm is more likely to default than if it had a higher (AAA) bond rating.
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Modigliani & Miller applied their theories with two modules, one which doesn’t include the taxes and this is their first finding, and another one with taxes to make it more realistic. The First Proposition without taxes: In this part Modigliani & Miller stated that the firm’s value is not affected by the structure of the capital between Equity and Debt, They proved this by having an example of two firms that have got the same conditions in everything, same cash flow, same operational risks and same opportunity costs. One of the firm’s capital structure is all equity and the other firm’s capital structure is a mixture between equity and debt, since the form of financing (debt or equity) can neither change the firm’s net operating income nor its operating risk, the values of levered and unlevered firms will be the same. They have concluded that the value of the levered firm = the value of the unlevered firm, only if they have the same conditions, same risk levels, cash and opportunity cost.
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Higher leverage is very likely to create value for a firm considering capital structure change by exerting financial discipline and more efficient corporate strategy changes.
Berk, J., & DeMarzo, P. (2011). Corporate finance: The core, second edition. (2nd ed.). Boston, MA: Prentice Hall.
Brealey, Richard A., Marcus, Alan J., Myers, Stewart C. 1999, Fundamentals of Corporate Finance, 2nd edn, Craig S. Beytien, USA.
The capital structure decisions for Target Inc. are significant since the profitability of the firm is specifically influenced by this decision. Profit maximization is part of the wealth creation process and wealth maximization can be a lengthy process for financial managers. Profits affect the value of the firm and it is expressed in the value of stock. Cost of capital is how investors evaluate weighted average cost of capital (WACC). Capital structure ratios help investors gauge the level of risk that a company is taking on through financing. While Target
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.
a. 1. What sources of capital should be included when you estimate Harry Davis’s weighted average cost of capital (WACC)?