[Year]Implication of Capital Structure and Efficient market to Large corporations

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[ Implication of Capital Structure and Efficient

market to Large corporations ][Type the abstract of the document here. The abstract is typically a short summary of the contents of the document. Type the abstract of the document here. The abstract is typically a short summary of the contents of the document.]

Executive Summary:

The Assignment focuses on two broad topics of corporate finance

i.e. the capital structure and the efficient market hypothesis.

In the first section, the paper discusses the concept of capital

structure, how it is influenced by cost of capital, different

sources of capital for large companies. Next, Modigliani–Miller

theorem that challenges the concept of capital structure has also

been discussed. Finally, there were comments on the optimal

capital structure based on the above discussion.

The second and last section discusses the efficient market

hypothesis. The concept has been discussed briefly including

different kinds of market that exists as per the hypotheses. The

hypothesis has also been discussed with its implications for

investors. Finally, there were comments based on the findings of

the above discussion.

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Table of ContentsExecutive Summary:...................................................2

Chapter 1: Capital Structure and the cost of capital in the efficient financial management of large companies:.............................3

1.1 Capital structure:..............................................3

1.2 Source of finance available to large companies..................4

1.3 Relevant models and theories underpinning the capital structure.................7

1.4 Optimal Capital Structure.......................................9

Chapter 2: Efficient Market Hypothesis..............................10

2.1 Implications of efficient market hypothesis for the investors andmanagers...........................................................11

Conclusion..........................................................13

References..........................................................14

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Chapter 1: Capital Structure and the cost of capital inthe efficient financial management of large companies:

No business can be run without capital. It is the most import

part for running all kinds of business activities although may

vary in size depending on size and nature of the business

concern. So, maintaining adequate and expected level of capital

is important for any company as it helps to earn profit resulting

in distribution of expected dividends to its shareholders.

1.1 Capital structure:

Capital Structure, in simple terms, refers to the ratio of long-

term debt to equity for a company.  It is the mix of different

sources of long-term sources such as equity shares, preference

shares, debentures, long-term loans and retained earnings.

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Capital structure is concerned how a company's permanent assets

are financed. So, value of the firm is naturally tightly

associated with the suitable capital structure and it is one of

the most important financial decisions that a company makes.

There are different factors such as Leverage, Cost of Capital &

Government Policy that contribute to determining the capital

structure of a firm or company.

Leverage involves fixed cost financing such as debt, equity and

preference share capital. It is closely related to the overall

cost of capital.

Cost of Capital constitutes the major part for deciding the

capital structure of a firm. Both equity and debt as a source of

long term finance involves fixed cost for mobilization. When this

mobilization cost increases, value of the firm normally

decreases. So, a firm always tries to reduce its cost of capital

to maximize the value of the firm and its choice of capital

depends on:

(a) Nature of the business: Use of equity or debt as source of

finance depends upon the nature of the business. A business

tends to apply for equity than debt if it is in a long period

of operation to reduce the cost of capital.

(b) Size of the company: Large firms can manage the financial

requirements with the help of internal sources. But small5 | P a g e

size firms have to go for external finance that involves high

cost of capital.

(c) Legal requirements: Sometimes firms are handicapped by Legal

requirements to raise firms from some sources. For example,

banking companies cannot raise funds from some sources which

have impact on cost of capital.

(d) Requirement of investors: In order to collect funds from

different type of investors, it will be appropriate for the

companies to issue different sources of securities.

Lastly Government policy also determines the capital structure of

the company. Company Act has fixed the percentage that promoter

could engage in a company. It has certain restrictions to

mobilize large, long-term funds from external sources.

1.2 Source of finance available to large companies

As discussed above, there are certain considerations that large

companies take for granting while obtaining finance. The main aim

is to raise fund from source which cost the least. Apart from the

above considerations or factors, the large companies also

consider following general factors.

The amount of interest to be paid on borrowed funds or

dividends expected on shares.

The available tax relief on interest or dividends

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Obligations of the company to make regular payments of

dividends or interest and to repay or redeem the source

The effect of the source on control of the firm

The time span of the source and whether it matches the

purpose of funding

Sources of finance can be mostly concerned with the distinction

between:

i. Long and short-term finance

ii. External and internal

iii. Equity and debt finance

i. Long and short-term finance

Long-term sources used to fund investment in assets that form

part of a company's permanent capital base, short-term sources

will be used for assets that need to be replaced more often. This

is the principal of matching.

Examples are long-term: Ordinary Shares, Preference Shares, Loans

and debentures, convertible loans, Eurobonds, Leases, Grants

Short-term: Bank overdrafts

ii. External& internal sources

External financing requires the company seeking finance outside

itself. This will always result in additional cost.

External finances are

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Ordinary Shares known as Equity Finance

Preference Shares

Loans and debentures Known as Debt Finance

Convertible loans,

Eurobonds,

Leases,

Grants and

Bank overdrafts

Internal sources

Normally it is wisest for a company to make use of money which it

is already owns. Internal finance will almost definitely a

cheapest source of finance available to companies. The most

common internal finance is the retained profit

iii. The Equity and Debt finance

Equity Finance is that belonging to the owners of the company,

the ordinary share capital. Debt finance is obtained from other

sources.

The various sources of financing have varying impacts in the

value of the company and cost of capital. For example if company

decide to opt for debt say by issuing debentures, long-term block

loans etc, the company can raise finance for these projects

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without costs like stock exchange costs, costs in issue of

prospectus, share transfer levy etc.

Debt finance is considered to be cheaper compared to equity as

the interest payments attract tax deductions. But the downside in

going for debt is it creates additional financial risk. Having

more debts will increase the gearing and the investors will

consider the company to be a risky one. If there are covenants,

additional issue of debt finance can be limited or restrict by

the existing debt holders.

The prospective debt holders may require the company to pledge

its asset collaterals. This is an additional risk of insolvency.

Further, whether company makes profits or not it is bound to

service the interest payments.

The traditional view (in contrast to Modigliani & Miller theory)

suggests the cheaper nature of debt will be present only up to a

certain level, after which the debt holders will also require

higher returns to compared to the higher risk they undertake. If

the traditional theory holds there, value of the business will

suffer as the cost of capital starts escalating after a certain

level of debt finance. However, the dilution of control is

minimal by going for debt financing.

If the director of the company are concerned about maintain their

control the best approach would be going for debt, but the

downside effects mentioned above paragraphs should be carefully

considered.

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Now let us consider the impact of going for equity financing.

This can be done by going for a totally new share issue or by

private placements. In any of these ways a dilution of ownership

can be expected. The impact of EPS (earning per share) also

change as and this share price will be affects accordingly.

Compared to debt financing there will be lower fluctuations in

EPS.

However the company can avoid payment of dividends if the company

does not make enough profits or by convincing shareholders about

prospective future growth. However, due consider deeming dividend

tax should be given, in making dividend retention policies.

Company's gearing will not suffer and company can show a less

risky picture. The problem of pledge its assets will not pop up,

but due to these reasons the new equity holders will demand high

dividend rates.

1.3 Relevant models and theories underpinning the capitalstructure

The most dominant theorem concerning capital structure is

Modigliani–Miller theorem. It states that, in the absence of

taxes, bankruptcy costs, and asymmetric information, and in an

efficient market, a company’s value is unaffected by how it is

financed, regardless of whether the company’s capital consists of

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equities or debt, or a combination of these, or what the dividend

policy is. The theorem is also known as the capital structure

irrelevance principle.

A number of principles underlie the theorem, which holds under

the assumption of both taxation and no taxation. The two most

important principles are that, first, if there are no taxes,

increasing leverage brings no benefits in terms of value

creation, and second, that where there are taxes, such benefits,

by way of an interest tax shield, accrue when leverage is

introduced and/or increased.

The theorem compares two companies—one unlevered (i.e. financed

purely by equity) and the other levered (i.e. financed partly by

equity and partly by debt)—and states that if they are identical

in every other way the value of the two companies is the same.

As an illustration of why this must be true, suppose that an

investor is considering buying one of either an unlevered company

or a levered company. The investor could purchase the shares of

the levered company, or purchase the shares of the unlevered

company and borrow an equivalent sum of money to that borrowed by

the levered company. In either case, the return on investment

would be identical. Thus, the price of the levered company must

be the same as the price of the unlevered company minus the

borrowed sum of money, which is the value of the levered

company’s debt. There is an implicit assumption that the

investor’s cost of borrowing money is the same as that of the

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levered company, which is not necessarily true in the presence of

asymmetric information or in the absence of efficient markets.

For a company that has risky debt, as the ratio of debt to equity

increases the weighted average cost of capital remains constant,

but there is a higher required return on equity because of the

higher risk involved for equity-holders in a company with debt.

Traditional view: dividends are relevant

Traditional view of dividends is relevant in determining the

value of shares. Supporters of the traditional view believe

that investors prefer dividends to capital gains on their

shares. Since no risk attached to the dividend an investor

receives today, they will prefer to receive the dividend

payment rather than leaving the funds invested, because

future values are uncertain. Because of their reliability,

current dividends are preferred to future capital gains.

The relevance of dividends to share value is an assumption

of Gordon's model of dividend growth, which determines the

value of a share price by the value of future dividends.

The problem with the traditional view of the relevance of

dividends is one of risk anomaly. All companies go through a

cycle of growth to maturity. At the start, they are using

all their available funds to reinvest in the operation and

consequently, they have little spare cash out of which to

pay dividends. As the company matures it does not need to

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reinvest as much and so has more funds available to pay out

as dividends.

Modigliani and Miller's theory: dividends are irrelevant

MM's theory of dividend irrelevancy refers not to the

payment of the dividends but to the timing of their payment.

MM's theory is that in a perfect and efficient market, the

pattern of dividend payments should not affect share values

and shareholder wealth. If the company pays a lower dividend

in order to retain profits for investment, shareholders will

compensated by an increase in the value of the company and

in share price.

According to MM, if a company has an investment opportunity

giving a positive NPV, it should take up using retained

earnings rather than paying out a dividend.

MM's view is that it is not company but the individual

shareholder who decide dividend policy. Therefore, there is

no such dividend policy for company, only an optimal

investment policy.

Advantages

In practice, it’s fair to say that none of the assumptions are

met in the real world, but what the theorem teaches is that

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capital structure is important because one or more of the

assumptions will be violated. By applying the theorem’s

equations, economists can find the determinants of optimal

capital structure and see how those factors might affect optimal

capital structure.

Disadvantages

Modigliani and Miller’s theorem, which justifies almost

unlimited financial leverage, has been used to boost economic and

financial activities. However, its use also resulted in increased

complexity, lack of transparency, and higher risk and uncertainty

in those activities. The global financial crisis of 2008, which

saw a number of highly leveraged investment banks fail, has been

in part attributed to excessive leverage ratios.

1.4 Optimal Capital Structure

The optimal capital structure for a company is one which offers a

balance between the ideal debt-to-equity ranges and minimizes the

firm's cost of capital. In theory, debt financing generally

offers the lowest cost of capital due to its tax deductibility.

However, it is rarely the optimal structure since a company's

risk generally increases as debt increases. Besides, in reality,

there are significant inter-industry differences in debt ratios

that persist overtime. Following table can illustrate the fact:

Industry Debt as a Percentage of the

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Market Value of Equity and debt

(Industry Medians)Air Transport 57.9Television broadcasting

stations

54.0

Hotels and lodging 44.2Natural gas distribution 41.8Building Construction 40.4Educational Service 7.8Drugs 6.8Biological Products 5.9Electronics 3.3Computers 1.6

Source: ibboston 2008 Cost of Capital Yearbook (Chicago:

Morningstar.2008)

So, it is fair to say that optimal capital structure is not a

universal ratio. Rather it varies amongst industries depending on

the nature of business as well as target debt-equity ratios opted

by individual companies.

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Chapter 2: Efficient Market Hypothesis

Eugene Fama propounded the Efficient Market Hypothesis in the

1960s. According to Fama, in an active market that includes many

well-informed and intelligent investors, tocks always trade at

their fair value, making it impossible for investors to either

purchase undervalued stocks or sell stocks for inflated prices.

As such, it should be impossible to outperform the overall market

through expert stock selection or market timing, and that the

only way an investor can possibly obtain higher returns is by

purchasing riskier investments.

  

There are three forms of the efficient market hypothesis:

 

1. The Weak form implicates that all past market prices and data

are fully reflected in securities prices. Future prices cannot be

predicted by analyzing price from the past. So, investor will not

able to receive permanent profit in the long run on the base of

past prices. Future price movements are determined entirely by

information not contained in the price series. In this case

applying of technical analysis in the long run is useless.

Additional return can be received via fundamental analysis or

insider information.

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2. The Semistrong form implicates that all publicly available

information is fully reflected in securities prices. Share prices

adjust to publicly available new information very rapidly and in

an unbiased fashion.  Here, applying of fundamental and technical

tools in the long run is useless. Participant can use insider

information only.

3. The Strong form implicates that all information is fully

reflected in securities prices. So, even insider information is

not to be used.

2.1 Implications of efficient market hypothesis for theinvestors and managers

The obvious implication of efficient market hypothesis for

investors is to find the answer “How efficient is the market?”

If the market is truly efficient, no information will be of any

use to investors, not even monopolistic information. So,

investor’s position becomes hopeless. However, different studies

show that the market is not absolutely efficient because

investors can beat the market averages. So, investors have to

determine the degree of market inefficiency. Following figure may

help to determine the degrees of inefficiency of the market.

Degrees of Efficiency of Information in the Stock Market

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.

If the market is totally inefficient, all information is useful.

In such case, investors can take the advantage of the market in

all cases. But investors know that the market is not totally

inefficient because none of the analysts and investors who

analyze information has been able to consistently earn returns in

excess of the market averages. So, information between the

extremes of all and none, namely, historical, public, and private

information determines the efficiency of the market.

According to the weak and semi strong forms of the efficient

market hypothesis, the use of technical and fundamental analysis

does not consistently produce superior returns. Rather, the two

seemingly sure ways to earn returns in excess of the market

returns are to obtain insider information and to become a

specialist.

The efficient market hypothesis suggests that all information

(public and private) is incorporated into the price of the stock

and that the prices of stocks with good fundamentals will be bid

up to reflect this situation. Similarly, stocks that are in

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trouble will be sold to bring their stock prices in line with

their intrinsic value. In other words, no undervalued or

overvalued stocks exist.

The efficient market hypothesis is highly debated as the jury of

academicians is still undecided about the degree of efficiency of

the market. Although most investors have little respect for

efficient market hypothesis, its implications are important

because they shatter any illusions of creating overnight wealth

in the stock market.

The efficient market hypothesis suggests that few investors will

beat the market averages consistently over a long period. If the

market increases by 10 percent over a one-year period, most

investors will not earn more than an average of 10 percent. In

fact, most investors earn less than the market average because of

transaction costs and fees. However, this does not mean that some

investors will not do much worse than 10 percent or will not earn

abnormally high returns.

Anomalies to the efficient market hypothesis can be proven from

simple examples around us. Warren Buffett has consistently beaten

the market over long periods of time which is impossible

according to the market hypothesis. The events like 1987 stock

market crash when the Dow Jones Industrial Average (DJIA) fell by

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over 20% in a single day can also challenge the market hypothesis

as stock prices can seriously deviate from their fair values.

ConclusionHowever, in conclusion, it has to be said that these anomalies

should not lead investors to think that the markets are

inefficient. Rather, the anomalies should be viewed as

exceptions. Academic studies lend support for the weak and semi

strong forms of the efficient market hypothesis, which lends

support to the conclusion that very few investors outperform the

markets over extended periods. So, investors should be careful on

their investment decisions.

References

Bodie, Z.; A. Kane.; A.J. Marcus. 2007. Essentials of investments, 6th

edition, McGraw-Hill / Irwin.

Fama, E. 1965a. “The Behavior of Stock-Market Prices.” The Journalof Business, Vol. 38, No.1, pp. 34-105

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Fama, E. 1965b. “Random Walks in Stock Market Prices”, Selected Papers.No.16, University of Chicago.

Miller, M. H. (1977). Debt and Taxes. Journal of Finance, 32, 261-75.

Miller, M.H.; F. Modigliani. 1961. “Dividend Policy, Growth andthe Valuation of Shares” Journal of Business, Vol.34, No.4, pp411-433

Modigliani, F. and Miller, M. H. (1958). The Cost of Capital, Corporate

Finance and the Theory of Investment. American Economic Review, 48, 261-97.

Ross-Westerfeild-Jordan (2008). Fundamentals of Corporate Finance.

Network. USA

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