FINANCE

Corporate Finance

Corporate Finance

Introduction

Today's business environment is highly competitive and rapidly advancing, which requires the businesses to become more and more competitive and efficient. Among other measures, cost controlling while having higher returns is one of the main aspects through which companies seek lead and success in the market. Therefore, the way through which companies finance their assets i.e. Capital Structure and the type of finance hold immense importance and play a vital part for business. This report focuses on capital structure and various relevant theories that illustrate a clear understanding of the concepts. Furthermore, this report also focuses on type of debt companies' use, particularly long-term financing sources including corporate bonds; equity financing; and capital notes. Moreover, the report also takes into account two cases i.e. GM and Al-Harthy Companies' WACC calculations, while discussing advantages & disadvantages of debt finance as a source of long-term finance, circumstances in which WACC can be used in investment capital, and advantages & disadvantages of CAPM.

Question 1

Main Theories of Capital Structure

Capital structure is basically the way through which the firms finance their assets via certain mixture of debt, equity, or hybrid securities. So, a capital structure of a business refers to a structure of composition of its obligations. In general, the capital structure of businesses can be highly complicated and involve several different sources of finance. This can be justified by the fact that financial management is one of the most significant as well as vital component of every business and therefore capital structuring also holds an immense importance in businesses as being a vital part of financial management. Furthermore, several financial economists also extensively agree on the view that capital structure is highly relevant, however, it is also apparent that no complete model of capital structure that includes all empirical observations exist (Baker & Martin, 2011, p.275). Based on this, it is clearly apparent that capital structure is immensely significant for businesses and therefore requires high concentration. There are different theories regarding capital structure that have been presented by various authors, which are discussed below.

Modigliani-Miller Theorem

Modigliani and Miller developed a theory regarding Capital Structure in a perfect market, which employs certain qualifications including: perfect information, no bankruptcy or transaction cost, same interest rate for individuals and firms, no taxes, and financing decisions not affected by investing decisions. So, according to them, two assumptions are made under these conditions: company's value is independent of its capital structure and the equity cost of leveraged business is equal to the equity cost of unleveraged business, in addition to an added premium for financial risk. Thus, Modigliani and Miller's theorem suggests that in a perfect market the capital structure is irrelevant, so the imperfections that exist in actual world should be the reason of its relevance (Luigi & Sorin, 2009, p.315).

Trade-Off Theory

This theory allows the cost of bankruptcy to exist, i.e. Trade-Off theory states that financing with debt holds an advantage (the tax benefit of debt) and that financing with debt also holds certain ...