2. Literature Review:
Capital structure is termed as an important area in financial decision making. It has relationship with other variables of financial decisions. Capital structure is composed of debt and equity capital that is used by the organizations to run its operations.
The debate on capital structure has been started after provision of theory of Irrelevance by Modigliani and Miller. Modigliani and Miller (1958) concluded that financial leverage has no affect the market value of firm. However the theory is based some assumptions that do not exist in the actual world. The assumptions are perfect capital markets, no taxes, homogenous expectations and no transaction costs. But the results may be different in presence of bankruptcy cost and tax shield treatment of interest payments that have impact on cost of capital. Modigliani and Miller (1963) have revised their earlier theory by including text benefit as determinant of the capital structure. They termed the interest expense on debt as tax saving instrument. The term is known as tax-shield in finance and it lowers the tax paid by the firm.
Brealey and Myers (2003) were of the point of view that the selection of capital structure is basically a marketing problem. They further explained that the firm can issue many different securities in numerous combinations, but it tries to find the specific combination that capitalizes the market value of firm. In this regard their argument is that the financial managers attempts to find out the combination that increases the market value of the firm. They also argued that a strategy which capitalizes the firm’s value also maximizes the wealth of the shareholders. In this regard, it may be deduced that the financial manager’s attentio...
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...on American industrial companies.
The Pecking Order hypothesis predicts that firms only sell their equity when the market have overvalued it (Myers, 1984). The base of the theory is that managers wants to give benefit to the existing shareholders. They are not willing to issue equity shares at low price than their actual value. It may be concluded that new share will only be issued when the market is willing to pay higher price than the actual value of shares. Therefore, it give a signal to investors that a firm is overpricing it equity.
Myers and Majluf (1984), ascertain that firms have preference to internal sources instead of external that have more cost than internal. Therefore, in the light of pecking order theory, it is deducted that the firms with higher profits will use equity mode of financing and firms will use debt financing who generate low earnings.
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.
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.
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.
The market value is not affected by the firm’s capital structure, that’s what the M&M first proposition stated; in proposition one it is stated that under certain conditions the firm’s debt equity has got no effect on the firm’s market value. This approach is based on the below:
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.
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.
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.
This paper will discuss the role of the financial manager and how that particular role, in the area of corporate expertise, differs from that of the shareholder and of the employee. The discussion the paper provides will help determine how the financial manager maximizes shareholder value in today's financial market. Lastly, the viewpoint of the financial manager will be compared to that of the shareholder and employee.
This paper will define and discuss five financial theories and how they impact business decisions made by financial managers. The theories will be the Modern Portfolio Theory, Tobin Separation Theorem, Equilibrium Theory, Arbitrage Pricing Theory (APT), and the Efficient Markets Hypothesis.
Sources of finance are the different methods for a business to earn and obtain money. There are lots of ways to obtain money but two large basic sources of finance, which are the “owner’s capital” and “capital borrowed”. They are also called internal sources of finance and external sources of finance. In those sources, they are mainly divided in two groups, which are short-term sources of finance and long-term sources of finance.
than we can assume that the financial position of the company is not sound. This also indicates that there is over trading.