This chapter contains an analysis and summary of existing researches with regards to firms’ behaviour when making financing decisions. The aim of this is to reveal similarities and differences, consistencies and inconsistencies and controversies in previous research to fulfil the research objectives of this study, achieving this through analysing a range of sources including: academic theories, practitioner studies, corporate reports and more. The review is split into five sections, each one defined to support the research objectives specified in the proposal and furthermore the research aim.
3.1 Modigliani and Miller
It is important to consider the established capital structure theories because they are the foundation for the development
In 1961, the pecking order theory was started by Donaldson (1961) to challenge the idea of companies having a unique combination of debt and equity finance which lowers their cost of capital.
Donaldson (1961) was the first to observe that management preferred internal funds as a new source for their company’s capital investment. Myers (1984), Myers and Majluf (1984) later developed this theory by suggesting that firms have an order of priority when raising new finance. In particular, they found that firms prefer to use internal funds to finance the business rather than external funds because the information asymmetry can be created when firms seek for external funds. Unless internal funds (i.e. retained earnings) are insufficient then debt such as bank borrowing or corporate bonds are the second external source of finance in line to be used. Equity understood to be a last resort as it causes cost of capital to increase due to the higher level of risk. Furthermore, cost of equity being more expensive than debt, attributed to the increased rate of return expected by equity
They found that managers are in a stronger position to make judgement calls regarding the future financial decisions of a firm, based on the fact that an investors’ assessment of value associated with share price is vulnerable to a variety of volatile factors. Specifically, the inability to access inside information hinders investors from conducting accurate security valuations included in the share price. Furthermore, because of informational disadvantage representing higher risk, equity investors will demand for a “risk premium” result in higher return making it more expensive than other source of finance and therefore less attractive for firms as a finance instrument (Hawawini and Viallet,
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.
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.
Different management attitudes bring about varying capital structures. Management are conservative or aggressive depending upon their outlook on risk. Both management styles exercise different judgments. In the case of Johnson and Johnson management are conservative and use less debt, whereas management with an aggressive approach is more likely to use debt to grow profits.
Does the capital structure of a firm really matter? If so, how and why does it matter? Practitioners and scholars of corporate finance have debated these questions for several years and have found it difficult to come up with definitive answers. The classical work of Modigliani and Miller (1958) provided the impetus for what is now, orthodox corporate finance theory on the optimal capital structure of firms. They postulated that, in a perfect or frictionless capital market, the choice between debt and equity financing has no material effect on the value of the firm. Stern and Chew (2003) noted that following the Modigliani-Miller propositions, academic researchers in the 1960s and 1970s turned their attention to market imperfections that might make firm value depend on capital structure. They further noted that the main suspects were a tax code that encourages debt by making interest payments but not dividends tax-deductible and expected costs of financial distress that rise with increasing amount of debt. Towards the end of the 1970s, they noted, there was also discussion of signalling effects, such as the tendency for stock prices to fall significantly on the announcement of new equity issues and to rise on the news of stock buyouts. These effects seemed to confirm the existence of large information cost that could influence financing choices in the predictable ways.Myers (1984), however, noted that there is a conflict which has existed among the different theories and referred to is as the “capital structure puzzle.” Barclay and Smith (2005) noted that it has been the difficulty of coming up with conclusive tests of the competing theories. Firstly, they noted that model on capital structure typically are less precise than...
Analyzing the pros and cons of structuring the additional capital funding as a debt rather than equity.
Capital structure is the composition of the company 's capital value and the proportion of the relationship which can reflect the company 's structural stratification and core competitiveness of the company 's business performance also has unpredictable impact on market value, shareholder wealth and even sustainable development capacity . Through the analysis of the equity ratio, the debt ratio, the long-term debt ratio, the return on assets and the Modigliani and Miller theory, Sainsbury 's capital structure is stable.
There is a range of criteria relevant for a decision of financing a new venture. To construct my list for the evaluation of a new company as an opportunity I have selected to refer to t...
Capital gearing ratio is important to the company and the prospective investors. It must be carefully planned as it affects the company's capacity to maintain a uniform dividend policy during difficult trading periods. It reveals the suitability of company's capitalization
Firm financing is a very important aspect for the operations of any company and this is done prior to any business strategies are made. Most company commonly pursues to use equity financing and debt financing. In debt financing funds borrowed must be repaid with interest whereas equity financing funds is acquired by sale of shareholders interest of the company.
In choosing between internal sources or external sources of capital, the directors of a company are obligated to act in the way in which the directors consider (in good faith) would promote the success of the company for the benefit of its members. Some of the likely considerations around debt are:
The rapid development of media and technology in the world market today has helped companies to sell their products and get in touch with their customers more easily (Rayburn, 2012). However the success of a company depends on many factors, not that only whether it has brilliant advertisement or marketing campaigns. The main aim of a company is to create shareholder’s value which according to Bender and Ward (2008), companies have to manage both well in a trading environment and financial environment in order to do that. Hence, the financial strategy can be seen as one of the most important factors in contributing to the business’s success especially to a large company such as Unilever as it is all about strategic decisions related to raising and manage the funds in the most appropriate manner.
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)
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.
Smaller companies are much more likely to obtain an attentive audience with a commercial loan officer after the start-up phase has been completed. In determining whether to extend debt financing--essentially, make a loan--bankers look first at general credit rating, collateral and your ability to repay. Bankers also closely examine the nature of your business, your management team, competition, industry trends and the way you plan to use the proceeds. A well-drafted loan proposal and business plan will go a long way in demonstrating your company's creditworthiness to the prospective lender.