Capital structure

A review of keen mental synthesis theories 1. 0 Introduction One of the most contentious flnancial issues that af theater provoked intense academic research during the last decades is the possibleness of upper-case letter social system. Capital twist behind be defined as a Mix of different securities issued by a firm (B sincereey and Myers, 2003). Simply speaking, dandy grammatical construction mainly contains twain elements, debt and virtue.In 1958, through combining tax and debt factors in a simple illustration to price the lever of a company, Modigliani and miller basic begin to explore a modern swell social organization theory, and their invent inspired this atomic number 18a study. However, the MM theory has no practical subprogram because It lacks of direct guidance for companies to determine seat of government structure In real Ilfe (Baxter, 1967 Sarlg and Warga, 1989 Vernimmen et al, 2005).During the past years, researchers strived to establish a more reasonable great(p) structure theory that can be put into practices efficiently, and they attempted to expand debt dimension and tax advantage factors Into a new argona. Myers (1984) states that only practical hood structure theories, which Introducing adjustment be that includes histrionics apostrophize and information unbalance occupations, ould provide a useful guidance for firms to determine their seat of government structure.However, from modern studies, Myers (2001) believes that how information differences and berth be Influence the capital structure Is mum an open question. From this perspective, it is very important to review the development of these deuce factors which key out theoretical research having a strong alliance with reality. Thus, this project bequeath summarize the capital structure theories orientated by agency greet and asymmetric Information from extant literature. overly some gaps and conflicts among heories of capital structure pass on b e found and discussed In order to further meliorate this ara study.The rest of this project is arranged as follows. Section 2 will present the theories base on agency monetary value that causes the conflicts betwixt lawfulness holders and debt holders or managers. Section 3 will Illustrate from 2 beas, Interplay of capital structure and Investment, followed by signal effect of debt ratio, to show the theories based on asymmetric information. In conclusion, Section 4 will summarize the entire essay and suggest further research direction of capital structure theory. 0 Capital structure theories based on agency cost Although Berry and Means (1931, cited in Myers, 2001) state an adverse human relationship between the separated ownership and corporate control status, it commonly admits that Jensen and Meckling (1976) firstly conducted the research in how agency costs determine capital structure (Harris and Ravlv, 1991 Over the past decades, researchers cause tried to add agency costs to capital structure models (Harris and Raviv, 1991). The perfect alignment between firm investors and firm agencies, such as managers, does not exist (Myers, 2001 ).According to Jensen and Meckling (1976), company agents, the managers, unendingly accentuate on their own interests, such as towering salary and reputation. Also these company agents use entrenching enthronisations, which make the plus and capital structure orientated by the 1 OF3 company holders (Chen and Kensinger, 1992). However, Myers (2001) believes that the firm holders can reduce such transferred value through using different kinds of methods of control and supervising, only if he further points out the weakness that these methods are expensive and reduce returns.As a result, the perfect monitoring system is out of work, and agency costs are produced from these conflicts. According to Jensen and Meckling (1976), the conflicts between investors and agencies are generally divided into two types. The f irst conflict occurs between debt holders and integrity holders, and the second conflict is from between law holders and managers. Consequently, all the capital structure theories based on agency costs can be also classified based on these two conflicts. In the rest of this section, each individual conflict will be separately discussed. 1 Conflicts between Debt holders and Equity holders Jensen and Meckling (1976) point out that agency costs line of works happen in determining the structure of a firms capital when the conflict between debt holders and candour holders is caused by debt contracts. Similar to Jensen and Mecklings conclusion, Myers (1977) observes that since equity holders survive the whole cost of the investing and debt holders get the main part of the kale from the investment, equity holders may have no interest in drop in value- affix argumentationes when ompanies are likely to face bankruptcy in the concisely term future.Thus, if debt occupies a large part of firms capital, it will lead to the rejection of spend in more value-increased business projects. However, in 1991, Harris and Raviv cast a contrasting opinion to adjust the capital structure theory based on this conflict. They point out that most debt contracts give equity holders a oppose power to invest sub- optimally investment project. If the investment fails, due to extra liability, debt holders bear the consequences of a decline of the debt value, that equity holders get ost of yields if the investment could generate returns above the debt par value.In order to pr item debt holders from receiving unfair treatment, equity holders normally get less for the debt than original expectation from debt holders. Thus, the agency costs are created by equity holders who issue the debt rather than debt holders reason (Harris and Raviv, 1991). contendoff capital structure theory has a basic and strong relationship with this type of agency costs. However, different researchers hold various explanations of the relationship.Myers (1977) points out the debt cost eason, Green (1984) announces that convertible bonds can reduce the asset substitution problem which comes from the tradeoff theory, Stulz and Johnson (1985) consider about collateral effect. In the end, only infield model (1989) is widely accepted. If Equity holders do not consider reputational reason, they are willing to trade relatively safe projects, but this activity will lead to less debt financing (Diamond, 1989 mike et al, 1997). Diamond model (1989) assumes two tradeoffs, risky and risk-free, to show that the debt repayment should consider both possible nvestment plans.Furthermore, Mike et al (1997) use empirical evidence to indicate how to use debt to trade off these two optional investment plans. Moreover, in 1991, Harris and Raviv expanded Diamonds model to three investment choices. They point out that one choice of investment can only contain the risk-free project, one option In fact, sin ce the reputation factor is vital for a manager, managers are willing to pack risk-free investment projects that have more possibility of success. Consequently, the amount of debt is ofttimes reduced by managers.Capital StructureCAPITAL twistQ1. Which of the following statements is/are correct? (MRQ)The cost of equity is higher than the cost of debtWACC is inversely relative to the securities industry place valueAn increase in the cost of equity leads to an increase in share price Debt is less risky as interest is always standard but paid at last in an way out of liquidation (2 marks)Q2. Which of the following statements is not a part of the traditional theory of capital structure? (MCQ)There must be no taxes as its a perfect capital commercialize As the gear direct increases its an character of an increase in the cost of debt When the cost of equity increases the effect is translated on to the gear wheel level of the company resulting in its decreaseThe WACC will be at optimum when the market value of the company is at its lowest (2 marks)Q3. The private instructor of Alpha believes that in that respect is an optimal balance of debt and equity. The charabanc of Zeta believes that the gearing decisions have no effect on the business value. Which theories are the managers relating to? (P&D)Manager Alpha Manager Zeta MM THEORY(with evaluate) MM THEORY(without Tax) TRADITIONAL THEORY(2 marks)Q4. Select the appropriate option in relation to the capital market. (HA)Taxes are inapplicable PERFECT MARKET watery MARKET spirited chances of bankruptcy PERFECT MARKET continuous tense MARKETBorrowing is up to a peculiar(a) level PERFECT MARKET IMPERFECT MARKET(2 marks)Q5. Which of the following relates to the high level of gearing? (MRQ)Agency CostTax ExhaustionDifferences in risk tolerance levels between shareholders and directorsNo borrowing limits are specified(2 marks)Q6. Bache Co. leaves its operating risk unchanged after including the increased d ebt finance in its capital structure. Which of the following correctly describes the effect on the companys cost of capital and market value assuming perfect capital market with sens tax? (HA)WACC INCREASE DECREASE UNAFFECTEDCost of Equity INCREASE DECREASE UNAFFECTEDTotal market value INCREASE DECREASE UNAFFECTED(2 marks)Q7. Rearrange the hierarchy of sources of finance for Pecking battle array Theory? (PD) Preference Shares 1Equity Finance 2Straight Debt 3Retained Earning 4Convertible Debt 5(2 marks)Q8. Quarto Co is considering acquiring data point Co. Quarto Co wants to use its own cost of capital but is confused as in which passel their weighted total cost capital will remain unchanged. Which of the following is/are appropriate circumstances? (MRQ)Historic proportions of debt and equity are not to be changedOperating Risk of the company form unchangedThe acquired company is small that any changes are insignificantProjects are financed from a jackpot of funds(2 marks)Q9. E duardo Co is an all-equity financed company which wishes to invest in the new project in a new business area. Its existing equity genus Beta is 1.4. The debt to equity ratio is 35% and 65% respectively the average equity genus Beta for the new business area is 1.9. The government security in the market gives a return of 4% and market risk premium is 3%. If the tax is ignored, what is the risk- correct cost of equity for the new project using the capital asset pricing model? (MCQ) 6.73%7.71%8.2%9.7%(2 marks)Q10. Identify the weaknesses of risk-adjusted the weighted average cost of capital? (MCQ)It is tough to identify similar operating characteristics of other firms Estimates of of import are only accurate Betas may differ due to debt capital be risk-free It ignores earning a potential of the company (2 marks)Q11. Arco Co has an equity beta of 0.89 and it is being considered to be acquiring by Draco Co. Arco Co is financed by 79% equity and Draco Co is financed by 80% equity. C alculate the Risk-adjusted beta if the tax rate in the market is 30% up to two decimal places? (FIB)4521202667000Be (2 marks)Q12. What is the correct procedure for calculating risks adjusted the weighted average cost of capital? (PD)Converting proxy asset beta into risk-adjusted beta using investing company capital structure 1Calculate the risk-adjusted weighted average cost of capital 2Converting proxy equity beta into asset beta 3Calculate the risk-adjusted cost of equity 4(2 marks)Q13. Tito Toto are identical in both respect apart from their capital structure. Tito has a debt equity ratio of 14 and an equity beta of 1.6. Toto has a debt equity ratio of 26. Corporation tax is 30%. What is an appropriate equity beta for Toto? (MCQ)2.563.934.224.51(2 marks)CAPITAL STRUCTURE (ANSWERS)Q1. The cost of equity is higher than the cost of debt WACC is inversely proportional to the market value are correct statements.An increase in the cost of equity leads to a decrease in share price ra ther than increasing the share price as WACC increases market value decreases, hence ill-advised Debt is less risky as interest is always received but paid at last in an event of liquidation. In the event of liquidation banks are paid first as they are creditors with set charges, hence statement is incorrect.Q2. DThere must be no taxes as its a perfect capital market (Correct)As the gearing level increases its an indication of an increase in the cost of debt (Correct) When the cost of equity increases the effect is translated on to the gearing level of the company resulting in its decrease (Correct) The WACC will be at optimum when the market value of the company is at its lowest. The market value should be at its highest to make WACC at the optimum level which it is at the lowest, hence the statement is incorrectQ3. Manager Alpha TRADITIONAL THEORYManager Zeta MM THEORY(without Tax)Traditional theory states that WACC will be optimum when its at the lowest pointMM (with Tax) states there is no need for a balance of equity and debt assuming snow% gearing is optimal MM (without Tax) states WACC is unaffected as the benefit received from debt cancels with the cost of equityQ4.Taxes are inapplicable PERFECT MARKET High chances of bankruptcy IMPERFECT MARKETBorrowing is up to a limited level IMPERFECT MARKETQ5.Agency Cost Providers of debt finance are likely to impose suppressive covenants hence is a problem due to high gearing (Correct) Tax Exhaustion As companies increase their gearing they may reach a certain point where there are not enough lettuce from which to obtain all available tax benefits hence is a problem due to high gearing (Correct)Differences in risk tolerance levels between shareholders and directors The directors have high risk in the company rather than shareholders as they have well-diversified portfolios hence is a problem due to high gearing (Correct)No borrowing limits are specified Restrictions are specified in the articles of connected ness for companys ability to borrow hence the statement is not related to high gearing (Incorrect)Q6. WACC DECREASE Cost of Equity INCREASE Total market value INCREASE In a perfect capital market, the theories of Modigliani Miller on gearing applyQ7.Retained Earning 1Straight Debt 2Convertible Debt 3Preference Shares 4Equity Financing 5Q8. All options are correct as under all circumstances the company can use its own weighted average cost of capital.Q9. B(A) De-gearing the equity beta of Eduardo Co Ba= 1.4 0.65 = 0.91Ke= 4 + (3 0.91) = 6.73%(B) De-gearing the equity beta of the new business gives Ba= 0.65 (0.65+0.35) 1.9 = 1.235Ke= 4 + (3 1.235) = 7.71% (C) exploitation equity beta of Eduardo Co. Ke= 4 + (3 1.4) = 8.2%(D) Using the de-geared average equity beta Ke= 4 + (3 1.9) = 9.7% This means the new average equity beta for the new business area was not de-gearedQ10. AIt is difficult to identify similar operating characteristics of other firms (Weakness) Estimates of beta are wholly inaccurate Betas may differ due to debt capital not being risk free It ignores earning potential of the company (Disadvantage of DVM)Q11. Be = 0.88Ba = 79 (79 + (21 1-30%) 0.89 = 0.750.75 = 80 (80 + (20 1-30%) Be Be = 0.88Q12. Converting proxy equity beta into asset beta 1Converting proxy asset beta into risk-adjusted beta using investing company capital structure 2Calculate the risk-adjusted cost of equity 3Calculate risk-adjusted weighted average cost of capital 4Q13. CBa = 4 (4 + (1 1-30%) 1.6 = 1.361.36 = 2 (2 + (6 1-30%) Be Be = 4.22