Final Corporation Finance Question Accounting, Finance Coursework

Corporation Finance Question
1 Define capital structure and list the key elements of capital structure. (1/2 page)
Capital structure is the funding of a company to subsidize its operations and long-term performance which is composed by various, critically-arranged sources – debt and equity, for example (Boodhoo 2009). However, there is no universal form on how companies build their capital structure. Nonetheless, theorists created frameworks to better comprehend how firms maximize their capital structure. Some of these theories are tradeoff theory, which is focused on how companies mix their equity and debt finance by looking at costs and benefits’ corresponding; and pecking order theory, which suggests that companies prioritize internal financing then debt to provide for their capital expenditure before resorting to equity (Myers 2001).
According to Gulati (1978), there are six key elements of capital structure. These are capital mix, terms and conditions firms, currency firms, financial market segments, maturity and priority, and financial innovations. All of these are important to consider when it comes to balancing the mix between debt and equity for the company.
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).
Comparably, M&M’s Proposition II (no taxes) suggests that despite the more favorable feature of debts (pecking order) compared to equity, the firm cannot rely too much on this kind of resource for it would still result in an increased cost in buying equities. Thus, it is best to have the right balance between them.
2 1963 model – with taxes, no bankruptcy costs
Under the 1963 Model, M&M’s First Proposition suggests that when taxes are added, the investors ROE has a direct correlation with the risks associated with acquiring debt from external sources. However, this can be assumes that the borrowing rates and the same and there are zero-costs transactions.
Under their second proposition (no taxes), M&M suggested that choosing equity distribution as compared to low quality debts would be better than the other way around. This is because the high reliance on low quality debt could lead to the firm’s failure to pay its financial obligations.
3 Tradeoff model – with taxes and bankruptcy costs
The third mode, provides that using a tailored approach would be better since it would help the firm in creating the best type of capital structure and budgeting. Accordingly, a tailored approach would also give the management an increased financial flexibility since they would be able to ascertain both the advantages and disadvantages of every decision.
3 Describe the pecking order theory of capital structure. (1/2 page)
The main premise of pecking order theory is that firms do not focus on balancing their capital structure but rather on following a certain order in funding their capital expenditure by preferring to focus first on their internal finance, before considering debt finance, and lastly, equity finance (Chen and Chen 2011). Abosede (2012) mentioned that to lessen the conflict the equity may bring with shareholders if asymmetries will be addressed, companies resort to pecking order – exhausting their profits first.
Chen and Chen (2011) further said that pecking order theory has four variables that responds “positively” with capital structure. These are growth opportunity, asset structure, tax rate, and dividend payment rate. On the other hand, profitability does not improve capital structure if pecking order is utilized (Chen and Chen 2011). In other words, the more a firm relies on their internal finance and debt, the more money they lose which leads to lesser profit, rather than getting funded by shareholders.
4 Discuss the importance of game theory in corporate finance; Provide 5 real-world examples. (1/2 page)
The business world is a large battlefield with players who ranges from wealthy successful to beginners. Without fully understanding the game theory’s influence in corporate finance, a firm’s growth could be hindered as other businesses weaken them with each of their own strategies. Game theory can help different firms in making decisions for their business to stay in the zone by cross-referencing possible scenarios predicted by game theory with the actual profiles and strategies of competing companies.
Here are 5 real-world examples of game theory’s importance in corporate finance:
1 Capital Structure – Capital structure is relative to the characteristics of a business. Thus, owners or managers must be able to find the most sensible combination and amount of their fund’s sources.
2 Products – Without profit, the success of a business cannot be measured. However, product-related decisions cannot focus solely on the idea of company’s gain as competitors can already be in line with the thoughts of this company or ahead. Understanding Prisoner’s Dilemma is vital to realize the gain or loss a firm might encounter with their competitor.
3 Advertising – Two companies with similar product may opt to advertise it to reach wider audience, but having a similar product means people will have to decide on which is better. If a firm does not strategically check on how much they and their competitor are willing to spend on advertisement and correlates it with their offers, profit loss may be inevitable.
4 Third-party Contractors – Managers must be able to find the balance in maximizing their requested service from third-party contractor but without spending too much of their capital, while considering if the latter, who also wanted more income and less cash outflow, will agree.
5 New Market – Using game theory, firms can be guided on evaluating where and when they should enter a new market or exit and old one.
5 Discuss the motivations for mergers and acquisitions (1/2 page)
In a larger view, mergers and acquisitions happen when a firm sees more potential for the future of their company with merged companies or acquiring compared to their current state. To be more specific, however, one motivation for these would be synergy gain. Merged firms gain a larger scope of consumer base for their products which made their company more efficient. That is synergy gain (Motis 2007). Another motivation for mergers and acquisitions is faster growth. When assets are combined, capital structure becomes stronger for the firm due to added sources, plus profit can be driven higher with mixed products (Benston, Hunter, & Wall, 1995). Diversification is also a motivator for merger and acquisition. This makes a firm become flexible with the development of their upgraded business model CITATION Ben95 \l 1033 (Benston, Hunter, & Wall, 1995).
6 Discuss the types and motivations for divestures. (1/2 page)
Fogh (2009) mentioned three types of divestitures. First, asset sale/sell-off is where a firm buys an asset (such as division, subsidiary, product line, etc.) from another firm. Sell-off is a divestiture to the latter. Second, spin-off is selling or share-distributing of a firm’s division to their stakeholder, thus making this division an independent company from its parent. Third, equity carve-out is making a new subsidiary while the firm IPOs it at the same time (Fogh 2009).
Meanwhile, the drive to undergo divestitures varies. To name a few, “incentives and behavioral finance” is one motivation for divestitures. Firms believe that it would be more strategic to let go of the assets that other party can manage and lessen the divided focus in the company (Fogh 2009). Another motivation would be to attain more funds especially if divestiture can better help the capital structure of a firm rather than undergoing debt or relying on equity finance.
7 Describe the similarities between corporate social responsibility, socially responsible investing, impact investing and thematic investing (1/2 page)
Corporate social responsibility is the idea that companies includes government or citizen’s concerns, beside their business’ purpose, on their corporate procedures (Crowther and Aras 2008). Socially responsible investing is investing on firms that does not conflict with environmental preservation thus avoiding tobacco companies for example. Similarly, impact investing is capitalizing on markets that are beneficial to societal or environmental needs (Niggeman and Brägger 2011). Meanwhile, thematic investing focus on investing on smaller stocks of firms that still must be relevant to themes that concerns our society, environment, or technological progress (Bourgi 2018).
The similarity between these four is that they all give the idea that firms can earn money as they invest on socially relevant stocks or firms. Therefore, firms do not only focus on the growth of their company but at the same time, with the socially-ethical investments, they acknowledge what their government and society needs.
8 Summarize the results of the Graham-Harvey survey article on corporate finance in practice (on blackboard). (1 page). Article is in the link, please check.
Capital budgeting and structure is crucial for an organization’s functioning. It allows the management to have the capacity to take risks due to the increase in their financial flexibility. Accordingly, Graham and Harvey’s (2002) study tried to understand how CFOs make their decisions about structure and budgeting. To start with, the researchers focused on two (2) theories that academics think are the best ways of making such decisions, namely trade-off and pecking-order theories. According to the authors, the former suggests that CFOs must be able to strike the right kind of balance between debt and equity by thinking about the relative advantages and disadvantages of each. As compared to this, the latter (pecking-order) shows that CFOs must always choose hierarchically from using internal funds, to loans and debts, and finally to equity.
Nevertheless, their findings showed that most CFOs follows their own barometers, which emanates from their own practices. In line with this, the survey they conducted showed that plenty of CFOs prioritize ‘financial flexibility’ over other traits in trying making their own decisions. Thus, Graham and Harvey found out that in pursuant of maintaining this flexibility, CFOs tend to disregard those ‘academical...