Capital Structure and its Key Elements

Corporate Finance Questions
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December 9, 2019
1 Define capital structure and list the key elements of capital structure. (1/2 page)
Capital structure refers to how the company’s management strategically balances different sources of funding such as internal financing, debt, and equity in order to reach the necessary funding that it needs to fuel its operations. Although there are plenty of frameworks to understand capital structure, Graham and Harvey (2002), discussed two main theories which are (1) trade-off theory and (2) the pecking-order theory. On the one hand, the trade-off theory suggests that in deciding the right balance of capital structure between debt and equity, the management always places primary consideration on the benefits and risks included in each decision. On the other hand, the pecking order theory provides that choosing the right balance of capital structure always provides a hierarchy, from internal financing to debt, and lastly to equity.
The six (6) elements of capital structure are (1) capital mix, (2) maturity and priority, (3) terms and conditions firms, (4) currency firms, (5) financial innovations, and (6) financial market segments CITATION Gul78 \l 1033 (Gulati, 1978).
2 Describe the main results of Modigliani and Miller Propositions (I and II) for: ( 1 page)
1 1958 model – no taxes, no bankruptcy costs
In Modigliani’s and Miller’s First Proposition under the 1958 Model (no taxes), they concluded that the value of the unlevered firm is equal to the value of a levered firm. Thus, in order to get optimal investments, investors can borrow money to purchase securities of unleveraged firms, when they are undervalued as compared to the other. However, it must also be noted that this proposition can only exist with three important assumption requisites which are (1) absence of taxes, (2) zero-cost transactions, and (3) there are same rates for both individuals and corporations CITATION Mil88 \l 1033 (Miller, 1988).
In contrast, the authors’ second proposition shows that if a firm wants to lower capital costs for borrowing, then it is better to have the right balance between debt and equity since too much preference on debt (which is assumed to have lesser costs) would also increase the price of the equity mix. In turn, this would balance with one another.
2 1963 model – with taxes, no bankruptcy costs
Subsequently, the First Proposition of the 1963 Model would show that the increase in risks associated with depending on the debt would also raise the investors’ ROE. Such is similar to the idea of using WACC in deriving value of equity. However, this can be assumed when the borrowing rates and the same and without any associated costs.
In contrast, the authors’ second proposition under the 1963 Model, also states that raising the risks to be shouldered by the investors also increases their ROE. However, the addition of taxes shows that a capital structure wherein equity values are replaced with low-quality debt would not be efficient in meeting its obligations.
3 Tradeoff model – with taxes and bankruptcy costs
Lastly, the authors’ trade-off theory provides that finding the best capital structure requires a tailored approach since it depends on the type of firm. Nonetheless, finding the optimal capital structure is crucial since balancing debt has both pros and cons. On the one hand, debt could have a better advantage over equity when it comes to taxes. On the other hand, debt could increase the chances of bankruptcy.
3 Describe the pecking order theory of capital structure. (1/2 page)
The Pecking Order Theory of capital structure is one of the two theories of capital structure choice. According to this framework, internal financing must first resort to retained earnings as compared to other types of sources. Subsequently, if such a source is unavailable, then the management could then resort to external loans and debts. Lastly, equity issuance and subscription should always be the last resort when the aforementioned sources are unavailable. Accordingly, the importance of such an order is that the kind of financing utilized serves as a signal for other entities (i.e., shareholders) about the management performance in certain situations. Particularly, the use of internal financing, debt, and equity signals that the company’s performance is strong, able to meet obligations, and negative respectively CITATION Gra22 \l 1033 (Graham & Harvey, 2002).
4 Discuss the importance of game theory in corporate finance; Provide 5 real-world examples. (1/2 page)
Similar to other aspects of life, the use of Game Theory in Corporate Finance is important in order to get the biggest returns or assure the security of a decision. It is well-known that the world of finance is composed of a lot of entities that are struggling and competing with one another in order to get the most optimal returns for every decision. Thus, the Game theory would allow anyone to be able to weigh the pros and cons of a decision before they make it.
* Asset pricing – In pricing assets, the manager must be able to understand the concept of a zero-sum game. Specifically, he must know how to balance his target gains to the possible losses of the buyer.
* Mergers and Acquisitions – The management must be able to consider the extent and limits of his knowledge in relation to the knowledge of the other party in a negotiation (imperfect communication).
* Corporate governance – cooperation is the importance of corporate governance. Accordingly, managers must know how to form these strategically.
* Capital Structure – Managers must know how to balance the debt, equity, and other capital sources to be able to maximize funding.
* Debt – Game theory can be applied in entering in loans by considering symmetric gains.
5 Discuss the motivations for mergers and acquisitions (1/2 page)
Although there are many motivations for the conduct of mergers and motivations, some of the most common are (1) diversification, (2) accelerated growth, and (3) bargain prices. First, diversification expands the business model and revenue sources, which provides increased flexibility for the management in line with the associated risks of their business model. Second, accelerated growth happens since the company increases its consumer base, sources of funding, and product lines, among others. Third, bargain prices refer to the opportunity on the part of the acquiring company to purchase assets (i.e., factories, distribution lines) at a significantly lower cost than when buying them new CITATION Ben95 \l 1033 (Benston, Hunter, & Wall, 1995).
6 Discuss the types and motivations for divestures. (1/2 page)
The four main types of divestitures are (1) tracking stocks, (2) carve-outs, (3) spin-offs, and (4) sell-offs CITATION Slo95 \l 1033 (Slovin, Sushka, & Ferraro, 1995). Accordingly, there are different reasons/motivations for the divestitures of a company, such as (1) bankruptcy, (2) non-core line of business, and (3) for obtaining funds. In case of bankruptcy, the management could be motivated as it would allow the company to cut down some of its costs and recompense some of its debts, which are incurring interests. This is the same for the non-core line of businesses, where divestiture could give it greater purchasing power for its core businesses. Lastly, another motivation for divestiture could be due to the company’s desire (relative to its capital structure) to obtain funds for an existing venture. If the company believes that divestiture is a better way of obtaining funds than debt or equity, then such a method could motivate them to enter into this process.
7 Describe the similarities between corporate social responsibility, socially responsible investing, impact investing and thematic investing (1/2 page)
The main similarities between CSR, SRI, II and TI are their focus towards the promotion of the common good. In general, these four differs based on how they balance their goals for ‘profitability’ and the positive impacts of such. Nonetheless, what is similar is that they all strive to break the notion that investing should always be in line with the betterment of society. Among these three, CSR presents a general framework for the promotion of the common good. From time to time, CSR invests in funds that give back to society. In contrast, valuations of profitability in ESG is always taken in line with how an investment would impact both the society and the environment. Thus, investments that would cause environmental degradation would be ruled out CITATION Zho19 \l 1033 (Zhou, 2019). Lastly, SRIs imposes even stricter guidelines for investment strategies by using ethical guidelines as a framework for investment. For example, investors may then opt to invest in traded funds that invest in tobacco-production.
8 Summarize the results of the Graham-Harvey survey article on corporate finance in practice (on blackboard). (1 page). The article is in the link, please check.
The main question that Graham and Harvey (2002), sought in their article is the main factors that drive the decision making of CFOs when it comes to capital budgeting and structure. Academically, he first identified two main theories in the determination of capital structure, which are (1) the trade-off theory and (2) the pecking order theory. On the one hand, the trade-off theory suggests that in deciding the right balance of capital structure between debt and equity, the management always places primary consideration on the benefits and risks included in each decision. On the other hand, the pecking order theory provides that choosing the right balance of capital structure always provides a hierarchy, from internal financing to debt, and lastly to equity.
In order to understand whether academic theory, which is ‘safer’ is being applied accordingly to the real world, the authors conducted a survey from 392 CFOs. Subsequently, they found out that despite the inherent risks of “rules of thumb”, CFOs usually make decisions based on their own personal measurement instincts rather than the accepted methods that are recognized in the academic world.
More specifically, the authors surveyed showed that current CFO practices are most apparent when it comes to designing capital structure. Despite the survey showing that a significant number of CFOs believe and relies in the theory of optimal structure, the interviews that they conducted showed that CFOs do not really ascribe to the same.
Aside from the major findings, the authors also found out that these decision-making tendencies of CFOs could affect shareholder’s value in the long term especially when they enter into sub-optimal loans to bolster their ratings. Additionally, they also realized that there is a certain disconnect between how CFOs and academics value EPS dilution in order to fuel a project through the issuance of new common stocks, with the former latter...