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,
These ratios can be used to determine the most desirable company to grant a loan to between Wendy’s and Bob Evans. Wendy’s has a debt to assets ratio of 34.93% while Bob Evans is 43.68%. When it comes to debt to asset ratios, the company with the lower percentage has the lowest risk. Therefore, Wendy’s is more desirable than Bob Evans. In the area of debt to equity ratios, Wendy’s comes in at 84.31% while Bob Evans comes in at 118.71%. Like debt to assets, a low debt to equity ratio indicates less risk in a company. Again, Wendy’s is the less risky company. Finally, Wendy’s has a times interest earned ratio of 4.86 while Bob Evans owns a 3.78. Unlike the previous two ratios, times interest earned ratio is measured on a scale of 1 to 5. The closer the ratio is to 5, the less risky a company is. From the view of a banker, any ratio over 2.5 is an acceptable risk. Both companies are an acceptable risk, however, Wendy’s is once again more desirable. Based on these findings, Wendy’s is the better choice for banks to loan money to because of the lower level of
Another observation is that GM looks to use more debt financing that equity financing for funding their activities. The debt to equity ratio has steadily decreased over the past five years and is higher that the industry average. Also, the current and quick ratios are much lower than the industry averages. This again can pose so...
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.
Having a low P/E ratio with respect to the rest of the market, and the replacement cost of the firm being greater than its book value (argument 3), there is a good chance that the current stock price and the proposed offering price are too low. Although long-term debt is a better financing choice, a few of the drawbacks are pointed out. Debt holders claim profit before equity. holders, so the chances that profits may be lower than expected. increases risk to equity, may reduce or impede stock value. However, the snares are still a bit snare.
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...
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.
There is a close relation between the capital adequacy and the financial system but it is important to have an overview before get to the more detailed study of what is going on in the financial system.
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
Ÿ Capital structure/investment - This information is taking from the Balance sheet, but also from the Profit and Loss Account. This is examining the sources of finance the company has used and also looking at it as a potential investment opportunity. There are certain features, which must be present if financial information is to meet the needs of the user. The two most important features are that: Ÿ The information should be relevant to those who are using it.
A key benefit of equity financing is that the company will not be debt repayments. This is beneficial...
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.
Most critical to this discussion is a clear understanding of what a financial manager is and does and how his or her role aids in helping to establish the valuation of a corporate entity in today's global financial market. Quite simply, a financial manager helps to measure a company's market value and its risk, while also helping to systematically reduce its costs and the time necessary to make informed decisions regarding objective driven operations. This is quite a demanding game plan for an individual and most often financial managers, in the corporate world, working in cooperation with a team of financial experts. Each member of that team perhaps having expertise in differing areas of activity, but each however, being no less expert in his or her respective area of endeavors on behalf of the corporation. The team is assembled under the direction of the officer known in the corporation as the Chief Financial Officer who today is becoming increasingly indispensable to the CEO who directs a modern model of action driven, bottom-line oriented corporate activity (Couto, Neilson, 2004).
Short term and long capital are needed for organizations to survive in today's economy. Organization's now more that ever need these different sources to diversify, expand or to keep processes more efficient thus keeping them at the head of the pack. Today's businesses and consumers demand for speed and quality of products.
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)