FINANCIAL MANAGEMENT

Financial management

Financial management

The relative merits and limitations of the different sources of capital, both debt and equity, available for large, long term projects. This should include a discussion of the potential importance of gearing when raising new finance.

The capital structure of a company outlines the mix of debt and equity used by the company. The proportion of debt and equity has implications for the overall cost of capital (WACC) and thereby, an effect on shareholder-required return from cost of equity. Modigliani and Miller developed the very first capital structure theory by asking a simple question: 'does capital structure affect a company's efficiency in turning project cash flows into cash in the hands of providers of long-term capital. The M&M theory assumes that the capital market is perfect and everyone in the market has perfect information, and no one individual (or company) can influence the price. There is a single rate of interest for borrowing and lending. There are no homogeneous products and investors are rational risk adverse utility maximises. And finally, no personal or corporate taxations exist.

The traditional view of capital structure is that there are both advantages and disadvantages in maximising shareholders value trough corporate gearing. At relatively low levels of gearing the advantages outweigh the disadvantages and the market value of the business rises at first, but the relationship reverses and the disadvantages start to outweigh the advantages. The main advantage of gearing is that debt interest is allowable against taxation. The disadvantages are in terms of increase financial risks. The M&M proposition of the capital structure in a taxed world implies that the tax relief on debt interest would encourage businesses to gear up to a high level as possible (hence, 99.9% debt and 0.1% equity). The greater the level of gearing, the greater would be the tax subsidy on debt financing.

Several regularities have been observed in terms of capital structure in various countries. Firstly, capital structures varies significantly cross nations, for example German and Canadian firms have a lower book value debt than Japanese and Italian companies (Rajan, R., Zingales, L., 1996). The second observation is that capital structure is dependent on the industry the firm operates. Utilities, transportation and capital intense manufacturing firms have gearing then service companies. Thirdly, profitability is inversely linked to leverage. This contradicts the tax based capital structure theory. Other observations made regarding capital structure are that taxation does not affect it, despite various tax rule changes in US; the capital structure decisions of firs have remained the same.

There are three main capital structure theories, the first of which is the trade-off model. This is based on modification to the M&M proposition. The theory states that the capital structure choice of the firm is dependent upon its trade off between tax benefits and increase financial risk associated with high leverage. The empirical evidence for trade-off model is inconclusive. Bradley, M., Jarrel, G., Kim, E. (1984) develop a model where optimal leverage is inversely linked to the cost of financial ...