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Explain the traditional approach of capital structure
The traditional view of capital structure
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Chapter 1
Introduction
1.1 Introduction
One of the most common ways for a firm to operate or finances its assets is capital structure. Capital structures refer as a combination of equity, debt and hybrid securities that used in the firm operation. In a perfect market, transaction or bankruptcy cost, inefficient information and taxes will not exist. Therefore, Modigliani and Miller created a theory of capital structure in a perfect market. The use of capital structure is important as it affect the firm profitability.
Financial decision of a business organization becomes one of the important decisions that normally will represent by capital structure. Musiega, et al. (2013) claimed that choosing an appropriate capital structure will benefit the firm as it help a firm to adapt with various challenging and competitive business world thereby become more profitability. According to Zeitun and Tian (2007), managers who are able to identify the optimal capital structure will help the companies to increase the firm revenue or profitability and reduce the firm’s cost of finance. Nutshell, capital structure of a firm can influence a firm profitability; a firm health determined by a firm capital structure.
By analyzing the choice of firm’s capital structure, financial behavior of a firm can be explained by the pecking order theory and the trade off theory (Ana, Dragan & Monica, 2012). Both of this theory provides a different relationship between the capital structure and profitability. Based on the study of Zabri (2012), the pecking order theory provide a negative impact of profitability on leverage while the trade-off theory provide a positive relationship between the capital structure and profitability. There are some of the findings...
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...o investigate the relationship between the capital structure and profitability of firm. In order to have clearer and accurate evidence on the relationship between the capital structure and profitability, 24 of public listed companies in Sarawak Kuala Lumpur Stock Exchange (KLSE), Malaysia are chosen to test it. All the financial statement for 24 companies will record accurate and correctly in order to create an accurate test or relationship. The introduction of the research proposal will be discussed in chapter 1. In chapter 2, literature review will be discussed on various views of previous researches which relate to our topic. Research methodology and the data collection will be present in chapter 3 while chapter 4 will discuss about the result and discussion on the result. A conclusion and policy implication will be discussed in the final chapter of this study.
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
Based on the Consolidated Statements of Shareholder?s Equity, year ended September 2015, in page 71, as shown in the statement, there are no preferred stocks.
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.
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.
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
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.
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...
Assessing the capital structure of any firm is important for investors attempting to determine if...
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.
Before beginning an analysis of a company it is necessary to have a complete set of financial statements, preferably for the pas few years so that historical trends can be obtained. Ratios are a way for anyone to get an idea of the financial performance of a company by using the information contained in the financial statements. Ratios are grouped into four basic categories, liquidity, activity, profitability, and financial leverage. This document will use a variety of these ratios to analyze the firm, Sample Company, as of December 31,2000.
6. Capital structure and the discount rate 6.1. Features of debt and equity financing Financing through equity or debt has advantages and disadvantages as follows: Equity is more flexible for the company, since in a situation of lack of liquidity shareholders return could be delay or stopped, while debt interest always have to be paid (Atrill and McLaney, 2015). Debt is faster to obtain than a securities issue (Atrill and McLaney, 2015). Related to control, a debt does not provide lenders control over company´s operations and management decisions, except some previous agreements with lenders about limiting future borrowings, sale of assets and pay of dividends.
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 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.
... profitability being a goal in the industry, the function of rivalry among companies will exist. I found that financial management is a huge benefit in any company whether it is large or small. A company that thinks that they can do without it must not have their company’s interests in mind at all. From balance sheets to pro forma balance sheets, every company needs them.
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)