IFFM Blog #5 Capital Structure: Theory, Research and Practice

In the previous post, it was discussed that a company that is hoping to gain investors should first evaluate their cost of capital in order to ensure that cash generated is sufficient to cover the rate of returns expected by investors, as well as for company growth. This is calculated primarily through the use of Weighted Average Cost of Capital (WACC) formula should a firm have a mixed Capital Structure. According to Murray, capital structure is defined as the combination of equity and debt that a firm has on its balance sheets (Murray, 2017). Companies strive to optimise their WACC such that it is most beneficial for their operations. While individuals ranging from academics to corporate management have hypothesised the ideal capital structure models, the theories on what works best is not reflected in successful companies around the world (Baker, Singleton and Veit, 2010)  One factor that results in this is that how persons managing a company decide to structure the firm's debt or equity differs across the board based on their agendas.

The notion of capital structure was first coherently explained by Modigliani and Miller in a paper published in 1958 (Modigliani & Miller, 1958). Modigliani and Miller's Theory of Capital Structure presents that the valuation of a firm is not relevant to its capital structure. Instead, the profits made from operations is what drives the valuation. The conditions that had to be met in their theory include no taxes, no costs of financial burden, that all agents have access to the same information, and that firms can be classified according to risk classes (MM Propositions I and II (Case with No Taxes), 2018)  While it is important to understand this theory, some assumptions that were made by the duo renders the idea inapplicable to reality (Ozyasar, n.d.). The assumptions were:
  1. There are no transaction costs.
  2. Businesses and investors are able to borrow at the same cost.
  3. If there are worthwhile investment opportunities, the company will pursue them. If not, the company will return excess cash to shareholders in dividends.
In reality, there certainly are transaction costs in business dealings. For instance, companies that run e-commerce websites pay a transaction fee to services such as Braintree, which aids in facilitating the customer payment process. Businesses and investors as individuals borrow at different costs, and companies do not always instantly move excess cash generated from operations. Nevertheless, Modigliani and Miller's journal article earned them a Nobel prize (Modigliani, 1985). 

It also paved the way for other theories such as the Trade-Off Models of Capital Structure, which states that companies strive for a "value-maximising optimal capital structure" that greatly reduces the WACC (Kraus and Litzenberger, 1973)  According to Trade-Off Models, company valuation is independent of capital structure, and gearing is able to increase the wealth of investors/shareholders only up to a certain point. Gearing refers to a firm's leverage (Peavler, 2018)  In other words, gearing is the amount of funding that originates from creditors as opposed to people who own the company (Peavler, 2018). 


 References

 Murray, J. (2017). 3 Definitions of Business Capital. [online] The Balance. Available at: https://www.thebalance.com/capital-and-capital-structure-of-a-business-398170 [Accessed 1 Feb. 2018].

 Baker, H., Singleton, J. and Veit, E. (2010). Survey research in corporate finance. Oxford Scholarship Online.

 Modigliani, F., & Miller, M. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review, 48(3), 261-297. Retrieved from http://www.jstor.org/stable/1809766

 MM Propositions I and II (Case with No Taxes). (2018). [ebook] Available at: http://finance.wharton.upenn.edu/~jwachter/fnce100/h13.pdf [Accessed 1 Feb. 2018].

 Ozyasar, H. (n.d.). Assumptions of the Modigliani-Miller Theorem. [online] Smallbusiness.chron.com. Available at: http://smallbusiness.chron.com/assumptions-modiglianimiller-theorem-55674.html [Accessed 1 Feb. 2018].

 Modigliani, F. (1985). The Prize in Economics 1985 - Press Release. [online] Nobelprize.org. Available at: https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1985/press.html [Accessed 1 Feb. 2018].

 Kraus, A. and Litzenberger, R. (1973). A State-Preference Model of Optimal Financial Leverage. The Journal of Finance, 28(4), p.911.

 Peavler, R. (2018). What High Gearing Ratios Say About a Company. [online] The Balance. Available at: https://www.thebalance.com/calculating-gearing-ratio-393228 [Accessed 1 Feb. 2018].

Comments

Post a Comment

Popular posts from this blog

IFFM Blog #3: Modern Portfolio Theory and the Capital Asset Pricing Model

Image
Modern Portfolio Theory (MPT) is an investing model where the investor tries to keep the market risk to the minimum in order to enjoy maximum returns for a given portfolio of investments. (Thune, 2017) It utilises mathematical tools assist investors to diversify, resulting in reduced risk. Markowitz (1952) theorised two concepts of MPT, whic h are (D'Alessio, n.d.): Any investor's goal is to maxmise return for any level of risk Risk can be reduced by creating a diversified portfolio of unrelated assets Markowitz (1952) also identified two further types of risks which could be affected by a strategy of investment diversification: Systematic Risk  which affects all types of investments and impossible to diversify away Unsystematic (or Specific Risk ) which can be diversified away Capital Asset Pricing Model (CAPM)  is a stock valuation model that displays the correlation between expected returns and expected risks, where the return on an asset ...
Read more

IFFM Blog #2: Stock Market Efficiency and Capital Markets

Image
Capital Market  is a system in which investors transfer those funds to individuals, companies, and governments that have a need of fun ds. ( saylordotorg.github.io, n.d.)  It  carries ou t the desirable economic function of directing and driving funds in form of capital to productive uses. Capital markets can be accessed in either debt or equity. Market efficiency suggests that at any given time, prices fully reflect all available information on a particular market .  For it to become efficient, investors must have the  perception  that the market is inefficient and possible to beat. ( Heakal , 2013) In 1970, Eugene Fama hypothesised that there are 3 different forms of Market Efficiency (EMH): 1. Weak Form Efficiency Weak form is when available public information is used, mainly historical data, in attempts to determine the current share prices in the market. (open.edu, n.d.) There is fundamentally no mechanical trading rules based on historical move...
Read more

IFFM Blog #6: Dividend Policy

Dividend Policies determines when, how much cash and if a company should provide a pay out to the comapany's owners in form of dividend rather than repurchases of shares, reinvestments or reduction of debt. (Kennon, 2017) Such decisions are made by the company's board of directors, and it is up to them to formulate an effective dividend policy to provide maximum returns to its shareholders and yet, ensuring the continuity of the company's sustainability. The constraints in the construction of dividend policies come in four categories: Legal In reference to The Companies Act, it is specified that dividends should only be paid out of realised profits, inclusive of realised profits made in previous years Regulatory & Governmental Regulatory requirements may affect a companies ability to provide a payout to the shareholders. Windfall or supplementary taxes can be sometimes be targeted at regulated industries. Hence, further impeding their ability to provide p...
Read more