Capital structure

A review of capital structure theories 1. 0 Introduction One of the most contentious flnancial issues that have provoked intense academic research during the last decades is the theory of capital structure. Capital structure can be defined as a ‘Mix of different securities issued by a firm' (Brealey and Myers, 2003). Simply speaking, capital structure mainly contains two elements, debt and equity.In 1958, through combining tax and debt factors in a simple model to price the value of a company, Modigliani and Miller firstly begin to explore a modern capital structure theory, and their work inspired this area study. However, the MM theory has no practical use because It lacks of direct guidance for companies to determine capital 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 capital structure theory that can be put into practices efficiently, and they attempted to expand debt ratio and tax advantage factors Into a new area. Myers (1984) states that only practical capital structure theories, which Introducing adjustment cost that includes agency cost and information asymmetry problems, ould provide a useful guidance for firms to determine their capital structure.However, from recent studies, Myers (2001) believes that how information differences and agency costs Influence the capital structure Is still an open question. From this perspective, it is very important to review the development of these two factors which make theoretical research having a strong relationship with reality. Thus, this project will summarize the capital structure theories orientated by agency cost and asymmetric Information from extant literature. Also some gaps and conflicts among heories of capital structure will be found and discussed In order to further Improve this area study.The rest of this project is arranged as follows. Section 2 will present the theories based on a gency costs that causes the conflicts between equity holders and debt holders or managers. Section 3 will Illustrate from two areas, 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 costs Although Berry and Means (1931, cited in Myers, 2001) state an adverse 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 have 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 J ensen and Meckling (1976), company agents, the managers, always emphasize on their own interests, such as high salary and reputation. Also these company agents use ‘entrenching investments', which make the asset 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, but 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 first conflict occurs between debt holders and equity holders, and the second conflict is from between equity 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 problems happen in determining the structure of a firms' capital when the conflict between debt holders and equity holders is caused by debt contracts. Similar to Jensen and Meckling's conclusion, Myers (1977) observes that since equity holders bear the whole cost of the investment and debt holders get the main part of the profits from the investment, equity holders may have no interest in investing in value-increasing businesses when ompanies are likely to face bankruptcy in the short term future.Thus, if debt occupies a large part of firms' capital, it will lead to the rejection of investing 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 push power to invest sub- optimally investment project. If the investment fails, due to limited liability, debt holders bear the consequences of a decline of the debt value, but equity holders get ost of yields if the investment could generate returns above the debt par value.In order to prevent 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). Tradeoff 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, Stul z and Johnson (1985) consider about collateral effect. In the end, only Diamond 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 Diamond's model to three investment choices. They point out that one choice of investment can only contain the risk-free project, one option In fact, since the reputation factor is vital for a manager, managers are willing to choose risk-free investment projects that have more possibility of success. Consequently, the amount of debt is often reduced by managers. Capital Structure CAPITAL STRUCTUREQ1. Which of the following statements is/are correct? (MRQ)The cost of equity is higher than the cost of debtWACC is inversely proportional to the market valueAn increase in the cost of equity leads to an increase in share price Debt is less risky as interest is always received but paid at last in an event 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 it's a perfect capital market As the gearing level increases it's an indication of an increase in the cost of debt When the cost of equity increases the effect is translated on to the gearing 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 Manager of Alpha believes that there is an optimal balance of debt and equity. The Manager 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 Tax) 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 IMPERFECT MARKETHigh chances of bankruptcy PERFECT MARKET IMPERFECT MARKETBorrowing is up to a limited 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 debt finance in its capital structure. Which of the following correctly describes the effect on the company's cost of capital and market value assuming perfect capital market with corporation 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 Order Theory? (P;D) Preference Shares 1Equity Finance 2Straight Debt 3Retained Earning 4Convertible Debt 5(2 marks) Q8. Quarto Co is considering acquiring Datum Co. Quarto Co wants to use its own cost of capital but is confused as in which circumstances their weighted average 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 remains unchangedThe acquired company is small that any changes are insignificantProjects are financed from a pool of funds(2 marks) Q9. Eduardo Co is an all-equity financed company which wishes to invest in the new project in a new business area. Its existing equity beta is 1.4. The debt to equity ratio is 35% and 65% respectively ; the average equity 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-adjusted 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 difficult to identify similar operating characteristics of other firms Estimates of beta are wholly accurate Betas may differ due to debt capital being 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. Calculate 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? (P;D)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 every respect apart from their capital structure. Tito has a debt: equity ratio of 1:4 and an equity beta of 1.6. Toto has a debt: equity ratio of 2:6. 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 rather than increasing the share price as WACC increases market value decreases, hence incorrect 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 fixed charges, hence statement is incorrect. Q2. DThere must be no taxes as it's a perfect capital market (Correct)As the gearing level increases it's 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 incorrect Q3. Manager Alpha TRADITIONAL THEORYManager Zeta MM THEORY(without Tax)Traditional theory states that WACC will be optimum when it's at the lowest pointMM (with Tax) states there is no need for a balance of equity and debt assuming 100% gearing is optimal MM (without Tax) states WACC is unaffected as the benefit received from debt cancels with the cost of equity Q4.Taxes are inapplicable PERFECT MARKET High chances of bankruptcy IMPERFECT MARKETBorrowing is up to a limited level IMPERFECT MARKET Q5.Agency Cost: Providers of debt finance are likely to impose restrictive 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 profits 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 association for company's 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 apply Q7.Retained Earning 1Straight Debt 2Convertible Debt 3Preference Shares 4Equity Financing 5 Q8. 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 Ãâ€" 0.65 = 0.91Ke= 4 + (3 Ãâ€" 0.91) = 6.73%(B) De-gearing the equity beta of the new business gives Ba= [0.65 à · (0.65+0.35)] Ãâ€"1.9 = 1.235Ke= 4 + (3 Ãâ€" 1.235) = 7.71% (C) Using equity beta of Eduardo Co. Ke= 4 + (3 Ãâ€" 1.4) = 8.2%(D) Using the de-geared average equity beta Ke= 4 + (3 Ãâ€" 1.9) = 9.7% This means the new average equity beta for the new business area was not de-geared Q10. 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 à · (79 + (21 Ãâ€" {1-30%})] Ãâ€" 0.89 = 0.750.75 = [80 à · (80 + (20 Ãâ€" {1-30%})] Ãâ€" Be Be = 0.88 Q12. 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 4 Q13. CBa = [4 à · (4 + (1 Ãâ€" {1-30%})] Ãâ€" 1.6 = 1.361.36 = [2 à · (2 + (6 Ãâ€" {1-30%})] Ãâ€" Be Be = 4.22