APC308 Financial Management

In order to achieve the ultimate goal of financial management - shareholders’ wealth maximization, financial managers need to strive to determine the optimal mix of debt and equity in th

ASSIGNMENT COVER SHEET

UNIVERSITY OF SUNDERLAND

BA (HONS) BANKING AND FINANCE

Student Name: Nguyen Thi Kieu Anh

Module Code: APC 308

Module Name / Title: Financial Management

Centre / College: Banking Academy of Viet Nam

Hand in Date: 15th May 2015 Due Date: 15th May 2015

Assignment Title: Individual assignment

Student ID: 149078874/1

Students Signature: (you must sign this declaring that it is all your own work and all sources of information have been referenced)

Nguyen Thi Kieu Anh

Financial Management

APC 308

Nguyen Thi Kieu Anh - ID: 149078874/1

Submission date: 15th May 2015

Number of words: 3,500

TABLE OF CONTENTS

Part A: Critically analyse and evaluate whether an optimal capital structure does exist 4

I Introduction 4

II Optimal capital structure: Exist or not? 4

1 David Duran views 4

2 The traditional view 5

3 Modigliani-Miller (MM) views 6

3.1 MM without taxes 6

3.2 MM with taxes 7

4 Trade-off theory 9

4.1 Static trade-off theory 9

4.2 Dynamic trade-off theory 10

5 Pecking order theory 11

III Conclusion 11

IV References 17

Part B: Critically evaluate and analyse the three differing strengths of market efficiency 14

I Introduction 14

II Main Body 14

1 Weak form efficiency 14

2 Semi-strong form efficiency 15

3 Strong-form efficiency 16

III Conclusion 17

IV References 17

Part A: Critically analyse and evaluate whether an optimal capital structure does exist

I Introduction

The capital structure of a firm is the ‘mix of debt and equity financing’ that used to finance its operations (Brealey et al., 2011, p.418) It is generally believed that the capital structure is an important area of the financial management as it influences the shareholders’ wealth In order

to achieve the ultimate goal of financial management - shareholders’ wealth maximization, financial managers need to strive to determine the optimal mix of debt and equity in the firm’s capital so that the firm’s value is maximum or the overall cost of capital is minimum Nonetheless, whether or not such optimal capital structure exists for individual companies and businesses still remains a controversial issue in finance There are two schools of thought on this One school supports the existence of the optimal capital structure and other does against

it Therefore, this study attempts to shed light of this issue with the support of some empirical findings

II Optimal capital structure: Exist or not?

1 David Duran views

In 1952, David Duran propounded two opposing views on the existence of optimal capital structure, which is Net Income (NI) approach and Net Operating Income (NOI) approach One

important assumption for these approaches is that there is no tax According to NI approach,

the cost of equity (KE) and the cost of debt (KD) are independent of each other Since the cost

of debt (KD) is usually less than the cost of equity (KE), because debt has prior claim on the firm’s assets and earnings (less risky than equity) (Myers, 2001, p.84), an increase in gearing1

results in reduction of the overall cost of capital (WACC) (Sheeba, 2011, pp.293-294)

Figure 1: Net Income Approach (Sheeba, 2011, p.294)

Under this approach, a firm can reduce the WACC and increase its value by increasing the proportion of debt in its capital structure to the maximum possible extent That means the optimal capital structure would be 100% debt-financed This approach, therefore, is

1

The proportion of a company’s debt to its equity

considered to be no basis in reality (Saravanan, 2010)

Converse to NI Approach, NOI approach contends that there is no optimal capital structure

for any firm as the proportion of debt and equity in the firm’s capital structure does not have any impact on the firm’s value or its cost of capital (Sheeba, 2011, p.295)

Figure 2: Net Income Approach (Bhabotosh, 2008, p.200)

The figure illustrates that an increase in the use of cheaper source of debt capital is exactly offset by an increase in the cost of equity (KE) due to increasing financial risk (shareholders face higher risk thereby requiring higher return) The overall cost of capital (WACC), therefore, remains unchanged for all level of gearing The firm’s value also cannot increase

by debt-equity mix as a result (Bhabotosh, 2008, p.198)

2 The traditional view

Ezra Solomon developed the traditional view2 which lies mid-way between the NI and the NOI approaches It holds that there is an optimal capital structure by increasing the debt proportion in the capital structure to a certain limit (Pandey, 2005, p.316)

Figure 3: The traditional view (ACCA, 2009, p.275)

Look at the graph above, before point X (low gearing), since the proportion of debt in the capital structure increases within safe limits (either constant or rises slightly), the cost of equity (KE) rise as the reflection of the increased financial risk, but it does not rise fast enough to offset the advantage of low-cost debt Therefore the overall cost of capital

2

Assumptions: No taxes, no transaction costs, net profit are all paid as dividend rather retained

(WACC) initially fall and the firm’s value increase (Khan and Jain, 2006, p 9.22) After point X (high gearing), the gearing goes beyond the acceptable limit Bankruptcy risk causes the cost of equity curve rise at a steeper rate and also causes the cost of debt to start to rise Such thing causes increasing WACC and then decreasing the firm’s value (ACCA, 2009, p.82) At the point X (critical gearing), when the rising of the marginal cost of borrowing (KD) is equal to the overall cost of capital (WACC), the firm has reached the optimal capital structure where the overall cost of capital (WACC) is minimised and the firm’s value is maximized (Bhabotosh, 2008, p.201)

Horn and Wolinsky (1988) supported traditional view when admitting that a firm could enhance its market price of shares through the use of reasonable leverage (David et al., 2015, p.33) However, Pike and Neale (2006, p.479) stated that the critical gearing ratio is thought

to depend on factors such as the steadiness of the company’s cash flow and the saleability of its assets so the concept of optimal capital structure with the critical gearing ratio is “highly desirable but illusory and difficult to grasp” Thus, a firmer theoretical underpinning regarding the optimal capital structure is really needed to facilitate the capital structure decision

3 Modigliani-Miller (MM) views

3.1 MM without taxes

In 1958, Modigliani and Miller advanced a theory which supported the net operating income approach and rejected the traditional theory of capital structure (Baral, 2004, p.2)

 Proposition I

Under supposed conditions of a perfect capital market3, the value of the geared firm (Vg) is the same as that of the ungeared firm (Vug) due to the existence of arbitrage or switching process If the geared firm are priced too much, rational investors will simply borrow on their personal accounts to buy shares in ungeared firms (known as personal or homemade gearing) (Ross et al., 2008, p.430) As long as individual investors can borrow at the same rate of interest as corporations, arbitrage will take place to enable investors to engage in the personal gearing as against the corporate gearing to restore equilibrium in the market (Pandey, 2005, p.319) Thus, firm value is not affected by gearing

3

No taxes, no transaction costs, free information, individual investors can borrow at the same rate of interest as corporations, no other imperfections

 Proposition II

Figure 4: MM model with no taxes (Pandey, 2005, p.322)

Financial gearing causes two opposing effects: it increases the shareholders’ return but it also increases their financial risk In case of the ungeared firm, it is not exposed to financial risk so its cost of equity (Keu) is equal to the WACC In contrast, the levered firm will have higher required return on equity as compensation for the financial risk when the firm gears up The cost of equity (Keg) will increase enough to offset the advantage of cheaper source of debt capital (benefits of cheaper debt is equal to increase in Keg) so the overall cost of capital (WACC) remains constant Go beyond the NOI approach, MM argued that in the extreme gearing, the operating risk of shareholders is transferred to debt-holders thereby Ke declines and Kd increases as demonstrated in the graph above (Pandey,

2005, pp.321-322) Proposition I and II draw a conclusion that no optimal capital structure exist

However, it should be noted that this theory is only valid only if its strict assumptions regarding a perfect capital market are satisfied But in fact MM’s assumptions would never exist in the real world so MM arrived at invalid conclusion Durand (1959) was the first financial economist criticized MM model on the ground of this issue According to Ross et

al (2008, p.439), Modigliani - Miller themselves also have admitted that real-world factors may have been left out of the theory Because of this, Modigliani and Miller (1963) modified their original zero-tax model to include the tax effect

3.2 MM with taxes

 Proposition I

The previous zero-tax models mentioned that the firm can take advantage of low-cost debt because the debt is less risky than equity Now in the world of taxes, the debt further economizes as it incurs tax advantage (Sheeba, 2011, p.302) The value of the geared firm

is equal to the value of the ungeared firm plus the present value of the tax shield in the case of perpetual cash flows

Vg = Vug + t × D (1)4 Since the tax shield increase with the amount of debt, the firm can raise its value and lower the WACC by substituting debt for equity (Ross et al., 2008, pp.442-443)

 Proposition II

Interest paid on debt is tax deductible so it turns KD into KD (1 - t) The cost of debt is even cheaper

Figure 5: MM model with taxes (ACCA, 2009, p.279)

The increasing gearing increase the cost of equity However, it does not increase as fast as

it increases in the no taxes condition The increase in the cost of equity is less than the benefit of interest tax shield on debt (Sheeba, 2011, p.303) Such thing results in declining

in the overall cost of capital (WACC) and increasing the firm’s value The optimal capital structure is reached when the firm employs almost 100% debt (Pandey, 2005, p.325)

Unfortunately in practice the firm does not employ extreme level of debt because of tax advantage The reason is showed by Miller (1977) that MM model ignored the impact of personal tax for corporate borrowing The personal income tax paid by the debt holders on interest income may completely offset the advantage of interest shield Besides, some financial economists also criticised that MM model ignored the financial distress costs (including bankruptcy cots of debt and agency costs) In the extreme gearing, these costs may also eliminate benefits of tax shield Hence, it can be said that MM model actually overstates the value of gearing (Pandey, 2005, p.325) Even so, despite the criticism of MM’s framework, MM still stands as a corner of corporate finance because it acts as

4

V g = the value of a geared firm, V ug : the value of an ungeared firm (no debt), t: the corporate tax rate, D: the level of debt in the capital structure

paving the way for the development of several theories of capital structure, namely trade-off theory (Jensen, 2013, p.7)

4 Trade-off theory

Unlike MM theory, the firms should take on as much as debt as possible, trade-off theory avoids extreme predictions and rationalize moderate debt ratios (Jahan, 2014, p.12)

4.1 Static trade-off theory

Models of static trade-off are connected to the bankruptcy costs and agency costs

 Trade-off models related to bankruptcy costs

This model is presented by Baxter (1967) and Krause and Litzenberger (1973) It suggests the optimal capital structure exists and is determined by the achievement of balance between tax benefits and costs of debt (Ghazouani, 2013, p.626)

Figure 6: Static trade off theory of capital structure (Myers, 1984, p.577)

The tax shield increases the value of the geared (levered) firm Bankruptcy costs lower the value of the geared (levered) firm The two offsetting factors produce an optimal amount

of debt as point X in the figure above (Ross et al., 2008, p.465)

 Trade-off models related to agency costs

According to Jensen and Meckling (1976), agency costs arise due to conflicts of interest among management, shareholders and debt-holders Conflict occurs between management and shareholders which leads to agency cost of equity Such conflicts occur when management’s objectives are not fully aligned with those of shareholders Since the company issues debt, conflict arises between debt-holders and shareholders that lead to agency cost of debt Such conflict occurs when debt-holders imposes restrictive covenants

on the firm through debt agreement that prevent the manager from investing in high risk project because the debt-holders do not receive a return which compensates for engaging

in that risky project Consequently, it prevents the firm’s growth and earnings to shareholders (Sheeba, 2011, p.306)

Figure 7: Agency costs of debt (Jensen and Meckling,1976, p.55)

A trade-off between the agency costs of equity and the agency costs of debt produce an optimal capital structure In other word, the optimal capital structure can be achieved by finding the point where the total cost of agency costs is minimum (the agency costs of debt

is equal to the agency costs of equity) (Ghazouani, 2013, p.627)

Empirical findings on static trade-off theory conclude mixed results On one side, many studies showed that target leverage is not important For instance, Titman and Wessels (1988), Raijan & Zingales (1955) and Fama & French (2002) affirmed that higher profitability firms tend to borrow less that is inconsistent with the actual trade-off prediction that higher profitability firms should borrow more to reduce tax liabilities Graham (2000) estimated the cost and benefit of debt finds that the large and more profitable firms with low financial distress expectation use the debt conservatively and Microsoft is an typical example (Jahanzeb et al., 2014, p.13) On the other side, several studies support trade-off theory and confirm the role of target leverage, namely Marsh (1982) provided evidence companies appear to make their choice of financing instruments

as if they have target levels of debt in mind Furthermore, Walsh and Ryan (1997) found both agency and tax considerations were important in determining debt and equity issues But Lasfer (1999) investigated that the relationship between debt and agency costs only applies to large companies whereas small company debt appears to be driven by

profitability (Beattie et al., 2006, p.6)

4.2 Dynamic trade-off theory

The increasing dissatisfaction of static trade-off theory leads to the birth of dynamic trade-off theory It is firstly introduced by the Fischer, Heinkel and Zechner (1989) and further developed by Strebulaev (2007) It is assumed that the costs of constant capital adjustment