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Descriptive essay on theories of capital structure
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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. The decisions around capital structure lie with the managerial members of the firm, however, it is the debt holders and shareholders who are more prone to bear risk. The normal business risk is always present, but when there is a higher level of debt the equity holders also bear an additional financial risk as there are additional charges relating to the financing. There is also a risk that if future liquidation or bankruptcy was to occur, the creditor hierarchy would favour debt holders first. Modigliani & Miller, M&M, (1958) found that in a world without taxes, the value of the firm is not affected by its capital structure, and also that the total return to investors remains the same regardless. M&M showed the …show more content…
In order to maximise firm value under this model, the firm should seek to borrow until that tax benefit from an extra £1 of borrowing equals the cost arising from increased likelihood of financial distress. It is clear that this theory regards the capital structure as highly relevent to firm value, and supports a real world scenario more strongly than M&M as it allows for bankruptcy costs. On an empirical level this perhaps explains why there are differences in capital structures between different
Balance sheet lists assets, liabilities and owner’s equity. The assets listed on the balance sheet are acquired either by debt (liabilities) or equity. “Companies that use more debt than equity to finance assets have a high leverage ratio and an aggressive capital structure. A company that pays for assets with more equity than debt has a low leverage ratio and a conservative capital structure. That said, a high leverage ratio and/or an aggressive capital structure can also lead
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.
Ross, S.A., Westerfield, R.W., Jaffe, J.F., & Roberts, G.S (2001) Corporate Finance. 3 th ed.Toronto, McGraw-Hill Ryerson.
While taking into account the mix of the debt / equity that maximizes the price of the common stock, I assume that the optimal capital structure would be 70% equity and 30% debt.
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 basic relationship between the market volume and corporate tax rates. A decrease in the corporate rates would allow companies to pay less on their earnings, leaving them with more Net Income (NI). With this increase in net income, a company can afford to invest in other areas or it allows them to repurchase their stock. By repurchasing stock, the market volume drops by the amount of stock that has been bought back. In addition, buying back shares can affect the overall outcome of the market that day depending on the company engaging in the repurchase. A company with a large stake in the market who buys back a considerable amount of stock will cause a greater fluctuation in the volume. In buying shares, the overall value of the market will rise due to the price increases that occur. If the opposite occurs, the tax rate is increased; some firms may have different decisions to make. Because an increase in the tax rate affects a company’s net income in a negative manner, funds for operations and other activities will become diminished. With the net income being less significant, a firm may need to participate in a form of either debt or equity financing to obtain funds needed to operate. Upon re...
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.
In this chapter there were presented three basic discounted cash flow methods for firm valuation that are often used in practice and which explicitly or implicitly include the value of the tax shield of debt. It should be mentioned, as Bertoneche and Federici (2006) and Fernandez (2007a) prove, that the different valuation methods give the same result for total value of the firm as well as for the value of the tax shield of debt, as long as the valuation methods rely on the same hypotheses and do not implicitly include any additional assumptions. Indeed, Fernandez (2007a) notes: “This result is logical, as all the methods analyze the same reality under the same hypotheses; they differ only in the cash flows taken as a starting point for the valuation.”
The dividend policy of a firm will not affect the present value of its shares and shareholder’s wealth. A firm’s value depends on the profitability of its assets and its investment projects, but not how it is “packaged for distribution” (Miller and Modigliani, 1961: 414). Moreover, they indicated that investors would make homemade dividends by offsetting the amount they paid for the stock and reducing the effects of dividend policy. In addition, investors were rational who would choose to invest in plentiful pay-outs with their tax-preferences, which represented the “clientele effect” (Miller and Modigliani, 1961: 432).... ...
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.
Managers are encouraged to act more in the interest of shareholders and the amount of leverage in the capital structure affects firm profitability (Ebaid, 2009).
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.
Debt financing is also borrowing against future earnings. This means that instead of using all future profits to grow the business or to pay owners, you have to allocate a portion to debt payments. Overuse of debt can severely limit future cash flow and stifle growth. Debt is a bet on your future ability to pay back the loan. What if your company hits hard times or the economy, once again, experiences a meltdown?
While Bhide (1990) suggests that the difference lies in the dealings of customers, suppliers, lenders, and tax authorities with the diversified firm are affected by the aggregated fortunes of its constituent businesses and the additional level of administrative or corporate overhead, we see that there are three main reasons for diversification. First, Lewellen’s financial theory of corporate diversification (1971) argues that diversification at the firm level leads to a reduction in variance of future cash flows thus increasing the debt capacity of the diversified firm. He concludes that as long as debt capacity adds value, diversification is a source of added value. Secondly, diversified firm’s cash flows provide a superior means of funding an internal capital market which offers a number of possible sources of value to the firm’s owners as internally raised equity capital is cheaper than funds raised in the external capital market and this gives the firm’s managers superior decision control over project selection, rather than forcing them to base the firm’s investment decisions to perceptions less-informed investors in the external capital market. This was formally put forth by Stein (1997), who suggests that managers select better projects as they have superior information. Finally, Khanna and Palepu (1999) propose