d. Accounting 5. Which is not normally a responsibility of the controller of the modern corporation? a. Budgets and forecasts b. Asset management c. Financial reporting to the IRS d. Cost accounting Answers 1-a, 2-c, 3-c, 4-a, 5-b 5.13 REFERENCES References Bekaert, G. Harvey, C, R. & Lundblad, C. (2001). Emerging equity markets and economic development. Journal of Development Economics. Bekaert, G. Harvey, C, R. & Lundblad, C. (2005). Does financial liberalisation spur growth? Journal of Financial Economics. Bekaert, G. Harvey, C, R. & Lumsdaine, C. (2002). Dating the integration of world capital markets. Journal of Financial Economics. Textbooks Bennett, M. & Donnelly, R. (1993). The determinants of capital structure: some UK evidence. British Accounting Review. Berger, A, N. & Bonaccorsi, di, Patti, E. (2006). Capital structure and firm performance: A new approach to testing agency theory and an application to the banking industry. Journal of Banking and Finance. Bertero, E. (1994). The banking system, financial markets and capital structure: some new evidence from France. Oxford Review of Economic Policy. Website http://people.stern.nyu.edu/adamodar/pdfiles/acf3E/book/ch6.pdf https://en.wikipedia.org/wiki/The_Replacements_(band) https://www.ilo.org/wcmsp5 101 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT-6 CAPITAL STRUCTURE STRUCTURE 6.0 Learning Objective 6.1 Introduction 6.2 Concept 6.3 Significance 6.4 Sources of Long-Term Finance 6.4.1Debt vs. Equity Capital 6.5 Summary 6.6 Keywords 6.7 Learning Activity 6.8 Unit End Questions 6.9 References 6.0 LEARNING OBJECTIVE After studying this unit, you will be able to Explain the concept of capital structure. Illustrate the sources of long term finance. Explain the concept of debt vs. Equitycapital. 6.1 INTRODUCTION Capital structure is still a puzzle among finance scholars. Purpose of this study is to review various capital structure theories that have been proposed in the finance literature to provide clarification for the firms’ capital structure decision. Starting from the capital structure irrelevance theory of Modigliani and Millerthis review examine the several theories that have been put forward to explain the capital structure. Three major theories emerged over the years following the assumption of the perfect capital market of capital structure irrelevance model. Trade off theory assumes that firms have one optimal debt ratio and firm trade off the benefit and cost of debt and equity financing. Pecking order theoryassumes that firms follow a financing hierarchy whereby minimize the problem of information asymmetry. But neither of these two theories provide a complete description why some firms prefer debt and others prefer equity finance under different circumstances. Another theory of capital structure has 102 CU IDOL SELF LEARNING MATERIAL (SLM)
introduced recently by, Baker and Wurglermarket timing theory, which explains the current capital structure as the cumulative outcome of past attempts to time the equity market. Market timing issuing behaviour has been well established empirically by others already, but Baker and Wurglershow that the influence of market timing on capital structure is regular and continuous. So the predictions of these theories sometimes acted in a contradictory manner and Myers32 years old question “How do firms choose their capital structure?” still remains. The second financing choice faced by the firm; Capital Structure is still a puzzle in finance. Capital structure or financial leverage decision should be examined concerning how debt and equity mix in the firm’s capital structure influence its market value. Debt to equity mix of the firm can have important implications for the value of the firm and cost of capital. In maximizing shareholders wealth firm use more debt capital in the capital structure as the interest paid is a tax deductible and lowers the debt’s effective cost. Further equity holders do not have to share their profit with debt holders as the debt holders get a fixed return. However, the higher the debt capital, riskier the firm, hence the higher its cost of capital. Therefore it is important to identify the important elements of capital structure, precise measure of these elements and the best capital structure for a particular firm at a particular time. Researchers and practitioners explain conflicting theories on capital structure. Durandstates using the Net Income (NI) approach that firm can decrease its cost capital and consequently increase the value of the firm through debt financing. In contrast, Modigliani and Millerclaims in their seminal paper capital structure irrelevance that firm’s value is independent of its debt to equity ratio which is known as Net Operating Income (NOI) approach. They argue that perfect capital market without taxes and transaction cost the firm value remain constant to the changes in the capital structure. According to Pandeythe traditional approach of Solimanhas emerged a compromise to the extreme position taken by the NI approach. Traditional approach does not assume constant cost of equity change in debt to equity ratio and continuously declining Weighted Average Cost of Capital (WACC). Further this approach assume the concept of optimal capital structure and thereby very clearly implies that WACC decreases only for a certain level of financial leverage and reaching the minimum level. Further increase in financial leverage would increase the WACC. Capital structure irrelevance theory of Modigliani and Milleris considered as the starting point of modern theory of capital structure. Based on assumptions related to the behaviour of investors and capital market MM illustrates that firm value is unaffected by the capital structure of the firm. Securities are traded in perfect capital market, all relevant information are available for insiders and outsiders to take the decision (no asymmetry of information), that is transaction cost, bankruptcy cost and taxation do not exist. Borrowing and lending is possible for firms and individual investors at the same interest rate which permits for homemade leverage, firms operating in a similar risk classes and have similar operating leverage, interest payable on debt do not save any taxes and firms follow 100% dividend pay- out. Under these assumptions MM theory proved that there is no optimal debt to equity ratio 103 CU IDOL SELF LEARNING MATERIAL (SLM)
and capital structure is irrelevant for the shareholders wealth. This preposition presented by MMin their seminal paper and argue that value of levered firm is same as the value of unlevered firm. Therefore they propose that managers should not concern the capital structure and they can freely select the composition of debt to equity. Important contributions to the MM approach include Hirsh Leiferand Stiglitz. Further in their preposition II they claim that increase in leverage increase the risk of the firm and as a result the cost of equity increases. But WACC of the firm remain constant as cost of debt compensate with higher cost of equity. Capital structure irrelevance theory was theoretically very sound but was based on unrealistic set of assumptions. Therefore this theory led to a plenty of research on capital structure. Even though their theory was valid theoretically, world without taxes were not valid in reality. In order to make it more accurate Modigliani and Millerincorporated the effect of tax on cost of capital and firm value. In the presence of corporate taxes, the firm value increase with the leverage due to the tax shield. Interest on debt capital is an acceptable deduction from the firm’s income and thus decreases the net tax payment of the firm. This would result in an added benefit of using debt capital through lowering the capital cost of the firm. Drawbacks in MM theory stimulated series of research devoted on proving irrelevance as theoretical and empirical matter. So may other theories that contribute to capital structure theorem have developed based on the MM theorem and it is much hard to validate any of them. Even though there are weaknesses in MM theorem it cannot be completely ignored or excluded. One of the basic theory that have dominated the capital structure theory which recommends that optimal level of the debt is where the marginal benefit of debt finance is equal to its marginal cost. Firm can achieve an optimal capital structure through adjusting the debt and equity level thereby balancing the tax shield and financial distress cost. There is no consensus among researchers on what consist the benefit and costs. Eliminating the constraints of the capital structure irrelevance proposition of MM Myersuse the trade of theory as a theoretical foundation to explain the “Capital Structure Puzzle”. Myerssuggest that the use of debt up to a certain level offset the cost of financial distress and interest tax shield. According to Fama and Frenchthe optimal capital structure can be identified through the benefits of debt tax deductibility of interest and cost of bankruptcy and agency cost. 6.2 CONCEPT Assuming perfect capital market as proposed by MMMyers and Majlufpropose pecking order theory following the findings of Donaldsonwhich found that management prefer internally generated funds rather using external funds. Pecking order theory suggest that firm prefer internal financing over debt capital and explains that firms utilize internal funds first then issue debt and finally as the last resort issue equity capital. Al-Tallyconfirmed the same that firms prefer to finance new investments with internally generated funds first and then with debt capital and as the last resort they would go for equity issue. Pecking order theory further explains that firms borrow more when internally generated funds are not sufficient to fulfil 104 CU IDOL SELF LEARNING MATERIAL (SLM)
the investment needs. This is confirmed by Myersand found that debt ratio of the firm reflect the cumulative figure for external financing and firms with higher profit and growth opportunities would use less debt capital. If the firm has no investment opportunities profits are retained to avoid the future external financing. Further firms’ debt ratio represent the accumulated external financing as the firm do not have optimal debt ratio. Based on the pecking order theory Harris and Ravivclaim that capital structure decisions are intended to eliminate the inefficiencies caused by information asymmetry. Information asymmetry between insiders and outsiders and separation of ownership explain why firms avoid capital markets. Frydenbergexplains that debt issue of a firm give a signal of confidence to the market that firm is an outstanding firm that their management if not afraid of debt financing. Further Frank and Goyalshow that due to the agency conflict between managers and owners and outside investors pecking order can occur. Studies on pecking order theory have not been able to show the significance of this theory on determining firms’ capital structure. Fama and Frenchcompared the trade-off theory and pecking order theory and shows that certain features of financial data are better described by the pecking order theory. This is confirmed by Shyam-Sunder and MyersRaj Aggarwaland Karadeniz. Shortcomings in this theory pressed the further development of the theories of capital structure to solve the capital structure puzzle. Market timing theory of capital structure explains that firms issue new equity when their share price is overrated and they buy back shares when the price of shares are underrated. This fluctuation in the price of shares affect the corporate financing decisions and finally the capital structure of the firm. Further Baker and Wurglerexplains that consistent with the pecking order theory of capital structure market timing theory does not move to target leverage as equity transactions are completely time to stock market conditions. This implies that capital structure changes persuaded by market timing are long lasting. This preposition explains that gearing ratios are negatively related to the past stock returns and Welchfound that the most important determinant of capital structure is the stock returns. However Hovakimianstated that market timing does not have a significant effects on the firms’ capital structure in the long run. The market values of the firm’s debt and equity, D and E, add up to total firm value V. MM showed that V is a constant, regardless of the proportions of D and E, provided that the assets and growth opportunities on the left-hand side of the balance sheet are held constant. This result generalizes to any mix of securities issued by the firm. For example, it doesn’t matter whether the debt is short- or long-term, callable or call-protected, straight or convertible, in dollars or euros, or some mixture of all of these or other types. If leverage is irrelevant, then each firm’s overall cost of capital is a constant, regardless of the debt ratio D/V. The cost of capital can be measured by the weightedaverage expected return on a portfolio of all the firm’s outstanding securities. The economic intuition for MM’s leverage-irrelevance proposition is simple, equivalent to asserting that in a perfect-market supermarket “The value 105 CU IDOL SELF LEARNING MATERIAL (SLM)
of a pizza does not depend on how they are sliced.” But is the theory credible? Could financial markets ever be sufficiently perfect? After all, the values of pizzas do depend on how they are sliced. Consumers are willing to pay more for the several slices than for the equivalent whole. Perhaps the value of the firm does depend on how its assets, cash flows and growth opportunities are sliced up and offered to investors. For example, investors cannot easily borrow with limited liability, but corporations provide limited liability and can borrow on their stockholders’ behalf. There should be a clientele of investors standing ready to bid up the value of levered firms. The practical relevance and credibility of MM’s propositions therefore cannot rest on a lack of demand for financial leverage or for specialized securities. The proposition’s support must come from the supply side. The proposition works when the cost of “slicing the pizza” is small relative to the market value of the firm. If the supply-cost is small, then the clientele of investors who would be willing to pay extra to borrow thorough a corporation do not have to do so, because the cost of manufacturing debt and equity securities, rather than equity only, is a small fraction of the securities’ market values. The supply of debt expands until the value added for the marginal investor is zero. The supply of any mix of securities demanded by investors expands until investors’ demand is satiated and the contribution of that financing mix to the value of the firm is zero. These arguments are straight from Finance. But from the viewpoints of law, regulation and public policy, the MM leverage-irrelevance proposition is the ideal end result. If that result could be achieved in practice, then investors’ diverse demands for specialized securities would be satisfied at negligible cost. All firms would have equal access to capital, and the cost of capital would not depend on financing, but only on business risk. Capital would flow directly to its most efficient use. 6.3 SIGNIFICANCE The term ‘structure’ means the arrangement of the various parts. So capital structure means the arrangement of capital from different sources so that the long-term funds needed for the business are raised. Thus, capital structure refers to the proportions or combinations of equity share capital, preference share capital, debentures, long-term loans, retained earnings and other long-term sources of funds in the total amount of capital which a firm should raise to run its business. “Capital structure of a company refers to the make-up of its capitalisation and it includes all long-term capital resources viz., loans, reserves, shares and bonds.”—Greenberg. “Capital structure is the combination of debt and equity securities that comprise a firm’s financing of its assets.”—John J. Hampton. “Capital structure refers to the mix of long-term sources of funds, such as, debentures, long- term debts, preference share capital and equity share capital including reserves and surplus.”—I. M. Pandey. 106 CU IDOL SELF LEARNING MATERIAL (SLM)
The term capital structure should not be confused with Financial structure and Asset’s structure. While financial structure consists of short-term debt, long-term debt and share holders’ fund i.e., the entire left hand side of the company’s Balance Sheet. But capital structure consists of long-term debt and shareholders’ fund. So, it may be concluded that the capital structure of a firm is a part of its financial structure. Some experts of financial management include short-term debt in the composition of capital structure. In that case, there is no difference between the two terms—capital structure and financial structure. So, capital structure is different from financial structure. It is a part of financial structure. Capital structure refers to the proportion of long-term debt and equity in the total capital of a company. On the other hand, financial structure refers to the net worth or owners’ equity and all liabilities (long-term as well as short-term). Capital structure does not include short-term liabilities but financial structure includes short- term liabilities or current liabilities. Asset’s structure implies the composition of total assets used by a firm i.e., make-up of the assets side of Balance Sheet of a company. It indicates the application of fund in the different types of assets fixed and current. Capital structure is vital for a firm as it determines the overall stability of a firm. Here are some of the factors that highlight the significance of capital structure. Increase in Value of the Firm A sound capital structure of a company helps to increase the market price of shares and securities which, in turn, lead to increase in the value of the firm. Utilisation of Available Funds A good capital structure enables a business enterprise to utilise the available funds fully. Properly designed capital structure ensure the determination of the financial requirements of the firm and raise the funds in such proportions from various sources for their best possible utilisation. A sound capital structure protects the business enterprise from over-capitalisation and under-capitalisation. Maximisation of Return A sound capital structure enables management to increase the profits of a company in the form of higher return to the equity shareholders i.e., increase in earnings per share. This can be done by the mechanism of trading on equity i.e., it refers to increase in the proportion of debt capital in the capital structure which is the cheapest source of capital. If the rate of return on capital employed (i.e., shareholders’ fund + long- term borrowings) exceeds the fixed rate of interest paid to debt-holders, the company is said to be trading on equity. 107 CU IDOL SELF LEARNING MATERIAL (SLM)
Minimisation of Cost of Capital A sound capital structure of any business enterprise maximises shareholders’ wealth through minimisation of the overall cost of capital. This can also be done by incorporating long-term debt capital in the capital structure as the cost of debt capital is lower than the cost of equity or preference share capital since the interest on debt is tax deductible. Solvency or Liquidity Position A sound capital structure never allows a business enterprise to go for too much raising of debt capital because, at the time of poor earning, the solvency is disturbed for compulsory payment of interest to .the debt-supplier. Flexibility A sound capital structure provides a room for expansion or reduction of debt capital so that, according to changing conditions, adjustment of capital can be made. Undisturbed Controlling A good capital structure does not allow the equity shareholders control on business to be diluted. Minimization of Financial Risk If debt component increases in the capital structure of a company, the financial risk (i.e., payment of fixed interest charges and repayment of principal amount of debt in time) will also increase. A sound capital structure protects a business enterprise from such financial risk through a judicious mix of debt and equity in the capital structure. 6.4 SOURCES OF LONG TERM FINANCE In the previous lesson you learnt about the various methods of raising long-term finance. Normally the methods of raising finance are also termed as the sources of finance. But, as a matter of fact the methods refer only to the forms in which the funds are raised, and hence may or may not include the sources from, or through which the funds are raised. Hence, we must also have an idea about the sources of finance. You will recall that the various sources of long-term finance had been duly identified in the previous lesson. We shall now learn in detail about those sources. Capital market refers to the organisation and the mechanism through which the companies, other institutions and the government raise long-term funds. So it constitutes all long-term borrowings from banks and financial institutions, borrowings from foreign markets and raising of capital by issuing various securities such as shares debentures, bonds, etc. For trading of securities there are two different segments in capital market. One is primary market and the othersecondary market. The primary market deals with new/fresh issue of securities 108 CU IDOL SELF LEARNING MATERIAL (SLM)
and is, therefore, known as new issue market. The secondary market on the other hand, provides a place for purchase and sale of existing securities and is known as stock market or stock exchange. The new issue market primarily consists of the arrangements, which facilitates the procurement of long-term finance by the companies in the form of shares, debentures and bonds. The companies usually issue those securities at the initial stages of their formation and so also later on for expansion and/or modernization of their activities. However, the selling of securities is not an easy task, as the companies have to fulfil various legal requirements and decide upon the appropriate timing and the method of issue. Hence, they seek assistance of various intermediaries such as merchant bankers, underwriters, stock brokers etc. to look after all these aspects. All these intermediaries form an integral part of the primary market. The secondary market (stock exchange) is an association or organisation or a body of individuals established for the purpose of assisting, regulating and controlling the business of buying, selling and dealing in securities. It may note that it is called a secondary market because only the securities already issued can be traded on the floor of the stock exchange. This market is open only to its members, most of whom are brokers acting as agents of the buyers and sellers of securities. The main functions of this market lie in providing liquidity (ready encashment) to securities and safety in dealings. It is because of the availability of such facilities that people are ready to invest in securities. We shall learn more about the capital market. A number of special financial institutions have been set up by the central and state governments to provide long-term finance to the business organisations. They also offer support services in launching of the new enterprises and so also for expansion and modernisation of existing enterprises. Some of the important ones are Industrial Finance Corporation of India (IFCI), Industrial Investment Bank of India (IIBI), Industrial Credit and Investment Corporation of India (ICICI), Industrial Development Bank of India (IDBI), Infrastructure Development Finance Company Ltd. (IDFC), Small Industries Development Bank of India (SIDBI), State Industrial Development Corporations (SIDCs), and State Financial Corporations (SFCs), etc. Since these institutions provide developmental finance, they are also known as Development Banks or Development Financial Institutions (DFI). Besides these development banks there are a few other financial institutions such as life Insurance Corporation of India (LIC), General Insurance Corporation of India (GIC) and Unit Trust of India (UTI) which provide long-term finance to companies and subscribe to their share and debentures. Industrial Finance Corporation of India (IFCI): It is the oldest SFI set up in 1948 with the primary objective of providing long-term and medium-term finance to large industrial enterprises. It provides financial assistance for setting up of new industrial enterprises and for expansion or diversification of activities. It also provides support to modernisation and renovation of plant and equipment. It can grant loan or subscribe to debentures issued by companies repayable in not more than 25 years. It can also guarantee loans raised from other 109 CU IDOL SELF LEARNING MATERIAL (SLM)
sources or debentures issued to the public, and take up underwriting of the public issue of shares and debentures by companies. For ensuring greater flexibility to meet the needs of the changing financial system IFCI now stands transformed to IFCI Ltd. with effect from 1 June 1993. Industrial Credit and Investment Corporation of India (ICICI): It was set up in 1955 for providing long-term loans to companies for a period up to 15 years and subscribe to their shares and debentures. However, the proprietary and partnership firms were also entitled to secure loans from ICICI. Like IFCI, the ICICI also guarantees loans raised by companies from other sources besides underwriting their issue of shares and debentures. Foreign currency loans can also be secured by companies from ICICI. In the context of the emerging competitive scenario in the finance sector, ICICI has merged with ICICI Bank Ltd., with effect from 3 May 2002. Consequent upon the merger, the ICICI group’s financing and banking operations have been integrated into a single full service banking company. Industrial Development Bank of India (IDBI): It was set up in 1964 as a subsidiary of Reserve Bank of India for providing financial assistance to all types of industrial enterprises without any restriction on the type of finance and the amount of funds. It could also refinance loans granted by other financial institutions and offer guarantees for the loans raised from the capital market or scheduled banks. It also discounts and rediscounts the commercial bills of exchange and undertakes underwriting of the public issues. IDBI, like ICICI, has also transformed into a commercial bank and has been retitled as IDBI Ltd. with effect from 1 October 2004 with IDBI Bank merged into it. Industrial Investment Bank of India (IIBI): The erstwhile Industrial Reconstruction Bank of India (IRBI), an institution which was set up for rehabilitation of small units has been reconstituted in 1997 as Industrial Investment Bank of India. It is a full-fledgedall-purpose development bank with adequate operational flexibility and autonomy. After the reconstruction its focus has changed from rehabilitation finance to development banking.Small Industries Development Bank of India (SIDBI): It was set up in 1990 as a principal financial institution for the promotion, financing and development of small-scale industrial enterprises. It is an apex institution of all the banks providing credit facility to small-scale industries in our country. It offers refinancing of bills, rediscounting of bills, and several other support services to Small Scale Industries (SSI). It undertakes a wide range of promotional and development activities for improving the inherent strength of SSI units and creating avenues for the economic development of the rural poor.State Financial Corporations (SFCs): In order to provide financial assistance to all types of industrial enterprises (proprietary and partnership firms as well as companies) most of the states of our country have set up SFCs. Note’s objective of these corporations is to accelerate the pace of Industrial development in their respective states. SFCs provide finance in the form of long- term loans or through subscription of debentures, offer guarantee to loans raised from other sources and take up underwriting of public issues of shares and debentures made by companies. However, they cannot directly subscribe to the shares issued by the companies. The SFC (Amendment) Act, 2000 has provided greater flexibility to SFCs to cope with the changing economic and financial environment of the country. State Industrial Development 110 CU IDOL SELF LEARNING MATERIAL (SLM)
Corporations (SIDCs): These corporations were set up in 1960s and early 1970s by most state governments for promotions and development of medium and large-scale industries in their respective states. In addition to providing financial assistance to industrial units, they also undertake a variety of promotional activities. They also implement the various incentive schemes of the central and state governments. 6.4.1DEBT VS EQUITY CAPITAL Debt is the company’s liability which needs to be paid off after a specific period. Money raised by the company by issuing shares to the general public, which can be kept for a long period is known as equity. Debt is the borrowed fund while equity is owned fund. Debt reflects money owed by the company towards another person or entity. Conversely, Equity reflects the capital owned by the company. Debt can be kept for a limited period and should be repaid back after the expiry of that term. On the other hand, equity can be kept for a long period. Debt holders are the creditors whereas equity holders are the owners of the company. Debt carries low risk as compared to equity. Debt can be in the form of term loans, debentures, and bonds, but Equity can be in the form of shares and stock. Return on debt is known as interest which is a charge against profit. In contrast to the return on equity is called as a dividend which is an appropriation of profit. Return on debt is fixed and regular, but it is just opposite in the case of return on equity. Debt can be secured or unsecured, whereas equity is always unsecured. When financing a company, \"cost\" is the measurable expense of obtaining capital. With debt, this is the interest expense a company pays on its debt. With equity, the cost of capital refers to the claim on earnings provided to shareholders for their ownership stake in the business. For example, if you run a small business and need $40,000 of financing, you can either take out a $40,000 bank loan at a 10 percent interest rate, or you can sell a 25 percent stake in your business to your neighbour for $40,000. Suppose your business earns a $20,000 profit during the next year. If you took the bank loan, your interest expense (cost of debt financing) would be $4,000, leaving you with $16,000 in profit. Conversely, had you used equity financing, you would have zero debt (and as a result, no interest expense), but would keep only 75 percent of your profit (the other 25 percent being 111 CU IDOL SELF LEARNING MATERIAL (SLM)
owned by your neighbour). Therefore, your personal profit would only be $15,000, or (75% x $20,000). From this example, you can see how it is less expensive for you, as the original shareholder of your company, to issue debt as opposed to equity. Taxes make the situation even better if you had debt since interest expense is deducted from earnings before income taxesare levied, thus acting as a tax shield (although we have ignored taxes in this example for the sake of simplicity). Of course, the advantage of the fixed-interest nature of debt can also be a disadvantage. It presents a fixed expense, thus increasing a company's risk. Going back to our example, suppose your company only earned $5,000 during the next year. With debt financing, you would still have the same $4,000 of interest to pay, so you would be left with only $1,000 of profit ($5,000 - $4,000). With equity, you again have no interest expense, but only keep 75 percent of your profits, thus leaving you with $3,750 of profits (75% x $5,000). However, if a company fails to generate enough cash, the fixed-cost nature of debt can prove too burdensome. This basic idea represents the risk associated with debt financing. 6.5 SUMMARY You must have heard about various housing finance companies, investment companies, vehicle finance companies etc. operating in private sectors different parts of our country. These companies are categories under Non-Banking Financial Companies, because they perform the twin functions of accepting deposits from the public and providing loans. However they are not regarded as banking companies as they do not carry on the normal banking activities. They raise funds from the public by offering attractive rate of interest and give loans mainly to the wholesale and retail traders, small-scale industries and self-employed persons. The loans granted by these finance companies are generally unsecured and the interest charged by them ranges between 24 to 36 percent per annum. Besides giving loans and advances, the NBFCs also have purchase and discount hundis, undertaken merchant banking, housing finance, lease financing, hire purchase business etc. In our country, NBFCs have emerged as an important financial intermediary due to simplified loan sanction procedure, attractive rate of return on deposits, flexibility and timeliness in meeting the credit needs of the customers. Mutual fund refers to a fund established in the form of a trust by a sponsor to raise money through one or more schemes for investing in securities. It is a special type of investment institution, which acts as an investment intermediary that collects or pools the savings of a large number of investors and invests them in a fairly large and well diversified portfolio of sound investments. This minimizes their risk and ensures good 112 CU IDOL SELF LEARNING MATERIAL (SLM)
returns to the investors. Thus, they act as an investment agency for small investors and a good source for long-term finance for the business. You learnt about leasing arrangement as a method of long-term finance in the previous unit. This method has become quite common among the manufacturing companies. Leasing facility is usually provided through the mediation of leasing companies who buy the required plant and machinery from its manufacturer and lease it to the company that needs it for a specified period on payment of an annual rent. For this purpose a proper lease agreement is made between the lessor (leasing company) and lessee (the company hiring the asset). Such agreement usually provides for the purchase of the machinery by the lessee at the end of the lease period at a mutually agreed and specified price. It may be noted that the ownership remains with the leasing company during the lease period. Sometimes, a company, to meet its financial requirements, may sell its own existing fixed asset (machinery or building) to a leasing company at the current market price on the condition that the leasing company shall lease the asset back to selling company for a specified period. Such an arrangement is known as ‘Sell and Lease Back’. The company in such arrangement gets the funds without having to part with the possession of the asset involved which it continues to use on payment of annual rent for the lease. It may be noted that in any type of leasing agreement, the lease rent includes an element of interest besides the expenses and profits of the leasing company. In fact, the leasing company must earn a reasonable return on its investment in lease asset. The leasing business in India started, in seventies when the first leasing company of India was promoted by Chidambaram Group in 1973 in Chennai. The Twentieth Century Finance Company and four other finance companies joined the fray during eighties. Now their number is very large and leasing has emerged as an important source. It is very helpful for the small and medium sized undertakings, which have limited financial resources. These include loans obtained at concessional rates of interest with long maturity period and commercial borrowings. The major sources of concessional loans have been the International Monetary Fund (IMF), Aid India Consortium (AIC), Asian Development Bank (ADB), World Bank (International Bank for Reconstruction and Development) and International Financial Corporation. The World Bank grants loans for specific industrial projects of high priority and given either directly to an industrial concern or through a government agency. The International Finance Corporation, an affiliate of the World Bank, grants loans to industrial units for a period of 8 to 10 years. 113 CU IDOL SELF LEARNING MATERIAL (SLM)
6.6 KEYWORDS Capitalized Interest: A portion of bond proceeds that are set aside to pay interest on the bonds until the projects funded by those bonds are built, operating, and capable of generating revenues for making debt service payments. Carryover: The process in which, at the end of one fiscal year, appropriation authority for previously-approved encumbrances and unexpended grant and capital funds are carried forward to the next fiscal year. Cash Management: An effort to manage cash flows in such a way that interest and penalties paid are minimized and interest earned is maximized. Categorical Grants: A type of grant that may only be used for a specific program that is usually limited to a narrowly defined activity. Categorical grants consist of formula, . project, and formula-project grants. Certificate of Participation (COP): A form of lease obligation in which the county enters into an agreement to pay a fixed amount annually to a third party, usually a non-profit agency or a private leasing company. Otherwise, they do what municipal bonds do: They raise money to acquire equipment or construct a facility. According to municipal finance experts, almost anything can be engineered for lease. COPs are similar to bonds, but are not legally classified as such, meaning that state and local governments can issue them without voter approval and without affecting their overall bonding capacity. 6.7 LEARNING ACTIVITY 1. Create a session on debt vs. equity capital. ___________________________________________________________________________ ___________________________________________________________________________ 2. Create a survey on sources of long-termfinance. ___________________________________________________________________________ ___________________________________________________________________________ 6.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What is meant by optimal capital structure? 2. List the factors influencing capital structure? 114 CU IDOL SELF LEARNING MATERIAL (SLM)
3. Write the meaning of dividend. 24? 4. List out the determinants of dividend policy? 5. Write a note on internal rate of return? Long Questions 1. Explain the concept of debt. 2. Elaborate the concept of equity capital. 3. Illustrate the sources of long-term finance. 4. Discuss on the concept of capital structure. 5. Examine the advantages of capital structure. B. Multiple Choice Questions 1. What does all constituencies with a stake in the fortunes of the company are known as? a. Shareholders b. Stakeholders c. Creditors d. Customers 2. Which of the following statements is not correct regarding earnings per share (EPS) maximization as the primary goal of the firm? a. EPS maximization ignores the firm's risk level b. EPS maximization does not specify the timing or duration of expected EPS c. EPS maximization naturally requires all earnings to be retained. d. EPS maximization is concerned with maximizing net income 3. What is concerned with the maximization of a firm's stock price a. Shareholder wealth maximization b. Profit maximization c. Stakeholder welfare maximization d. EPS maximization 4. What does a corporate governance success includes three key groups? a. Suppliers, managers, and customers b. Board of directors, executive officers, and common shareholders c. Suppliers, employees, and customers 115 CU IDOL SELF LEARNING MATERIAL (SLM)
d. Common shareholders, managers, and employees 5. What if in 2 years you are to receive Rs.10, 000. If the interest rate were to suddenly decrease, the present value of that future amount to you would? a. Fall b. Rise c. Remain unchanged d. Cannot be determined Answers 1-b, 2-d, 3-a, 4-b, 5-b 6.9 REFERENCES References Bessler, W. Drobetz, W. & Gruninger, M, C. (2011). International Review of Finance. Bevan, A, A. & Danbolt, J. (2002). Capital structure and its determinants in the United Kingdom – a decompositional analysis. Applied Financial Economics. Bhaduri, S, N. (2000). Liberalisation and firm‟s choice of financial structure in an emerging economy: the Indian corporate sector. Development Policy Review. Textbooks Bhaduri, S, N. (2002). Determinants of capital structure choice: A study of the Indian corporate sector. Applied Financial Economics. Bhaduri, S, N. (2005). Investment, financial constraints and financial liberalisation: Some stylized facts from a developing economy, India. Journal of Asian Economics. Bhattacharya, S. (1979). Imperfect information, dividend policy and “the bird in the hand” fallacy. Bell Journal of Economics. Website https://www.investopedia.com/ask/answers/05/debtcheaperthanequity.asp https://www.yourarticlelibrary.com/financial-management/capital-structure/capital- structure-meaning-concept-importance-and-factors-accounting/65150 https://www.oecd.org/daf/ca/corporategovernanceprinciples/1857283.pdf 116 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT-7 THEORIES OF CAPITAL STRUCTURE I STRUCTURE 7.0 Learning Objective 7.1 Introduction 7.2 NI Approach 7.3 NOI Approach 7.4 Summary 7.5 Keywords 7.6 Learning Activity 7.7 Unit End Questions 7.8 References 7.0 LEARNING OBJECTIVE After studying this unit, you will be able to: Explain the concept of NI approach. Illustrate the concept of NOI approach. Explain the theories of capital structure. 7.1 INTRODUCTION When I first studied finance in the 1960s, there were no traded options, financial futures or swaps. There was no organized junk-bond market. There were no floating-rate preferred shares or catastrophe bonds. The private-equity partnerships that now invest in venture capital and buyouts were not yet invented. There were no mechanisms for routine syndication and trading of bank loans. The number of new securities, markets and trading and hedging strategies developed in the last 30 years seems almost countless. The continuing innovation in the corporate financing proves that financing can matter. If new securities or financing tactics never added value, then there would be no incentive to innovate. On the other hand, financial innovation provides the best circumstantial evidence that financing is, if not irrelevant, at least unimportant. The costs of designing and creating new securities and financing schemes are low, and the costs of imitation are trivial. Thus temporary departures from MM’s leverage-irrelevance proposition create the opportunity for financial innovation, but successful innovations quickly become “commodities,” that is, standard, low-margin financial products. The rapid response of supply to the discovery of successful new financial 117 CU IDOL SELF LEARNING MATERIAL (SLM)
products restores the MM equilibrium. Companies may find it convenient to use these new products, but only the first users will increase value, or lower the cost of capital, by doing so. Therefore law and regulation should accommodate financial innovation because it makes financing decisions relatively unimportant. History provides many examples where law or regulation has impeded financial innovation. For example, the development of the Japanese domestic bond market was for many years held back by various hurdles set for would-be issuers. But this sort of direct restriction on financing choices is presumably now rare in OECD countries. The more important restrictions may now lie in the structure of financial markets and institutions. For example, private investment in venture capital won’t work unless there is a stock market prepared to accept IPOs by young and unproved growth companies. New European exchanges, particularly EASDAQ, the Neuer Markt and the Nouveau Marche, allow such companies go public early in order to cash out the venture capitalists and to maintain incentives for the managers and employees. This does not mean that all new ventures should be separate public corporations. Financing in public equity markets has its own costs, particularly where accounting and disclosure standards are substandard. In some cases it can be more efficient for large corporations to finance new ventures in house, by way of an internal capital market. Financial innovation will lead to very different financing strategies for different purposes. Policymakers, particularly in developing countries, often aspire to an idealized, modern financial system, with public companies, banks and bond and stock markets playing their conventional roles. This is fine so long as companies are not locked into a Modigliani and Miller showed why financing decisions cannot increase value in perfect financial markets. They would agree that financing mistakes can destroy value. Mistakes are inevitable, but governments should not encourage them. One obvious mistake is to finance risky, high-tech investments mostly with debt. But governments often try to subsidize investment in favoured areas by offering low interest rate loans. The classic bad example is the U. S. savings and loan (S&L) crisis. S&Ls had been designed in the 1930s to make mortgage loans to individuals buying homes. The S&Ls took short-term deposits and savings accounts – with federal deposit insurance – and acquired long-term, fixed-rate loans. They were designed to “borrow short, lend long.” When interest rates rose steeply in the late 1970s, the value of these loans fell, leaving a large fraction of the S&L industry insolvent on a market-value basis. An insolvent, or near-insolvent company has little to lose by borrowing more and making risky investments. Normal lenders recognize this temptation and try to step in and protect their interests. But in this case the lenders were savers and depositors protected by the government. Then legislation was passed which loosened the restrictions on the investments S&Ls were allowed to undertake. For example, they were allowed to borrow, by taking in deposits at government-guaranteed rates, and invest real estate development loans and junk bonds. They were allowed to take on more leverage and more asset risk at the same time. Is it any surprise that so many S&Ls failed in the recession of the late 1980s? 118 CU IDOL SELF LEARNING MATERIAL (SLM)
7.2 NI APPROACH Net Income Approach suggests that value of the firm can be increased by decreasing the overall cost of capital (WACC) through higher debt proportion. There are various theories which propagate the ‘ideal’ capital mix / capital structure for a firm. Capital structure is the proportion of debt and equity in which a corporate finances its business. The capital structure of a company/firm plays a very important role in determining the value of a firm. Debt structuring can be a handy option because the interest payable on debts is tax deductible (deductible from net profit before tax). Hence, debt is a cheaper source of finance. But increasing debt has its own share of drawbacks like increased risk of bankruptcy, increased fixed interest obligations etc. .For finding the optimum capital structure in order to maximize shareholder’s wealth or value of the firm, different theories (approaches) have evolved. Let us now look at the first approach. According to Net Income Approach, change in the financial leverage of a firm will lead to a corresponding change in the Weighted Average Cost of Capital (WACC) and also the value of the company. The Net Income Approach suggests that with the increase in leverage (proportion of debt), the WACC decreases and the value of firm increases. On the other hand, if there is a decrease in the leverage, the WACC increases and thereby the value of the firm decreases. corporate can finance its business mainly by 2 means i.e. debts and equity. However, the proportion of each of these could vary from business to business. A company can choose to have a structure which has 50% each of debt and equity or more of one and less of another. Capital structure is also referred to as financial leverage, which strictly means the proportion of debt or borrowed funds in the financing mix of a company. 119 CU IDOL SELF LEARNING MATERIAL (SLM)
Figure 7.1: Net Income Approach Net income (NI) approach as this is also called as traditional approach. This is an approach in which both cost of debt, and equity are independent of capital structure. The components which are involved in it are constant and doesn't depend on how much debt the firm is using. This theory was proposed by David Durand. In this change in financial leverage leads to change in overall cost of capital as well as total value of firm. If financial leverage increases, weighted average cost decreases and value of firm and market price of equity increases. If this decreases then weighted average cost of capital increases and value of firm and market price of equity decreases. The assumptions which can be made according to this approach is that there are no taxes involved in this and the use of debt doesn't change the risk factor for the investors and will remain the same throughout. 120 CU IDOL SELF LEARNING MATERIAL (SLM)
Figure 7.2: Assumption of NI Approach Capital is the major part of all kinds of business activities, which are decided by the size, and nature of the business concern. Capital may be raised with the help of various sources. If the company maintains proper and adequate level of capital, it will earn high profit and they can provide more dividends to its shareholders. Net income approach suggested by the DurandAccording to this approach, the capital structure decision is relevant to the valuation of the firm. In other words, a change in the capital structure leads to a corresponding change in the overall cost of capital as well as the total value of the firm. According to this approach, use more debt finance to reduce the overall cost of capital and increase the value of firm. Net income approach is based on the following three important assumptions. There are no corporate taxes. The cost debt is less than the cost of equity. The use of debt does not change the risk perception of the investor. Another modern theory of capital structuresuggested by Durand. This is just the opposite to the Net Income approach. According to this approach, Capital Structure decision is irrelevant to the valuation of the firm. The market value of the firm is not at all affected by the capital structure changes. According to this approach, the change in capital structure will not lead to any change in the total value of the firm and market price of shares as well as the overall cost of capital. 7.3 NOI APPROACH Net operating income (NOI) is a calculation used to analyse the profitability of income- generating real estate investments. NOI equals all revenue from the property, minus all 121 CU IDOL SELF LEARNING MATERIAL (SLM)
reasonably necessary operating expenses. NOI is a before-tax figure, appearing on a property’s income and cash flow statementthat excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization. When this metric is used in other industries, it is referred to as “EBIT,” which stands for “earnings before interest and taxes.” et operating income is a valuation method used by real estate professionals to determine the precise value of their income-producing properties. To calculate NOI, the property's operating expenses must be subtracted from the income a property produces. In addition to rental income, a property might also generate revenue from amenities such as parking structures, vending machines, and laundry facilities. Operating expenses include the costs of running and maintaining the building, including insurance premiums, legal fees, utilities, property taxes, repair costs, and janitorial fees. Capital expenditures, such as costs for a new air-conditioning system for the entire building, are not included in the calculation. NOI helps real estate investors determine the capitalization rate, which in turn helps them calculate a property’s value, thus allowing them to compare different properties they may be considering buying or selling. For financed properties, NOI is also used in the debt coverage ratio (DCR), which tells lenders and investors whether a property’s income covers its operating expenses and debt payments. NOI is also used to calculate the net income multiplier, cash return on investment, and total return on investment. Where Operating expenses are cost of Selling, general and administrative expenses; other misc. operating expenses etc. Operating Expenses is discussed in detail below. Operating Income also be known as EBIT (Earnings before Interest and taxes) as well as can also be referred as EBITDA (i.e. the cash operating profit before adjustments of Depreciation & Amortisation).Operating Income is used to evaluate the earning performance of the company horizontally (for analysing its historical trends) as well as vertical (for comparison among other companies in peer group). The major earnings performance metrics are EBIT margin % & EBITDA margin %.For valuation purposes operating earrings/income is also a useful tool for comparison purpose among other companies in peer group. The major multiples are used in terms of valuation are – EV/EBITDA; EV/EBIT etc. Operating income is an accounting figure that measures the amount of profit realized from a business's operations, after deducting operating expenses such as wages, depreciation, and cost of goods sold (COGS). Operating income—also called income from operations—takes a company's gross income, which is equivalent to total revenue minus COGS, and subtracts all operating expenses. A business's operating expenses are costs incurred from normal operating activities and include items such as office supplies and utilities. Analysing operating income is helpful to investors because it doesn't include taxes and other one-off items that might skew profit or net income. A company that's generating an increasing amount of operating income is seen as 122 CU IDOL SELF LEARNING MATERIAL (SLM)
favourablebecause it means that the company's management is generating more revenue while controlling expenses, production costs, and overhead. Many companies focus on operating income when measuring the operational success of the business. For example, Company ABC, a hospital and drug firm, reports an operating income rise by 20% year-over- year to $25 million during the first two quarters of its fiscal year. The company realized an increase in revenue and operating income due to an increase in patient volume over the two quarters. The rise in patient visits was driven by two of the company's new immunotherapy drugs: One drug treats lung cancer and the other drug treats melanoma. In another example, we have Company Red, which reports financial results for the first quarter of its fiscal year. The company saw operating income rise by 37%, when compared with the same period in the previous year. The report of the increase in operating income is especially important because the company is looking to merge with Company Blue, and shareholders are slated to vote on the potential merger next month. While Company Red's first-quarter sales did fall by 3%, its operating income growth could potentially give Company Blue shareholders confidence in voting to merge the two companies. 7.4 SUMMARY The main goal of every company is to improve the profit margin. In the light of this goal, the two main methods of accomplishing the profit margin improvement are cutting operating expenses and increasing revenues. OCI contains the obtained results of profit and loss accounts. In addition, the profit and loss are received in the equity. As a result of these two facts, transforming other OCI into a clearer reality in accordance with the IFRS makes its implementation more productive in companies. Most importantly, the companies acquire a better capability to determine the flow of finances and detect future profit and loss. These accomplishments are as a result of the fact that OCI is made up of all the changes that are not acceptable to be part of profit or loss. In conclusion, while the profit and loss act as an indicator of a company’s progress, OCI acts as a financial performance concept; a collection of gains and losses over a particular period of time that is created to account for the items that are not recorded in the net profit and the figures of earnings per share. In essence, the two complement each other to show the progress of a company. Operating Income, also known as EBIT or Recurring Profit, is an important yardstick of profit measurement and reflects the operating performance of the business and doesn’t take into consideration non-operating gains or losses suffered by business, the impact of financial leverage and tax factors. It is calculated as the difference between Gross Profit and Operating Expenses of the business. 123 CU IDOL SELF LEARNING MATERIAL (SLM)
One of the basic objectives of all for-profit business entities is to generate income or profit for their owners. The total income generated by a business can be segregated into two types – operating income and non-operating income. The operating income has the primary importance for any business i.e., it is the basic type of income for which a business entity was primarily established or developed. The non-operating income, on the other hand, has the secondary importance i.e., it is the additional income earned by a business in result of undertaking some additional economic activities that cannot be regarded as the core business activities of the entity. For example, income earned through the sale of merchandise is the operating income for a merchant. However, if the same merchant rents out the additional space of his warehouse to another merchant, the rental income received by him would be treated as non-operating income because the core business activities of a merchant include buying and selling merchandise and not renting out buildings or warehouses. The operating income (also referred to as operating profit) is the basic or primary income that a business derives solely from its core operations. On the income statement, operating income is commonly reported as line item before non-operating income. For any business, the operating income figure can be computed by deducting cost of goods sold and all operating expenses from the revenue realized through primary business operations. Many businesses also earn non-operating income in addition to operating income. The non-operating income (also referred to as non-operating profit) is the income that a business earns from other than its primary business operations. It can be a regular income like rent, dividend or interest or a one-off income like gain on sale of investment. In a multi-step income statement, the non-operating income is often computed and presented in a separate section known as non-operating income section which usually appears near the bottom of the income statement. In this section, any non-operating expenses or losses are deducted from the total non-operating revenues or benefits and the net amount is reported as line item below the operating income. 7.5 KEYWORDS Compensation: Payment made to employees in return for services performed. Total compensation includes salaries, wages, employee benefits (Social Security, employer¬-paid insurance premiums, disability coverage, and retirement contributions), and other forms of remuneration when these have a stated value. 124 CU IDOL SELF LEARNING MATERIAL (SLM)
Commercial Paper: A form of short-term tax-exempt debt issued by state and local governments that matures within a short period (less than 365 days) from the date of Issue. Competitive Underwriting: A sale of municipal securities by an issuer to the underwriter offering the best bid (lowest net or true interest cost) in open competitive bidding. Contrasts with negotiated underwriting. Constant Yield Tax Rate: A rate which, when applied to the coming year’s assessable base, exclusive of the estimated assessed value of property appearing on the tax rolls for the first time (new construction), will produce tax revenue equal to that produced in the current tax year. Construction Fund: A special fund, often held by the trustee or other fiduciary, into which the net proceeds of an issue are deposited and are to be used to pay project costs. The construction fund is often pledged for the payment of the securities, pending its use for the purpose of paying the project costs. 7.6 LEARNING ACTIVITY 1. Create a session on NI approach. ___________________________________________________________________________ ___________________________________________________________________________ 2. Create a survey on NOI approach. ___________________________________________________________________________ ___________________________________________________________________________ 7.7 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. List the various components of operating cycle. 2. Define cash management. 3. What is receivable management? 4. What are credit policies? 5. Write the full form of NOI? Long Questions 1. Examine the advantages of NI approach. 125 CU IDOL SELF LEARNING MATERIAL (SLM)
2. Elaborate the disadvantages NI approach. 3. Explain the advantages of NOI approach. 4. Discuss on the disadvantages of NOI approach. 5. Illustrate the theories of capital structure. B. Multiple Choice Questions 1. What is referred as Interest paid (earned) on both the original principal borrowed (lent) and previous interest earned? a. Present value b. Simple interest c. Future value d. Compound interest 2. What is the long-run objective of financial management is? a. Maximize earnings per share b. Maximize the value of the firm's common stock c. Maximize return on investment d. Maximize market share 3. What is the present value of a Rs.1, 000 ordinary annuity that earns 8% annually for an infinite number of periods? a. Rs.80 b. Rs.800 c. Rs.1, 000 d. Rs.12, 500 4. Which one of the following is / are the relevance theory? a. Gorden b. Walter c. Residual d. Both (a) and (b) 5. What is a set of possible values that a random variable can assume and their associated probabilities of occurrence? a. Probability distribution b. The expected return 126 CU IDOL SELF LEARNING MATERIAL (SLM)
c. The standard deviation d. Coefficient of variation Answers 1-b, 2-d, 3-b, 4-d, 5-a 7.8 REFERENCES References Booth, L. Aivazian, V. Demirguc-kunt, A. & Maksomovic, V. (2001). Capital structures in developing countries. The Journal of Finance. Bonfiglioli, A. & Mendicino, C. (2004). Financial Liberalisation, Bank Crises and Growth: assessing the links. Economics and Finance Working Paper. Borio, C, E, V. (1990). Leverage and financing of non-financial companies: an international perspective. BIS Economic Papers. Basle: Bank of international settlements. Textbook Boyle, W. & Eckhold, K, R. (1997). Capital structure choice and financial market liberalisation: evidence from New Zealand. Applied Financial Economics. Bowman, R, G. (1980). The importance of a market-value measurement of debt in assessing leverage. Journal of Accounting Research. Bradley, M.. Jarrell, A. & Kim, H. (1984). On the existence of an optimal capital structure: theory and evidence. The Journal of Finance. Website https://www.termscompared.com/difference-between-operating-income-and-non- operating-income/ https://www.tutorialspoint.com https://www.slideshare.net/ShahidAfzalSyed/5-capital-structuretheories-32694984 127 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT-8 THEORIES OF CAPITAL STRUCTURE II STRUCTURE 8.0 Learning objective 8.1 Introduction 8.2 MM approach 8.3 Capital Structure in Practice 8.4 Summary 8.5 Keywords 8.6 Learning Activity 8.7 Unit End Questions 8.8 References 8.0 LEARNING OBJECTIVE After studying this unit, you will be able to Explain the concept of MM approach. Illustrate the capital structure in practice. Explaintheadvantages of capital structure. 8.1 INTRODUCTION The companies involved in LBOs and restructurings have a surplus of cash and a shortage of good investments. Companies with credibly profitable growth opportunities are exempt from these transactions. The third alternative channel is mergers and acquisitions. Takeovers are often launched in order to shrink the target firm. Notice that over-capacity in an industry is generally a prelude to mergers. For example, the end of the cold war meant rapid shrinkage of U. S. defence budgets, and triggered a series of mergers in the defines industry. Another clear example is banking: state regulation left the U. S. with far too many banks, and deregulation was followed by merger after merger. This is not to say that all LBOs, restructuring and takeovers were economically efficient. Mistakes were made, and some of the gains to investors were at the expense of other stakeholders. For example, the mere announcement that a company would be “in play” for an LBO in the 1980s triggered immediate losses averaging 5.2% of the market value of the company’s existing bonds.5 Nevertheless, laws or regulations which prevent takeovers, or restrict the “excessive” leverage in LBOs and restructurings, close off channels that can convey large amounts of capital back to investors 128 CU IDOL SELF LEARNING MATERIAL (SLM)
for reinvestment elsewhere in the economy. If those channels are blocked and share repurchases prohibited, only one channel is left, cash dividends. The amount of cash flowing along the dividend channel is typically a small fraction of the value of the firm. That small flow is of no concern when the firm can invest profitably. In fact, most growth firms pay no dividends at all. But firms which should return capital in large amounts to investors are unlikely to do so through dividends aloneI should not leave the impression that all of the cash flow generated by a mature firm should go to outside investors. There are also inside investors, namely managers and employees. The insiders’ investment comes in the form of personal risk-taking, sweat equity (working extra-hard for less than an opportunity wage) and by specialization of human capital to the firm. So a general financial theory of the firm would model the co-investment of human and financial capital. Some basic theoretical work has done here, focused primarily on the conditions under which insiders can raise financing from outside investors when insiders make the investment decisions and can extract cash or private benefits after the investment is made.6 But this work has not focused on the form of outside financing, for example debt vs. equity. There are, to my knowledge, no formally developed theories of capital structure derived from the conditions for efficient co-investment of human and financial capital. Buildings, aircraft, skeletons, anthills, beaver dams, bridges and salt domes are all examples of load-bearing structures. The results of construction are divided into buildings and non- building structures, and make up the infrastructure of a human society. Built structures are broadly divided by their varying design approaches and standards, into categories including building structures, architectural structures, civil engineering structures and mechanical structures. The structure elements are combined in structural systems. The majority of everyday load- bearing structures are section-active structures like frames, which are primarily composed of one-dimensional (bending) structures. Other types are Vector-active structures such as trusses, surface-active structures such as shells and folded plates, form-active structures such as cable or membrane structures, and hybrid structures. Load-bearing biological structures such as bones, teeth, shells, and tendons derive their strength from a multilevel hierarchy of structures employing biominerals and proteins, at the bottom of which are collagen fibrils. The term of post bureaucratic is used in two senses in the organizational literature: one generic and one much more specific. In the generic sense the term post bureaucratic is often used to describe a range of ideas developed since the 1980s that specifically contrast themselves with Weber's ideal type bureaucracy. This may include total quality management, culture management and matrix management, amongst others. None of these however has left behind the core tenets of Bureaucracy. Hierarchies still exist, authority is still Weber's rational, legal type, and the organization is still rule bound. Heckscher, arguing along these lines, describes them as cleaned up bureaucraciesrather than a fundamental shift away from 129 CU IDOL SELF LEARNING MATERIAL (SLM)
bureaucracy. Gideon Kunda, in his classic study of culture management at 'Tech' argued that 'the essence of bureaucratic control - the formalization, codification and enforcement of rules and regulations - does not change in principleit shifts focus from organizational structure to the organization's culture'. Another smaller group of theorists have developed the theory of the Post-Bureaucratic Organizationprovide a detailed discussion which attempts to describe an organization that is fundamentally not bureaucratic. Charles Heckscherhas developed an ideal type, the post- bureaucratic organization, in which decisions are based on dialogue and consensus rather than authority and command, the organization is a network rather than a hierarchy, open at the boundaries (in direct contrast to culture management); there is an emphasis on meta- decision-making rules rather than decision-making rules. This sort of horizontal decision- making by consensus model is often used in housing cooperatives, other cooperatives and when running a non-profit or community organization. It is used in order to encourage participation and help to empower people who normally experience oppression in groups. Still other theorists are developing a resurgence of interest in complexity theory and organizations, and have focused on how simple structures can be used to engender organizational adaptations. For instance, Minerstudied how simple structures could be used to generate improvisational outcomes in product development. Their study makes links to simple structures and improviser learning. Other scholars such as Jan Rivkin and Sigglekowand Nelson Repenningrevive an older interest in how structure and strategy relate in dynamic environments. A functional organizational structure is a structure that consists of activities such as coordination, supervision and task allocation. The organizational structure determines how the organization performs or operates. The term organizational structure refers to how the people in an organization are grouped and to whom they report. One traditional way of organizing people is by function. Some common functions within an organization include production, marketing, human resources, and accounting. 8.2 MM APPROACH \"Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as is. Or he can separate out the cream and sell it at a considerably higher price than the whole milk would bring.But, of course, what the farmer would have left would be skim milk with low butterfat content and that would sell for much less than whole milk. That corresponds to the levered equity. The M and M proposition says that if there were no costs of separation (and, of course, no government dairy-support programs), the cream plus the skim milk would bring the same price as the whole milk.\" At the time, both Modigliani and Miller were professors at the Graduate School of Industrial Administration at Carnegie Mellon University. Both were required to teach corporate finance to business students but, unhappily, neither had any 130 CU IDOL SELF LEARNING MATERIAL (SLM)
experience in corporate finance. After reading the course materials that they were to use, the two professors found the information inconsistent and the concepts flawed. So, they worked together to correct them. The Modigliani and Miller approach to capital theory, devised in the 1950s, advocates the capital structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has a lower debt component has no bearing on its market value. Rather, the market value of a firm is solely dependent on the operating profits of the company. The capital structure of a company is the way a company finances its assets. A company can finance its operations by either equity or different combinations of debt and equity. The capital structure of a company can have a majority of the debt component or a majority of equity, or an even mix of both debt and equity. Each approach has its own set of advantages and disadvantages. There are various capital structure theories that attempt to establish a relationship between the financial leverage of a company (the proportion of debt in the company’s capital structure) with its market value. One such approach is the Modigliani and Miller Approach. This approach was devised by Modigliani and Miller during the 1950s. The fundamentals of the Modigliani and Miller Approach resemble that of the Net Operating Income Approach. Modigliani and Miller advocate capital structure irrelevancy theory, which suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has a lower debt component in the financing mix has no bearing on the value of a firm. The Modigliani and Miller Approach further states that the market value of a firm is affected by its operating income, apart from the risk involved in the investment. The theory stated that the value of the firm is not dependent on the choice of capital structure or financing decisions of the firm. 131 CU IDOL SELF LEARNING MATERIAL (SLM)
Figure 8.1: MM Approach The Modigliani and Miller approach to capital theory, devised in the 1950s, advocates the capital structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has a lower debt component has no bearing on its market value. Rather, the market value of a firm is solely dependent on the operating profits of the company. The capital structure of a company is the way a company finances its assets. A company can finance its operations by either equity or different combinations of debt and equity. The capital structure of a company can have a majority of the debt component or a majority of equity, or an even mix of both debt and equity. Each approach has its own set of advantages and disadvantages. There are various capital structure theories that attempt to establish a relationship between the financial leverage of a company (the proportion of debt in the company’s capital structure) with its market value. One such approach is the Modigliani and Miller Approach. The cost of capital and the total market value of the firm are independent of its capital structure. The cost of capital is equal to the capitalisation rate of equity stream of operating earnings for its class, and the market is determined by capitalizing its expected return at an appropriate rate of discount for its risk class. The second proposition includes that the expected yield on a share is equal to the appropriate capitalisation rate for a pure equity stream for that class together with a premium for financial risk equal to the difference between the pure-equity capitalisation rate (K.) and yield on debt (Kd). In short, increased Ke is offset exactly by the 132 CU IDOL SELF LEARNING MATERIAL (SLM)
use of cheaper debt. The cut-off point for investment is always the capitalisation rate which is completely independent and unaffected by the securities that are invested. 8.3 CAPITAL STRUCTURE IN PRACTICE We examine the relation between the quality of corporate governance and the value of excess cash for large European firms. We use Deminor ratings for Shareholder rights, Takeover defences, Disclosure and Board as proxies for the quality of corporate governance. We find that the value of excess cash is positively related to the Takeover defences score only. It seems that governance mechanisms—except the market for corporate control—are not strong enough to prevent managers from wasting excess cash. For non-UK firms we find that the value of €1 of excess cash in a poorly governed firm is valued at only €0.89 while the value is €1.45 for a good governed firm. We show that poorly governed firms dissipate excess cash relatively quickly with a negative impact on their operating performance as a result. We study the impact of corporate governance on the value of excess cash holdings by firms. Jensenargues that poorly monitored managers of publicly listed companies waste free cash by investing money in value decreasing projects. In this context corporate governance could be of great value, if it protects shareholders against mismanagement and irresponsible dissipation of cash. In the absence of any market imperfections, the value of €1 on the bank account of firms should be valued equally by the capital market. However, in practice it is possible that management invests this €1 in a project that is worth less. These agency costs imply that the €1 held within the firm will be valued at a discount. The higher the probability of misallocation of cash holdings under management’s controlthe lower its market value. Good corporate governance could lower this probability of wasting by management and as such increase the value of firms’ cash holdings. If firms held only little amounts of cash, the sketched problem would be of minor importance. However, firms’ cash holdings often are substantial. For the largest listed European non- financial firms the sum of cash and cash equivalents was more than 13% of net assets (total assets minus cash) in the year 2000, while by 2005 this percentage had even increased to almost 17%.2 For some individual firms these percentages are much higher. For example, cash holdings by H & M Hennes & Mauritz from Sweden were 52% and 103% of net assets in 2000 and 2005, respectively. Firm’s cash holdings also are very volatile. For example, AFC Ajax NV’s cash holdings varied from 79% in 1998 (the IPO year of ACF Ajax) via 18% in 2000 to 27% in 2005. If agency problems did not exist, there would be no valuation problem, even if the cash holdings are at such high levels as observed in practice. However, if shareholders fear misallocation of firm’s cash by the incumbent management, the negative effects on the valuation of the firm can be huge. A large body of literature explores the influence of corporate governance on the return on equity, firm value and firm performance, see Nesbitt, Yermack, Core, GompersBauer BebchukCremers and NairBrown and Caylorand Coreamong others. However, previous literature has not related the quality of corporate 133 CU IDOL SELF LEARNING MATERIAL (SLM)
governance directly to the value of firm-level cash holdings. A notable exception is Pinkowitzwho study the relationship between cash holdings and firm value and the influence of governance on that relationship in an international context using a sample of firms from 35 countries. Pinkowitzfind that a dollar increase in cash holdings is worth roughly a dollar in countries with strong investor protection, but much less than a dollar in countries with poor investor protection. Other papers that deal with the value of cash are Faulkender and Wangand Pinkowitz and Williamson. Both papers study the marginal value of cash but without taking into consideration corporate governance. Faulkender and Wangfind, amongst other things, that the marginal value of cash holdings declines with larger cash holdings and higher leverage, while Pinkowitz and Williamsondocument that the value of cash depends on both the investment and financing opportunity sets of the firm. In this chapter we focus on the effect of corporate governance on the value of excess cash, as this part of cash holdings is most easily accessible by management to derive ‘private benefits. As pointed out by Myers and Rajanit is easier to make cash disappear than to make a plant disappear. We argue that it is even easier to make excess cash disappear, as this part of the firm’s cash holdings is not needed for other, economically motivated purposes such as financing new investment opportunities. We are interested in the valuation of excess cash by the market and especially in the influence of corporate governance on this valuation. A first attempt to examine this issue was made by Dittmar and Mahrt-Smithfor U.S. firms. Dittmar and Mahrt-Smithfind that governance has a positive effect on the value of excess cash and on the marginal value of total cash. In particular, the market value of excess cash for firms that have poor internal or external corporate governance in the form of extensive anti-takeover provisions and a low level of large shareholder monitoring, respectively, is found to be approximately one-half of the value of excess cash for firms that are well governed. Depending on the measure of corporate governance, the marginal value of $1.00 held by a poorly governed firm varies between $0.42 and $0.88, compared to $1.27 to $1.62 for a well governed firm. Dittmar and Mahrt-Smithfurther show that poorly governed firms dissipate cash more quicklyand in such a way that they experience lower operating performance. Explanations given by Dittmar and Mahrt-Smithfor the lower value of (excess) cash for poorly governed firms are that these firms invest (more) money in negative NPV projects (poorly governed firms spend more on acquisitions)and may make managers ‘lazy’ in the sense that it reduces their incentives to control costs, improve margins etc. In contrast to Dittmar and Mahrt-Smith, our study analyses the relation between four different governance mechanisms and excess cash, i.e. Shareholder rights, Takeover defences, Disclosure and Board functioning. Our unique governance dataset provided by Deminormakes it possible to pinpoint which governance provisions influence the value of excess cash and which ones do not. In addition, we focus on the effects of corporate governance on the value of excess cash for a sample of large publicly listed European firms. To determine the effects of governance on the value of excess cash we follow the methodology of Dittmar and Mahrt-Smith. We use a cash model based on Oplerto determine the normal cash holdings and define excess cash as the difference between the 134 CU IDOL SELF LEARNING MATERIAL (SLM)
actual cash holdings and the predicted normal cash holdings. We use value regressions as employed in Fama and Frenchand return regressions as used by Faulkender and Wangto determine the value of (positive) excess cash. We find that the level of (excess) cash as well as the value of excess cash is positively related to the score for the corporate governance measure of Takeover defences. These findings indicate that firms with less anti-takeover provisions (low management rights) hold more cash than well protected firms (high management rights), and that excess cash held by the first type of firms is valued higher. Other corporate governance measures do not explain differences in (excess) cash holdings nor in the valuation of excess cash. For non-UK firms we find that the value of € 1 of excess cash is only €0.89 for the lower Takeover defences quartile and €1.45 for the upper quartile. We interpret these findings as follows. The value of excess cash of firms with high management rights is relatively low, because the capital market cannot correct nor prevent the misuse of these cash holdings. Cash holdings of these firms are accordingly valued below ‘face value’. On the other hand, firms with low management rights run the risk of being taken over if they destroy valueby investing in negative NPV projects or by operating extremely inefficient. Because of this threat of control over the amount of excess cash, the probability that it will be allocated wrongly is smaller and hence excess cash is valued higher. We find empirical evidence that firms with high management rights spend their excess cash more quickly and on less profitable investments than firms with low management rights (that is, high governance scores). This indicates that indeed well governed firms operate under the fear of the capital market for misallocation of their excess cash holdings. The other governance mechanisms do not seem to be strong enough to convince the capital market that management will act in the shareholders’ best interests. The structure of this chapter is as follows. In sectionwe discuss the Deminor governance data. In sectionwe present the models we use to estimate normal and excess cash and the relation between corporate governance and the value of excess cash. Data and summary statistics on cash are provided in the same section. In sectionwe report our empirical results. We use Deminor ratings to measure the quality of firm-level corporate governance. These ratings cover firms included in the FTSEurofirst 300 Index for the years 2000- 2004. The Deminor ratings are based on 300 different governance indicators that refer to internationally accepted standards, as outlined by the International Corporate Governance Network (ICGN), the World Bank, the Organisation for Economic Cooperation and Development (OECD) and the Conference Board. The different indicators or criteria can be classified into four categories: rights and duties of shareholdersrange of takeover defences disclosure on financial matters and corporate governanceand Board structure and functioning. For each category a rating is available on a scale from 1 to 10, where a score of 10corresponds to the best (worst) possible governance quality. The total governance score is simply the sum of the rating scores of the four categories. The first category of governance criteria, Shareholder rights, concerns the question whether shareholders can exert sufficient power to determine corporate action. The score is based on 135 CU IDOL SELF LEARNING MATERIAL (SLM)
i. The ‘one share - one vote - one dividend’ principle ii. Access to and voting procedures at general meetings and iii. Maintenance of pre-emptive rights Firms that respect the control and ownership roles of shareholders, score high on the ‘one share - one vote - one dividend’ principle. Deminor evaluates whether companies submit voting issues that are perceived as particular significant to the general meeting of shareholders and assesses the voting structure. Furthermore, companies should respect the pre-emptive rights of the existing shareholders as these stakeholders would like to prevent dilution of their voting or economic power. The second category, Takeover defences, examines the extent to which the firm attempts to decrease the likelihood of a hostile takeover through the adoption of antitakeover provisions. Deminor examines the presence and strength of anti-takeover devices such as poison pills, golden parachutes, core shareholdings and extensive cross-shareholdings. To achieve a high score for this aspect of governance, the range of takeover defences should lead to a favourable bidding process and not preclude the success of a takeover attempt per se. The third category, Disclosure, measures whether shareholders are able to obtain convenient and comprehensive information about the company’s financial matters as well as its governance characteristics. Deminor analyses for instance the quantity and quality of non-financial information, such as the diversity and independence of board members, board committees, accounting standards and information on major shareholders of the company. The fourth category, Board, measures issues relating to the governance of a Board, such as the presence of independent directors, the division between the role of Chairman and Chief Executive and the election of the board. Presents descriptive statistics of the governance scores for our sample, comprising 271 large European firms over the period 2000-2004We observe a positive trend in the overall governance scores, as well as in the sub-scores. The average total score in 2000 is equal to 19.02, which gradually increases to 23.84 in 2004. This trend is in line with the increased attention paid to governance structures by policy makers, see footnotefor a list of National Codes of Best Practice, and the subsequent firm actions to improve their corporate governance. Our main specification includes measures for size, cash flow, cash substitutes, risk, growth options, and costs of financial distress. These variables are commonly used as proxies for the determinants of normal cash holdings that arise through the transactions motive and the savings motive, where the latter refers to the incentive to accumulate cash for financing new investment opportunities when external finance is costly, see Opler. Size plays a double role, in the sense that it acts both as a measure of the transactions motive as well as a proxy for access to financial markets. Cash flow and net working capital are interpreted as substitutes for cash. The market-to-book ratio and R&D expenses serve as proxies for growth opportunities, information asymmetry, and financial costs of distress. We expect a negative coefficient for size and net working capital and a positive coefficient for growth 136 CU IDOL SELF LEARNING MATERIAL (SLM)
opportunities, R&D expenses and risk. The expected sign for cash flow is positive according to the pecking order theory and negative according to the trade-off theory. The year dummies are included to account for macroeconomic factors which may influence overall demand and supply of liquidity. The firm fixed effects control for the fact that due to idiosyncratic reasons some firms may consistently hold higher or lower normal cash levels than required for economic reasons. Excess cash is defined as the difference between the actual cash holdings and the estimated normal cash holdings, that is, the residual from. Following Dittmar and Mahrt-Smithhowever, we do include the firm fixed effects as part of excess cash, as this does not reflect the generally accepted economic reasons for holding cash, such as operational needs or future investments. As Dittmar and Mahrt-Smith we include the year fixed effects as part of excess cash as well. Following Dittmar and Mahrt-Smithto determine the effect – if any – of corporate governance on the value of excess cash, we estimate value regressions based on Fama and French. The dependent variable is the market-to-book ratio, which is taken as a measure of total firm value (equity and debt). The regression model includes control variables representing factors that are likely to affect investors’ expectations of future net cash flows. Specifically, the control variables are past changes, future changes, and current levels of earnings, R&D expenses. 8.4 SUMMARY This chapter examines the relation between the quality of corporate governance and the cost of debt for large European firms (FTSEurofirst 300 Index). We use Deminor scores for Shareholder rights, Takeover defences, Disclosure and Board as proxies for the quality of corporate governance. As a proxy for the cost of debt we use the yield and yield spread of 319 bonds issued in the years 2001-2005. After adjusting for issuer characteristics, issue characteristics and market characteristics, we find a negative relation between disclosure and the cost of debt. We uncover that this relation is in fact nonlinear and crucially depends on the quality of shareholder rights. If the quality of shareholder rights is high, the effect of disclosure on the cost of debt is insignificant. However, if the quality of shareholder rights is low, the negative effect of disclosure is statistically and economically significant. This novel interaction effect between shareholders rights and disclosure on the cost of debt is explained by our ‘share rights or disclose’ hypothesis. According to this hypothesis, agency conflicts between the management and the providers of capital are negatively related with the quality of shareholder rights. We argue that firms with higher shareholder rights exhibit lower information risk. In this chapter we examine the relation between European firm’s quality of corporate governance and their cost of debt. The quality of corporate governance is measured by means of the corporate governance rating constructed by Deminor. This rating contains four different 137 CU IDOL SELF LEARNING MATERIAL (SLM)
components i.e. rights and duties of shareholders range of takeover defences disclosure on financial matters and corporate governance; andsupervisory board structure and functioning. The cost of debt is measured by the yield to maturity on new debt issues and the yield spread of these issues. A large body of literature explores the influence of corporate governance on the return on equity, firm value and firm performance, see e.g. NesbittYermackCoreGompersBauer BebchukCremers and NairBrown and Caylorand Core. Previous literature on the effects of corporate governance on the cost of debtincludes Sengupta, Bhojraj and Sengupta, Andersonand Klock, Mansi and Maxwell. These studies have in common that they only consider the effects of a specific aspect of corporate governance, such as shareholder rights or board structure. In this chapter, we conduct a comprehensive analysis of the effects of different components of corporate governance on the cost of debt. We do not limit ourselves to examining the effects of these components in isolation, but we also explore the possibility of interaction effects. In particular we formulate the hypothesis that the effects of disclosure on the cost of debt crucially depends on the level of shareholder rights. This ‘share rights or disclose’ hypothesis refers to the role that governance plays in agency conflicts between management and the providers of capital in combination with information risk. We hypothesize that these agency problems and information risk are positively related. We find that firms’ cost of debt is negatively associated with the quality of the corporate governance measure ‘Disclosure’. We also uncover that this relation crucially hinges upon the quality of the corporate governance measure ‘Shareholder rights’ which is in accordance with the ‘share rights or disclose’ hypothesis. If the quality of shareholder rights is high, the relevance of Disclosure for the cost of debt is low. However, if the quality of Shareholder rights is low, the negative effect of disclosure is statistically and economically significant. We find that the credit spread for firms with shareholder rights lower than 5 (on a scale from 1-10) decreases with approximately 70 basis points if we move within this category from the lower quartile to the upper quartile of the governance measure disclosure. We do not find support for the hypotheses we formulate for the other governance components. We find no relation between Takeover defences and the cost of debt nor between governance component Board and the cost of debt. This research contributes to the literature in two ways. First, our governance measure contains four different components of corporate governance from one independent source. This makes it possible to determine the relevance of each component as well as their interaction for the cost of debt. This makes our study more comprehensive than studies that take one aspect into account only. 138 CU IDOL SELF LEARNING MATERIAL (SLM)
We introduce the ‘share rights or disclose’ hypothesis and present empirical evidence in favour of this new hypothesis. Second, we provide empirical evidence for European firms instead of U.S. firms. The structure of the chapter is as follows. In we present the Deminor governance data. We discuss related prior empirical research inand formulate expected relations for each governance measure with the cost of debt. Describes our main model, our sample and some descriptive statistics and also presents the main empirical results. 8.5 KEYWORDS Cost Center: Expenditure categories within a program area that relate to specific organizational goals or objectives. Each cost centre may consist of an entire agency or a part of an agency. Cost of Issuance: Expenses paid by the issuer directly related to the authorization, sale, and issuance of bonds. These costs may include legal fees, trustee’s fees, printing costs, bond discounts, cost of credit ratings, fees and charges for execution, as well as filing and recording fees. Coupon: Detachable portions of a bond presented by its holder to bond issuer’s paying agent to document interest due. The coupon rate is the rate of interest on face value that the coupons reflect. Current Revenue: A funding source for the Capital Budget that is provided for annually within the Operating Budget from general, special, or enterprise revenues. Current revenues are used for funding project appropriations not eligible for debt financing or to substitute for debt-eligible costs. Debt Service: The annual payment of principal, interest, and issue costs of bonded indebtedness. Debt service is presented both in terms of specific bond allocations by category, fund and by sources of revenues used. 8.6 LEARNING ACTIVITY 1. Create a survey on MM approach. ___________________________________________________________________________ ___________________________________________________________________________ 2. Create a session on capital structure in practice. ___________________________________________________________________________ ___________________________________________________________________________ 139 CU IDOL SELF LEARNING MATERIAL (SLM)
8.7 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Write the full form on MM? 2. Write the main aim of MM approach? 3. Define the term structure? 4. What is working capital cycle? 5. What is receivable management? Long Questions 1. Explain the advantages of capital structure. 2. Elaborate the disadvantages of capital structure. 3. Illustrate the advantages of MM approach. 4. Discuss on the disadvantages of MM approach. 5. Examine the scope of MM approach. B. Multiple Choice Questions 1. What is the weighted average of possible returns, with the weights being the probabilities of occurrence is ? a. A probability distribution b. The expected return c. The standard deviation d. Coefficient of variation 2. On which capital gain and current income may influence form of capital? a. Legal stipulation b. Rate of tax c. Capital market condition d. Cost of floating 3. Which one of the following is the most important and common form of dividend is? a. Stock dividend b. Cash dividend c. Bond dividend d. Scrip’s dividend 140 CU IDOL SELF LEARNING MATERIAL (SLM)
4. Which form of market efficiency states that current security prices fully reflect all information, both public and private a. Weak b. Semi-strong c. Strong d. Flexible 5. Which form of market efficiency states that current prices fully reflect the historical sequence of prices? a. Weak b. Semi-strong c. Strong d. Flexible Answers 1-a, 2-b, 3-b, 4-a, 5-c 8.8 REFERENCES References Brounen, D. De, Jong, A. & Koedijk, K. (2006). Capital structure policies in Europe. Journal of Banking and Finance. Chang, C. Lee, A, C. & Lee, C, F. (2009). Determinants of capital structure choice: a structural equation modelling approach. The Quarterly Review of Economics and Finance. Chakraborty, I. (2010). Capital structure in an emerging stock market. Research in International Business and Finance. Textbook Chen, J, J. (2004). Determinants of capital structure of Chinese-listed firms. Journal of Business Research. Chow, G, C. (1960). Tests of equality between sets of coefficients in two linear regressions. Econometrica. Cobham, D. & Subramaniam, R. (1998). Corporate finance in developing countries: new evidence for India. World Development. 141 CU IDOL SELF LEARNING MATERIAL (SLM)
Website file:///C:/Users/Sony/Downloads/Erim_Schautenbwlr.pdf http://www.mpgmahavidyalaya.org/userfiles/Theory%20of%20Capital%20Structure. https://www.accountingnotes.net/financial-management/capital-structure/modigliani- miller-m-m-approach/6772 142 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT-9 COST OF CAPITAL PART I STRUCTURE 9.0 Learning Objective 9.1 Introduction 9.2 Meaning 9.3 Significance Cost of Debt 9.4 Cost of Preference Capital 9.5 Summary 9.6 Keywords 9.7 Learning Activity 9.8 Unit End Questions 9.9 References 9.0 LEARNING OBJECTIVE After studying this unit, you will be able to Explain the concept of cost of capital. Illustrate the significance cost of debt. Explain the cost of preference capital. 9.1 INTRODUCTION In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or, from an investor's point of view \"the required rate of return on a portfolio company's existing securities\". It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet. For an investment to be worthwhile, the expected return on capital has to be higher than the cost of capital. Given a number of competing investment opportunities, investors are expected to put their capital to work in order to maximize the return. In other words, the cost of capital is the rate of return that capital could be expected to earn in the best alternative investment of equivalent risk; this is the opportunity cost of capital. If a project is of similar risk to a company's average business activities it is reasonable to use the company's average cost of capital as a basis for the evaluation or cost of capital is a firm's cost of raising funds. 143 CU IDOL SELF LEARNING MATERIAL (SLM)
However, for projects outside the core business of the company, the current cost of capital may not be the appropriate yardstick to use, as the risks of the businesses are not the same. A company's securities typically include both debt and equity; one must therefore calculate both the cost of debt and the cost of equity to determine a company's cost of capital. Importantly, both cost of debt and equity must be forward looking, and reflect the expectations of risk and return in the future. This means, for instance, that the past cost of debt is not a good indicator of the actual forward looking cost of debt. Once cost of debt and cost of equity have been determined, their blend, the weighted average cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate for a project's projected free cash flows to the firm. Figure 9.1: Cost of Capital Suppose a company considers taking on a project or investment of some kind, for example installing a new piece of machinery in one of their factories. Installing this new machinery will cost money; paying the technicians to install the machinery, transporting the machinery, buying the parts and so on. This new machinery is also expected to generate new profit. So the company will finance the project with two broad categories of finance: issuing debt, by taking out a loan or other debt instrument such as a bond; and issuing equity, usually by issuing new shares. 144 CU IDOL SELF LEARNING MATERIAL (SLM)
The new debt-holders and shareholders who have decided to invest in the company to fund this new machinery will expect a return on their investment: debt-holders require interest payments and shareholders require dividends. The idea is that some of the profit generated by this new project will be used to repay the debt and satisfy the new shareholders. Suppose that one of the sources of finance for this new project was a bond (issued at par value) of $200,000 with an interest rate of 5%. This means that the company would issue the bond to some willing investor, who would give the $200,000 to the company which it could then use, for a specified period of time (the term of the bond) to finance its project. The company would also make regular payments to the investor of 5% of the original amount they invested ($10,000), at a yearly or monthly rate depending on the specifics of the bond (these are called coupon payments). At the end of the lifetime of the bond (when the bond matures), the company would return the $200,000 they borrowed. Suppose the bond had a lifetime of ten years and coupon payments were made yearly. This means that the investor would receive $10,000 every year for ten years, and then finally their $200,000 back at the end of the ten years. From the investor's point of view, their investment of $200,000 would be regained at the end of the ten years (entailing zero gain or loss), but they would have also gained from the coupon payments; the $10,000 per year for ten years would amount to a net gain of $100,000 to the investor. This is the amount that compensates the investor for taking the risk of investing in the company (since, if it happens that the project fails completely and the company goes bankrupt, there is a chance that the investor does not get their money back). This net gain of $100,000 was paid by the company to the investor as a reward for investing their money in the company. In essence, this is how much the company paid to borrow $200,000. It was the cost of raising $200,000 of new capital. So to raise $200,000 the company had to pay $100,000 out of their profits; thus we say that the cost of debt in this case was 50%. Theoretically, if the company were to raise further capital by issuing more of the same bonds, the new investors would also expect a 50% return on their investment (although in practice the required return varies depending on the size of the investment, the lifetime of the loan, the risk of the project and so on). The cost of equity follows the same principle: the investors expect a certain return from their investment, and the company must pay this amount in order for the investors to be willing to invest in the company. (Although the cost of equity is calculated differently since dividends, unlike interest paymentsare not necessarily a fixed payment or a legal requirement). The models state that investors will expect a return that is the risk-free return plus the security's sensitivity to market risk (β) times the market risk premium.The risk premium varies over time and place, but in some developed countries during the twentieth century it 145 CU IDOL SELF LEARNING MATERIAL (SLM)
has averaged around 5% whereas in the emerging markets, it can be as high as 7%. The equity market real capital gain return has been about the same as annual real GDP growth. The capital gains on the Dow Jones Industrial Average have been 1.6% per year over the period 1910-2005. The dividends have increased the total \"real\" return on average equity to the double, about 3.2%. The sensitivity to market risk (β) is unique for each firm and depends on everything from management to its business and capital structure. This value cannot be known \"ex ante\" (beforehand), but can be estimated from ex post (past) returns and past experience with similar firms. Cost of Retained Earnings/ Cost of Internal Equity Note that retained earnings are a component of equity, and, therefore, the cost of retained earnings (internal equity) is equal to the cost of equity as explained above. Dividends (earnings that are paid to investors and not retained) are a component of the return on capital to equity holders, and influence the cost of capital through that mechanism. 9.2 MEANING An investor provides long-term funds (i.e., Equity shares, Preference Shares, Retained earnings, Debentures etc.) to a company and quite naturally he expects a good return on his investment. In order to satisfy the investor’s expectations the company should be able to earn enough revenue. Thus, to the company, the cost of capital is the minimum rate of return that the company must earn on its investments to fulfil the expectations of the investors. If a company can raise long-term funds from the market at 10%, then 10% can be used as cut- off rate as the management gains only when the project gives return higher than 10%. Hence 10% is the discount rate or cut-off rate. In other words, it is the minimum rate of return required on the investment project to keep the market value per share unchanged. In order to maximise the shareholders’ wealth through increased price of shares, a company has to earn more than the cost of capital. The firm’s cost of capital can be determined by working out weighted average of the different costs of raising different sources of capital. It is a rate of returns expected by the investors i.e., K = or + b + f. i.e., the cost of capital includes the rate of return at zero risk + premium for business risk + premium for financial risk. It is the minimum rate of return the firm earns as its investment in order to satisfy the expectations of investors, who provide funds to the firm. 146 CU IDOL SELF LEARNING MATERIAL (SLM)
9.3 SIGNIFICANCE COST OF DEBT We propose a method to estimate the cost of debt in a continuous-time framework with an infinite time horizon. The approach builds on the class of well-known earnings before interest and taxes (EBIT)-based models. It extends other approaches based on option-pricing theory with a finite one-period horizon. The model is capable of splitting the observed yield spread of a corporate bond into the risk premium, which adds to the expected return of bondholders, and the default premium, which accounts for expected losses. The model can easily be calibrated for non-public firms, since most of its input parameters are readily observable, while the output, the model-implied cost of debt, proves to be very insensitive with respect to the remaining non-observable parameters, the EBIT growth rate, and the bankruptcy costs of the firm. We demonstrate the applicability of the cost of debt to calculate an approximate weighted average cost of capital for the purpose of firm and project valuation, and its usage and limitations. Cost of capital is one of the central issues in corporate finance. For a company’s management, the cost of capital is an important benchmark for capital budgeting and performance measurement. For external investors, the cost of capital is the appropriate discount rate for future cash flows to determine the value of a company. Estimating this key figure comes down to estimating its components, cost of equity, and cost of debt. While there is a large amount of literature concentrating on the estimation of the cost of equity (for a recent overview, see, for example, Daa little attention has been focused on the cost of debt. It is common practice to simply use the yield to maturity of the company’s debt securities as an approximation. However, using the yield to maturity neglects the risk of default, and is, therefore, only a reasonable approximation when default risk is small. Instead, cost of capital, defined as opportunity costs, is the required expected return to capital suppliers, as described, for example, in the textbook of Brealey. While the cost of equity is the expected return to stockholders, the cost of debt is the expected return to bondholders. When the debt is risky, meaning, when there is a non-zero probability of default, the expected return is not identical to the yield to maturity of corporate debt securities, because the risk of possible loss in the event of a default lowers the expected return. In this paper, we take a closer look at how the cost of debt is estimated for a defaultable firm. 147 CU IDOL SELF LEARNING MATERIAL (SLM)
We consider a situation in which the decision maker—either internally for capital budgeting, etc. or externally for firm valuation—has already carried out a reasonable estimation for the cost of equity. He or she additionally needs an estimation for the cost of debt. We take the yield to maturity of corporate debt as given and show how the actual cost of debt can be calculated as a value between the risk-free interest rate and this yield to maturity. As an input, the approach requires a current value of the fair corporate interest rate, either from a publicly traded debt instrument or, for example, from recent conditions of a fair bank loan. In particular, during the past financial crisis, it became obvious that the yield to maturity is not a good choice when default risk is large. The very large yields observed for many companies reflect the increased probability of default, especially in cases where the yield exceeds the cost of equity. Basically, an expected return can be calculated based on a given yield to maturity when the probability of default and the expected recovery rate are given. In the general case, for multi-period or continuous-time settings, time-dependent (marginal) probabilities of default or hazard rates are required to calculate the actually expected return and thus the cost of capital. However, estimations of default probabilities are difficult to obtain and suffer from a large estimation error. As an alternative, the expected return on debt could be calculated analogously to the common approach of calculating the expected return on equity, using the capital asset pricing model (CAPM). According to the CAPM, the expected return on any security is determined by its systematic risk, measured by the beta coefficient. To reasonably estimate the beta of corporate debt, a reliable and stable time series of bond values is required. Unfortunately, many bonds are not exchange-traded at all, and for those that are, trading volume is often so low that observed bond quotes are not accurate. Thus, this approach is only feasible for a small number of companies with outstanding bonds that are frequently traded. Hsiademonstrates the consistency of the CAPM with option-pricing theory. On this basis, Hsia suggests calculating the cost of capital in an option-pricing framework. Cooper and Davydenkopick up this idea and propose a method of calculating the expected return on a debt security based on the Mertonmodel. They use the model to split the observed yield spread of a bond; specifically, the difference between the bond’s yield to maturity and the corresponding default-free rate, into two components: the default premium (expected default effect), which 148 CU IDOL SELF LEARNING MATERIAL (SLM)
reflects the probability of default, and the risk premium (expected excess return), which reflects the bondholders’ surplus on the expected return for bearing additional risk compared to a risk-free bond. The actual cost of debt is the risk-free rate plus the second component, the risk premium. The great advantage of this approach is that the Merton model is not needed to estimate the absolute yield spread, which is already known as an input parameter. Instead, the model is applied to calculate the relative proportion of the default premium and the risk premium. The approach proves to be very robust with respect to the debt-to-equity ratio and the equity premium, but it is less robust with respect to equity volatility. This is not a serious concern when the equity volatility can be estimated from stock-price time series. For the purpose of capital budgeting, goalsetting, performance measurement, etc. in an exchange-traded company, the approach is easily applicable. However, for the purpose of firm valuation, an equity value, as well as its volatility, is not available, as it is the very objective of the valuation process to calculate this value. As a second drawback, the approach proves to be theoretically incompatible to the analysis of long-term valuation problems—either internally, such as for capital budgeting of long-term projects, or externally, for firm valuation. The Merton model is a single-period model by nature, so any conjunction oftheMerton model and multi-period capital budgeting, or firm valuation techniques, suffers from a kind of incompatibility. In this paper, we propose a method to calculate the cost of debt capital which is theoretically compatible with long-term applications, and which can be used for firm valuation, as well as in cases where the equity value and its volatility are not known a priori. Our approach is based on a structural asset- value model, like the Merton model. However, we do not follow Merton’s restrictive assumption of modelling debt as a single zero bond with finite maturity. Instead, debt is modelled as a perpetual bond which pays a continuous coupon. This approach is compatible with the common method of discounted cash flows for firm valuation, where an infinite time horizon is considered. Furthermore, our approach has the advantage of no debt maturity being necessary as a model parameter. The approach basically builds on the model of Leland. In Goldsteinwe do not model the asset value directly, but instead consider the flow of earnings as the source of firm value. Within a structural model, the cost of debt can be deduced from the yield spread based on market risk aversion. When risk aversion is zero, the total yield spread refers to the 149 CU IDOL SELF LEARNING MATERIAL (SLM)
default premium; the risk premium is zero, and the cost of debt equal the risk-free rate. When risk aversion is greater than zero, the model can be used to split the yield spread into the default premium and the risk premium: using riskneutral valuation, the debt value is the sum of expected payments to bondholders under the risk-neutral measure, discounted by the risk-free rate. On the other hand, given the expectation of payments under the physical measure, the expected return to bondholders is defined by that discount rate which gives the current debt value when applied to expected payments. This expected return must be larger than the risk-free rate, but smaller than the yield to maturity. The relative proportion of default premium (yield to maturity minus expected return) and risk premium (expected return minus risk-free rate) depends on the difference between the physical and the risk-neutral measure, hence the market risk aversion. Basically, the approach outlined in the present paper tries to give decision makers a tool for estimating the cost of debt (as the missing component when the cost of equity is given) based on parameters which are either observable or which do not have a large impact on the estimate. Instead of directly calculating the cost of capital for the total firm, it is very common in practice to estimate the cost of equity and the cost of debt separately. Such an approach allows us to place the actual cost of debt between the two polar values: the risk-free rate and the yield to maturity of corporate debt. We describe the approach in more detail. Based on the structural asset-value model, we show how to calculate the cost of capital (debt and equity) within this framework. Sectiondemonstrates how the model is calibrated to input data and provides a quantitative analysis of the model results for a typical investment grade and for a typical highly leveraged company. Furthermore, the aspects of the calibration and potential bond covenants are discussed. It gives attention to the application of the model for the valuation of a firm or projects within the firm. We show the applicability of the textbook formula of the weighted average cost of capital (WACC) for instantaneous returns, but demonstrate its inconsistencies for long-term returns. As a use case, we apply the model for a situation in which the WACC is valid (because of exogenous financing with constant leverage) and analyse the approximation error of the cost of debt calculated within the model for a situation which deviates in the financing assumption. 150 CU IDOL SELF LEARNING MATERIAL (SLM)
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