Edit the topic about capital structure
Abstract
In financing, any firm which has to invest has no choice but to consider ways of employing equity or debt sources which are used. With the mindset to achieve optimal performance, numerous theories have been developed to support equity-debt structure. Theories like the ones the M&M (1958) which was suggested by Modigliani and Miller gives a clear impression that managers of companies make their own choice of obtaining. It can be confidently said that this research has been on the move to back up other researchers and scholars on the correlation which exists between capital structure and value of a firm. This move has not been of own value but to motivate these other researchers and scholars to carry out more research on this correlation.
Owing to these, it is of importance to note that this research has played a vital role in the study of the correlation between capital structure and the value of a firm. The findings in this research indicate that when the debt ratio goes up then the return on quality antagonistically goes down. When this is considered, it therefore means that the companies have no choice but to utilize capital in boosting these firms rather than borrowing. This is because, the benefits of firms are smaller than the cost used in production, and this means that it is practically difiicult to manage servicing a loan.
Key words: Capital structure, firm value, financial leverage, corporate value
Contents
2.2 A review on the theories of capital structure. 9
2.2.2 Net operating income approach. 10
2.2.3 Madigliani and Miller approach (MM Approach). 10
2.2.7 The market timing approach. 10
2.3 Determinants of financial performance. 10
4.2 Design of the research. 13
4.4 Data collection methods. 13
CONCLUSIONS AND RECOMMENDATIONS. 16
CHAPTER ONE
INTRODUCTION:
In the financial background, capital structure standouts as a topic and should be given a consideration and priority in firms’ decision making processes. Since capital structure and enterprise value are correlated, they cannot be just understated. Apparently, the performance of a company or firm will definitely affect its equity.
1.1 Capital structure
Capital structure refers to a given combination of debt and equity or some funds used to manage a company’s overall operations and its growth (Tuivila, 2020). It is the way a firm or company chooses to finance its assets and resources. It is prudent for firms to find the optimal debt to equity ratio in order to avoid incidences of insolvency and increase profitability. This debt is perceived as the loans and bond issues offered by the company. Some of the capital structure types include equity capital, debt capital, optimal capital structure (Hayes, 2020), financial leverage and importance of capital structure. Significantly, capital structure focuses on the question, “what should be the ratio between equity and debt?”
1.2 Determinants of capital structure
There are a number of factors which in one way or the other influence capital structure (Nasimi, 2016). These factors are discussed as follows:
- Financial leverage: It is also referred to as trading on equity. This is the usage of a debt which bears long time fixed interests. If the resources financed by a debt yield more than the cost of that debt then the earnings are undoubtedly going to increase without the investment of the owner increasing.
- Growth and stability of sales: Growth and stability of sales has great influence on the capital structure of a firm. This can be attributed to the fact that whenever the sales of a firm remain stable, then it means the level of debt is going to increase.
- Cost of capital: any amount of money invested in a company has its cost. Cost of capital is the least return expected by suppliers of a firm.
- Risk: when capital structure is being planned, there are two types of risks which have to be considered and they are business and financial risk. Business risk refers to the possibility of a variation in earnings before taxes are involved.
- Cash flow: whenever a firm employs a huge amount of debt or preference capital then it means that the amount of fixed charges is going to be high.
- Nature and size of a firm: capital structure is greatly influenced by the nature and size of a firm. The size of a firm has influence on the resources which emanate from different sources.
- Control: in a situation where a firm needs additional funds, the firm management increases the funds without losing control over the company.
- Flexibility: this is the ability of a firm capital structure to adapt to the changing conditions.
- Investors’ requirements: the firm should be able to meet both the institutional and private investors’ financial needs.
- Conditions of the capital market: capital market is not always consistent, it keeps fluctuating, owing to this, the firm is not supposed to give out equity shares.
- Marketability: this refers to the ability of a firm to sell its security and the investors being able to give in to purchasing that security.
- Inflation: whenever inflation shoots, debts will be repaid by less worth dollars. In this situation the rate of borrowing is expected to go up because of the compensation paid to investors as a result of the value loss.
- Floatation costs: these costs are experienced when there is a rise in funds. The overall cost of floating a debt is much lower than that of floating anequity issue.
- Legal considerations: the manger has to take note of the legal situations when evaluating capital structure.
Firm value refers to the total value of a firm or a business excluding the cash owned by the business. It is also called the enterprise value or asset value (Lonkani, 2018). Financial leverage refers to the extent at which a firm initiates usage of borrowed money or its debts (Hayes, Leverage: what is leverage?, 2020).
1.3Research question
- How do the determinants of capital structure affect the performance of a firm?
Capital structure is an essential factor in valuing a business or a firm. The particular levels of equity and debt affect the cash flow. This therefore creates impact on the amount of money that an investor is willing to pay for that company or its interest (Valavoska, 2019).A good example is a firm or business that has $ 40 billion in equity and $ 60billion in debt is said to be 40% equity financed and 60% debt financed.
1.4Objectives
Basically, any objective of a financial decision in financial management context is to ensuring for the maximization of the shareholder’s wealth or to literally increase the value of a firm. The following are the main objectives of this study:
- To understand how the determinants of capital structure affect the performance of a firm.
- To come up with suggestions to improve the performance of a firm.
CHAPTER TWO
LITERATURE REVIEW:
2.1 Foreword
This episode brings about an assessment on the role of capital structure performed so as to shape the presentations by researchers and authors. It gives a vivid description of the perceptions and findings by several scholars.
2.2 A review on the theories of capital structure
Significant theories or approaches exist in the financial management system of the capital structure of a firm (Basha, 2014). There exist a number of capital theories which are outlined as follows: Net income, net operating income, traditional, M&M approach, the Pecking order theory, the trade-off theory, the asymmetric information approach and the Market timing approach.
2.2.1 Net income
This approach was given a s a suggestion by Durand who was in total favor of the financial leverage decision (Kenton, 2020). According to Durand, a change in the financial leverage would ultimately affect the cost of capital. In other words, if the ratio of debt in capital structure rises, then the average cost of capital reduces which in turn would lead to the value of the firm decreasing.
2.2.2 Net operating income approach
This theory is also suggested by Durand. If observed closely it is exactly the opposite of net income if at all there are no taxes included. According to this approach, the weighted average cost of capital remains constant (Smirnov, 2020).
2.2.3Madigliani and Miller approach (MM Approach)
This capital structure approach or theory was named after Franco Madigliani and Merton Miller. This theory gives two propositions:
- Proposition 1- the capital structure is irrelevant to the firm value. According to this theory, when there are no taxes, the value of a firm is dependent on future earnings of the firm.
- Proposition 2- according to this second proposition, the financial leverage boosts the firm value and in turn leads to reduction of WACC.
2.2.4The market timing approach
This theory brings about the positive outcome on a firm’s financial decision making process. According to this theory, the manager’s ability to time the equity market determines the choice to be made between equity and debt.
2.3 Determinants of financial performance
Return on total assets: this can be best described as the ratio combination between the net income and the total assets averagely in a given company.
Growth rate: this refers to the proportion of a definite variable within a given period of time over appropriate which include more and not los than the compounded annual growth rate, earnings of a company, growth of the company’s resources and the dividends of a company.
Liquidity: this refers to the extent at which security or an advantage can be bought or sold in the market without interfering with the firm’s asset prices. On the other hand, accounting liquidity refers to the easiness with which an individual or corporation can be able to meet their sole economic obligations with the liquid assets which is available for them.
2.4 Capital structure research in the USA
Since the end of World War II, about three quarters of plants in the USA have been accounted for by business corporations. Owing to this, corporate behavior is a foundational determinant of a firm’s overall performance.
According to A. Michael Spence, if at all choosing optimal capital structure helps in reducing the overall costs in these corporations, then it means that those corporations facing competition in their product market will have huge incentives which will eventually result to a greater tendency.
CHAPTER THREE
EMPIRICAL LITERATURE
The relationship between capital structure and firm value date back to1958 when M&M theory was invented (Chen, 2020). Since then a number of theories have been invented explaining the concept of capital structure and firm value and the relationship between each other. These other theories have contributed greatly to the subject matter. Each author has intensely addressed the concept of capital structure composition. For example, data from Bangladesh economy from 1997 to 2003 has been used by Chowdhury (2010) to understand the effect of capital structure on a firm’s value. It was observed that, in order to maximize the wealth of shareholders, there has to be a concrete combination of debt and equity. The cost of capital has to be kept as minimum as possible to because they have a negative correlation to the result.
According to SupaTongkong (2012), in order to maximize a firm’s value, they employed usage of multiple linear regression models which helped them to examine the factors influencing the capital structure decisions. A dynamic panel regression model was employed using one-step and two-step Arellano and Bond GMM estimation approach to determine the speed of adjustment towards target capital structure. Here, it was observed that there is an existence of a positive structure between the size of a firm and growth opportunity; and firm leverage. However, there is a negative relationship between profitability and leverage according to pecking order theory.
According to Cush and Hughes (1994), the relative cost of the different financial alternatives is mirrored by the order of inclination.
CHAPTER FOUR
RESEARCH TECHNIQUES
4.1 Introduction
This section gives a gateway to the modes and proposes of this study. It has the foundational data collection methods and also summarizes the data analysis. It gives a clear impression of what is entailed in the research and the methods used for the collection of data and how the data is analyzed.
4.2 Design of the research
This research is going to be conducted using the plan of the explanatory design. There are no other precedingreference sources to be examined. For this reason, familiarity and insights maybe required for future examinations.
4.3 Target population
The target population for this research will comprise of restaurants within the US and other companies for comparison and a variety of insights for the effectiveness of this research. This is because the concept of the correlation between capital structure and the value of a firm can be best described and applied in the restaurant industry.
4.4 Data collection methods
In this research, Descriptive Statistic Analysis will be used to explore capital structure in the USA real estate firms. This quantitative method collects data from the USA listed companies. Therefore, this research is going to compare the previous research with the current to see whether the theoretical results are still compatible or not. Some of the companies from which this research is based include: Jackson Hole WY Real Estate, Avon commercial real estate, ERA Real Estate and the Camden Property Trust.
4.5 Analysis of data
The type of data analysis in this research will be quantitative and descriptive. Moreover, other experimental quantitate techniques will be employed. This will enable for determination of mistakes and exclusions. The computations on the beta coefficients are going to be computed to determine the level of the debt ratio. We are going to use ANOVA to determine the effect of debt ratio on the return of equity.
4.6 Variable measurements
In this research, static panel data model will be used. The results of this research will eventually be run in a STATA program using the following empirical analysis:
Static Panel Data Model
The fundamental regression model is the OLS regression. Its formulation can be outlined as follows:
yit = α + x’itβ + ԑit, i= 1,2,…44; t =1,…12
in this particular model; yit represents the capital structure of firm i in the year t; α represents a constant; x’it refers to a 1 X 7 vector of seven variables which are independent which is basically the explanatory indicators; β represents a coefficient vector of parameters that is independent variables which is constant over quarters; ԑit is the disturbance term. The regression model is going to be constructed as per the following expression:
LEV = f (FS, Pro, GO, Tan, NTS, Liq, NTS, NCS)
LEV represents the debt ratio and therefore it is the dependent variable. The values in the bracket are the independent variables and they are outlined as follows;
- FS; Firm Size– which is obtained through first calculating the average firm size for each size bin by dividing the number of employees by the number of firms
- Pro; Profitability – which is obtained through; Net sales- cost of the goods sold
- GO; Growth Opportunity- present value of GO is obtained through; value of stock – ( earnings/cost of equity)
- Tan; Tangibility- The net tangible assets is obtained through; Total tangible assets – total intangible assets.
- Liq; Liquidity- which calculated through; current assets – current liabilities
- NTS; Non-taxable shields-value of tax – deductible expenses × tax rate
The reason for adoption of OLS in this research is due to the fact that it has become of the commonest languages in finance, economics and social sciences generally. It has been built in virtually all spreadsheets making it easier to use.
CHAPTER FIVE
CONCLUSIONS AND RECOMMENDATIONS
5.1 Recommendations
It would be prudent if equity would be employed rather than borrowing. This is due to the fact that borrowing does not always improve the performance of a firm. Instead of this, it leads to the fact that firms have no choice but to use shareholders’ funds before considering borrowing.
Firms should consider the leverage chance of the asset to be financed. When the funds of the company’s shareholders are exhausted, there is an obvious decision of embarking on borrowing loans. But before this decision is met, firms have to be so keen to ensure that the assets financed bring a greater return than the interest which is going to be paid by the firm.
5.2 Conclusion
From the research conducted, it is of importance to note that the debt ratio and the return of assets is inversely correlated. According to Miller and Modigliani (1958), it does not always matter the ways in which a company finances its functions. Since the firms self-regulated their capital structures, this makes capital configuration extraneous.It is of importance to note that this research has played a vital role in the study of the correlation between capital structure and the value of a firm. The findings in this research indicate that when the debt ratio goes up then the return on quality antagonistically goes down. When this is considered, it therefore means that the companies have no choice but to utilize capital in boosting these firms rather than borrowing.
The decision of capital structure is so vital to the company; the optimum capital structure helps in minimizing the firm’s overall cost of capital and maximizes the firm value. Usage of debt funds in the capital structure raise the EPS as since the interest on the debt is deductible which leads to increment the share price.
