International Finance

Financial Management



Financial Management

Introduction

Most current managerial finance textbooks devote considerable time and content to the mechanics of financial management, perhaps neglecting sufficient coverage of the wealth maximization, risk and return, and agency constructs that underlie the nuts-and-bolts content. The current series is designed to counter that deficiency by looking at some of the most relevant topics as they relate to the financial manager's role. In addition to an introductory article, topics to date have included financial analysis, leverage, and die valuation of stocks and bonds now we turn to die question of capital structure and die related cost of capital to address questions such as:

* What choices does a financial manager have in constructing the right-hand side of the balance sheet (i.e., the firm's capital structure)?

* Why is capital structure important? How does it influence stockholder wealth maximization (SWM)?

* What theories about capital structure prevail in the academic setting? Is there an optimal capital structure?

* What are die major determinants of capital structure?

* Does capital structure differ among industries? Over a time?

* What agency conflicts apply to the topic of capital structure?

* Do disclosure, transparency, and financial reporting matter?

We begin our investigation by establishing the theoretical framework commonly presented in textbooks, then look at how the literature inspects debt and equity financing, and finally offer some advice to the financial manager for tackling the important assignment of designing the firm's capital structure (Berger, 1997,, 1).

Theories of Capital Structure

On the most basic level, capital structure refers to the mix of debt and equity used to finance the assets of a business. Short-term debt often is excluded, however, and is treated under the topic of working capital management. Thus, the financial manager is left with term loans (long-term notes payable), leases, bonds, preferred stock, and common stock as the primary tools for financing a firm's profitable projects. The costs of the individual components of the capital structure (a valuation parameter, the returns demanded by debt and equity holders) are weighted according to their proportionality in the capital structure to calculate the WACC. In theory, by minimizing the WACC, the financial manager would help maximize shareholder wealth.

One of the theories related to capital structure states that, in the absence of taxes and bankruptcy costs, the composition of the right-hand side of the balance sheet (debt and equity financing elements, including the relative amount of leverage) would not matter - no optimal capital structure would exist. But debt-related interest is deductible in arriving at taxable income, thus reducing the cash outflows associated with this form of financing and lowering its cost. The resulting temptation to finance with cheap debt is tempered by the fact that bankruptcy costs can drive up the cost of all forms of financing, moving the firm away from some optimal, minimally costly, cost of capital.

The major determinants of capital structure

Those economic and psychological elements most likely to have a bearing on the manager's decisions about the debt equity mix. In addition to taxes and the costs of potential bankruptcy, ...