Free Essay

Capital Structure and Information Asymmetry

In: Business and Management

Submitted By thokzin87
Words 3507
Pages 15
This paper will discuss the choice of capital structure in markets where there is information asymmetry. Particular reference is made to how debt is used as a signalling tool along with a discussion on debt maturity structure. The pecking order theory is examined. Finally this paper reveals empirical evidence of capital structure.
Arnold Musadziruma 210525268 Clint Kruger 209541568 Kemsley Grantham 209538112

“Seminar 4- Capital structure and information asymmetry (2013)”

This study is going to discuss capital structure choices of companies in an environment of information asymmetry. Firstly we discuss information asymmetry and how firms attempt to avoid a pooling equilibrium by signalling the quality of the firm. Quality can be signalled through the use of debt. The use of long term debt is a sign that a firm can make the payment obligations of the long term debt which is shown to signal good quality. The pecking order theory makes use of a hierarchy of financing sources and indicates internally generated funds should be used first. Following this, short term debt should be used before long term debt because of the risk and costs involved. Due to the costs involved in issuing equity in an environment of information asymmetry, firms should make use of equity as a last resort. The maturity structure of debt should also match the maturities of those firms’ assets to reduce costs. Empirical evidence suggests there is no common result for which theory is followed in practice; however it is shown that small firms who are high growth firms tend to follow a pecking order and larger firms follow a trade-off model. Due to the clear complexity involved in capital structure decisions, it is advised that a company sets out its objectives before choosing a model to follow.

“Seminar 4- Capital structure and information asymmetry (2013)”

Table of Contents
1. 2. 3. 4. INTRODUCTION .............................................................................................................. 1 DEVELOPMENT OF CAPITAL STRUCTURE THEORY ............................................. 2 INFORMATION ASYMMETRY AND POOLING EQUILIBRIUM .............................. 3 DEBT SIGNALLING......................................................................................................... 5 4.1 How management can signal firm quality using debt ...................................................... 5 4.1.1 Uncertainty and signalling ...................................................................................... 7 4.1.2 Managerial Incentive signalling Equilibrium ................................................... 8 5. DEBT MATURITY STRUCTURE ................................................................................. 10 5.1 Asymmetric information relating to default premia....................................................... 12 5.2 Empirical results on debt maturity structure .................................................................. 13 6. THE PECKING ORDER THEORY (POT) ..................................................................... 14 6.1 Pecking Order Theory versus Static trade-off theory..................................................... 17 6.2 Implications of the Pecking Order Theory ................................................................ 20 6.2.1 Empirical Evidence ............................................................................................. 20 6.3 Implications for firms following the Pecking Order ..................................................... 22 7. 8. CAPITAL STRUCTURE IN PRACTICE ....................................................................... 23 CONCLUSION ................................................................................................................ 29

BIBLIOGRAPHY .................................................................................................................... 31

“Seminar 4- Capital structure and information asymmetry (2013)”

Until recently, the debate around capital structure has mainly been a theoretical one, with the relevance or irrelevance of financing decisions solely dependent upon the willingness to accept the existence of substantial market imperfections by the modeller, (see: DeAngelo and Masulis, 1980: 2, Titman, 1984: 25, Fama, 1980: 5, Smith and Warner, 1979: 22) for different perspectives on the relevance of these market imperfections. There has been a considerable amount of empirical evidence over the years as summarized by Smith (1986: 21), which now strongly indicates that changes in the capital structure of a firm can indeed affect the overall value of a firm. There has been a paradigm shift thus far, that has seen the focus of the debate shifting from whether capital structure decisions matter to why they actually matter (Pinegar and Wilbricht, 1989: 83). The fact that markets are not efficient and perfect makes the optimal capital structure decision even more intriguing, and the existence of information asymmetry between companies and investors also create a set of problems for identifying an optimal structure. In a market faced with information asymmetry, investors solely rely on signals from firms to come up with conclusions as to whether the decisions made reflect good news or bad news about the firm itself. One way a firm can attempt to signal its quality is through the use of debt where issuing long term debt can be seen as a signal that the firm has sufficient future expected cash flows to cover its interest obligations. Short term debt, on the other hand can be regarded as a bad quality signal as investors are led to assume that long term debt obligations cannot be met in the future. In addition, the maturity structure of debt can be regarded as very important, not only in portraying good information to outside investors, but also in managing the use of funds and costs associated with a particular set of funds. In order to determine the amount of debt used and the maturity of debt, one could follow the pecking order theory. The pecking order theory of capital structure thrives on the realm of information asymmetry. It suggests the use of less information sensitive sources of funds first such as internally generated funds followed by debt then other hybrid sources. This paper will be structured as follows; in Section 2, the development of capital structure theory is examined and will be followed by a discussion on information asymmetry and the pooling equilibrium in Section 3, which considers how a firm can use debt to signal good news (or quality) to the market in order to avoid the pooling equilibrium.

“Seminar 4- Capital structure and information asymmetry (2013)”

In Section 4 various forms of debt signalling are discussed, followed by the prospect of signalling using the maturity structure of debt in section 5. Section 6 will discuss the Peckingorder theory (POT) of capital structure, including the implications and predictions of the theory. Section 7 will subsequently follow thereafter and will highlight some of the empirical evidence in support of capital structure in the real world. Section 8 then conclude the paper.

It would be unwitting for anyone to start any discussion on capital structure theory in finance without mentioning the “two founding fathers”, Franco Modigliani and Merton Miller, who in 1958 and 1963 published two articles on corporate structure that laid a firm foundation for other subsequent models. They provided ten main assumptions that were later used as a basis to formulate new models. Although most of these assumptions were considered to be unrealistic, one cannot deny that they instigated debates and research in the realm of corporate structure theories that eventually led to the formulation of new models (Copeland, Weston and Shastri, 2005: 595). The central results of modern corporate finance, based on the Modigliani-Miller irrelevancy propositions, have been summarized nicely in the following quotations: “….. the market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate pk appropriate to its class” (Modigliani and Miller, 1958); And “….. the current valuation of any firms is unaffected by differences in dividend payments in any future period and thus….dividend policy is irrelevant for the determination of market prices, given investment policy” (Miller and Modigliani, 1961). (Ross, 1977) According to Frank and Goyal (200: 6), the pecking order and static trade-off, theories which will be discussed in detail in later sections, were derived from these articles by M&M.

“Seminar 4- Capital structure and information asymmetry (2013)”

The main focus of the M & M 1963 paper was to test the effects of taxes on the capital structure of a firm. They proposed that firms should be fully leveraged (100% debt) due to tax shields associated with interest payments that will result in savings for the firm. The assumption behind this was a constant cost of debt regardless of the amount of debt taken by the firm. Increasing debt, however, leads to other costs such as financial distress and bankruptcy costs; hence this capital structure is not optimal. As Kraus and Litzenburger (1973: 911) put it, the optimal debt to equity ratio may be seen as a trade-off between the tax savings that accrue from interest payments and increased financial distress and bankruptcy costs. Considering these costs means the capital structure should be at a point where the marginal benefit of taking on extra debt is equal to the cost associated with it. This, in essence, describes the static trade-off theory as proposed by Myers (1984: 576). Another assumption from the M & M model was that of perfect capital markets which, in essence, meant that there is no information asymmetry in the markets and that signalling does not exist. Markets are, however, not perfect and information asymmetry does exist and affects a firm‟s choice of capital structure. Arkelof (1970), one of the early pioneers of this topic, mentioned in his article that when information asymmetry is present, it results in the issue of adverse selection. Later proponents such as Ross (1977), who developed the incentive signalling approach; Myers and Majluf (1984), who developed the pecking order theory, and Flannery (1986) who developed the maturity signalling model, all mentioned information asymmetry in their articles and revealed how it affected the choice of capital structure of the firm.

Information asymmetry occurs when managers possess additional inside information about the firm not known by the other parties (investors/shareholders and/or the general market) (Harris and Raviv, 1991: 306). Managers and other market participants are assumed to possess the same market wide information about a firm or, in other words, non-firm specific information thus both bear market wide uncertainty (Dierkins, 1991: 182-183). Managers know more about the firm because they get first-hand private information about the firm not known by the market.

“Seminar 4- Capital structure and information asymmetry (2013)”

This information will, however, eventually be conveyed to the public either through the passage of time or via some information-releasing event such as earnings announcements or equity issue announcements (Dierkins, 1991: 183). As Akelorf (1970) asserted in his paper, the presence of information asymmetry results in adverse selection. In his analogy, he used a hypothetical example of the market for automobiles where there are four categories of cars (new cars, used cars, good cars and bad cars) which he referred to as “lemons” in the American context. When people buy the cars, they do so without knowing that it is a good car or a lemon. Assuming that q is the proportion or probability of getting a good car and (1-q) a lemon, individuals know that with probability q it will be a good car and (1-q) that it is a bad car. The buyer can only fully know the condition of the car after owning it for a considerable length of time. By virtue of these differences in estimates, that is, when one buys a car and when they have had it for some time, an asymmetry in available information develops for sellers will have more knowledge of the quality of the cars than the buyers (Akelorf, 1970; 489). If the same prices are charged for both good cars and bad cars, it would be difficult for the buyer to ascertain the quality of the car without “inside information” (Akelorf, 1970; 489). As a result, there will be an increased incentive for sellers to sell bad cars. This will eventually lead to a drop in the expected average value of cars on the market as bad cars drive out good cars. To prevent low quality sellers presenting a misleading signal, signalling needs to be costly (Heinkel, 1982). The equilibrium may be unbalanced if there is a pooling offer ( which is a purchase offer at a single price that relates to the price of the average quality of the product in the market) that offers profits to the buyers and all sellers prefer signalling contracts (Heinkel, 1982). The pooling equilibrium refers to high quality sellers receiving low quality price and low quality sellers receiving high quality price. The pooling equilibrium will be preferred if the cost of pooling is less than that of the cost of signalling true quality (Heinkel, 1982). This same analogy as in Akelorf‟s (1970) example can be applied to the “real world” when firms sell equity on the market. If investors cannot ascertain the true value of the firm due to lack of certain inside information only known to management, then the investors will be inclined to pay a particular price for the firm. As a result, the incentive to sell equity on the market will be more appealing to the “bad” firms as opposed to the “good” ones, which will eventually result in overall firm values falling (Akelorf, 1970: 490).

“Seminar 4- Capital structure and information asymmetry (2013)”

Flannery (1986: 21) postulated that if investors are unable to distinguish between good quality and bad quality firms this results in a pooling equilibrium outsiders cannot differentiate the quality of the firms. If information asymmetry exists, the manager possessing the inside information can convey this information by way of signalling. If certain information, for example, results in a positive effect on the firm, it would be rational for a manager to disclose it. As a result, it would be necessary for managers to find strategies that signal the quality and good news of their firm to outsiders in such a way that it differentiates their firms from others. In the sections to follow, we are going to explain how the use of debt can signal a firm‟s value in the market so as to avoid this problem of pooling equilibrium.

Debt signalling plays a crucial role in signalling the quality of a firm in the presence of asymmetric information between manager and investors. Such signals, for all intense and purpose, can be seen as a firm‟s choice of capital structure (Heinkel, 1982: 1142). These signals are considered to be of no welfare cost to the firm, however, since, as proposed by Modigliani and Miller (1958), the choice of capital structure of a firm is irrelevant. By taking on debt, a firm will be signaling its ability to meet its future contractual interest obligations to the market which is taken as evidence indicating sufficient future cash flows. On the flip side, decreasing the amount of debt could be taken as a signal that the firm is unable to make payments and is not at an optimal position (Heinkel, 1982). Ross (1977) postulated that values of firms increase with leverage as leverage increases positively contribute to firm value. Although debt capacity depends on the value of the firm and the ability to pay, above average performing firms will be able to borrow more compared to poor performing ones (Myers, 2001).

4.1 How management can signal firm quality using debt
Modigliani and Miller‟s (1958) debt irrelevancy theorem was hinged on the assumption that markets were perfect and all participants were aware of all the information available, thus the choice of capital structure was not important. Markets are, however, imperfect and when dealing with imperfect information, the Modigliani and Miller theory may not hold in practice as capital structure and firm value are linked (Heinkel, 1982).

“Seminar 4- Capital structure and information asymmetry (2013)”

Due to the presence of information asymmetry, the choice of incentive packages for managers and financial structures, signal information to the market which may alter the perceived value of the firm (Ross, 1977). In his paper, Ross (1977) developed the incentive-signalling equilibrium which separated firms where managers were confident of better prospects from those firms where the management was not. He used a basic example in which he illustrated the relationship between management incentives and signalling and how this relationship was portrayed in the financial market. In this example the following assumptions were made:  Financial markets are competitive and complete and there are no operational costs or tax effects, therefore the firm has no monopoly power and demand is infinitely elastic at quoted prices;  There is unbiased pricing within the market and this assumption is made to make the model less complex (Ross, 1977).

This example uses the basic concept that there are only two firms, Firm A and Firm B at time 0, where the total return (value) of firm A is denoted as „a‟ and that of firm B as „b‟. It is given that a>b and this simply implies that firm A earns a higher return and is of better quality than firm B (Ross, 1977). If uncertainty is not present in the market and investors can recognize both firms A and B, their respective values at time 0 will be as follows: V0A = a 1+r and V0B = b 1+r Where „r‟ is the sure rate of interest. As clearly shown in the equations, the value of the firm is unaffected by the mode of finance chosen by the firm. < V0A

“Seminar 4- Capital structure and information asymmetry (2013)”

As portrayed by Ross (1977: 26) in his example, firm A has the following characteristics: It is financed by debt (D) with a face value of (F) and an equity value (E), where the debt has the senior claim to the returns of the firm with a minimum value of {F, a} at t=1 and the equity will subsequently claim the residual {a – F, 0}. The respective amounts at t=0 will thus be:

Equity = max {a – F, 0} 1+r

and Debt = min {a, F} 1+r therefore, E+D= a 1+r = V0A ,

In such a simple world, the M & M theory will just be a restatement of Fisher‟s theorem (Ross, 1977).

4.1.1 Uncertainty and signalling
If it so happens that investors cannot distinguish A firms from B firms, we use q to denote the proportion of A firms, and (1-q) to denote B firms. We also assume all investors act as though any of these firms has a q chance of being an A firm (Ross, 1977). Given the above information at time zero, firms will have a q chance of being A firms and a (1-q) chance of being type B firms. This means all firms will have the same value as shown in the following equations:

“Seminar 4- Capital structure and information asymmetry (2013)”

( ( )



This result follows the M & M proposition that capital structure choice does not affect firm value. It will be a waste of resources for firm A to signal to the market that they are type A rather than type B. The difficulty stems from the fact that B firms may falsely provide the same signal, thus leading to an equilibrium where it is difficult to differentiate the firms as they all look the same (Ross, 1977). To explain this in a different context, suppose an A firm were to propose a certain action, (perhaps a financial package), as a signal of their quality ( )

to investors. Then, by virtue of initial information symmetry, Firm B will also follow policies of thus will also end up realizing the initial value of ( ( ) ( (Ross, 1977). ) policy, and refinance it with activity ) leading to an equilibrium of

Using the same logic, if firm B were to adopt a , a financer will gain riskless capital gains of

therefore a financer may buy Firm B and refinance it at a value of Firm A(Ross, 1977).

4.1.2 Managerial Incentive signalling Equilibrium
There is one way in which this “constraint” that binds the value of the both A and B firms can be broken and it is to presume an important role for managers as they are assumed to possess special information about a firm‟s type or quality not known by investors. Without normal investors knowing the quality of the firm, the capital market cannot arrive at correct prices for debt and equity securities and this creates incentives for misrepresentation for the insiders (Heinkel, 1982). In this model, the following assumptions have been noted:   Insiders (managers) are classified as possessors of inside information; Insiders are compensated by a known incentive schedule (Ross, 1977).

“Seminar 4- Capital structure and information asymmetry (2013)”

It is assumed that management is compensated in the following way:

Where M is the incentive,

the fixed non-negative weights,

is the

value of the firm at t=0 and t=1 respectively, L the penalty assessed on an insider if there is bankruptcy at t=1 and F denotes the face value of debt. It is also assumed that managers want to maximise their incentives at time 0 by setting a level of debt financing, F, at that time so as to maximise M (Ross, 1977). The above formula can be used to establish the signalling equilibrium, where Firm A issues more debt than Firm B. The market is able to read this, determine the type of firm, and price it accordingly. Taking when:   F> F< the market will assume that this is a type A firm; the market will assume that this is a type B firm. be the significant level of financing, with b<…...

Similar Documents

Premium Essay

Capital Structure

...CapStrMktPower I M Pandey CAPITAL STRUCTURE AND MARKET POWER I. M. Pandey Indian Institute of Management Ahmedabad Vastrapur, Ahmedabad 380015 India E-mail: W. P. No. 2002-03-01 March 2002 i CapStrMktPower I M Pandey CAPITAL STRUCTURE AND MARKET POWER I M Pandey ABSTRACT This paper provides new insights on the way in which the capital structure and market power and capital structure and profitability are related. We predict and show that capital structure and market power, as measured by Tobin’s Q, have a cubic relationship. That is, at lower and higher ranges of Tobin’s Q, firms employ higher debt, and reduce their debt at intermediate range. This is due to the complex interaction of the market conditions, agency problems and bankruptcy costs. We also show saucer-shaped relation between capital structure and profitability because of the interplay of agency costs, costs of external financing and debt tax shield. To our knowledge, we are the first to uncover these results. Key words: capital structure; market structure; market power; Tobin’s Q; riskshifting; moral hazard; agency problems; pecking order; trade-off theory; asset substitution. ii CapStrMktPower I M Pandey CAPITAL STRUCTURE AND MARKET POWER INTRODUCTION In corporate finance, works of Modigliani and Miller (1958; 1963) about capital structure irrelevance and tax shield advantage paved way for the development of alternative theories and a series of...

Words: 6718 - Pages: 27

Premium Essay

Information Asymmetry, Signaling, and Share Repurchase

...Information Asymmetry, Signaling, and Share Repurchase Jin Wang Lewis D. Johnson School of Business Queen‟s University Kingston, ON K7L 3N6 Canada Email: February 2008 We acknowledge helpful comments from participants at the presentation of an earlier version of this paper at the 2006 European FMA Conference in Stockholm, Sweden. 1 We examine whether share repurchase announcements or actual share repurchases provide reliable signals to convey information to investors. We find that increases in operating performance and decreases in systematic risk are correlated with actual repurchase amounts but are not correlated with repurchase announcements. Further, we find that long-run abnormal stock returns are correlated with actual repurchase amounts but not with repurchase announcements. The paper has important implications for research on stock repurchases, since most literature to date has focused on the announced repurchase magnitude, which may lead to misleading results. Keywords: Share repurchase, operating performance, signaling JEL Classification: G35 2 Information Asymmetry, Signaling, and Share Repurchase Repurchasing of shares has represented a growing proportion of total U.S. corporate payouts in recent years. The ratio of expenditure on the purchase of common and preferred stocks to market value has risen from 0.19% in 1972 to 1.36% in 2000, whereas the ratio of total dividends declared......

Words: 12949 - Pages: 52

Premium Essay

Capital Structure

...1 Capital Structure Group 58 1. Overview of New Zealand Industry Selection We have chosen 12 different industries with in 21 listed companies belong to 21 NZX industry groups shows in Table 1 below. The three latters in brackets followed by each company name are their listed symbol in New Zealand Stock Exchange. Table 1 List of Selected Industries and Firms. 1) Consumer | 7) NZ Debt Market | Pumpkin Patch Limited (PPL) | New Zealand Government Stock (GOV) | The Warehouse Group Limited (WHS) | Tower Capital Limited (TWC) | 2) Finance & Other Services | 8) NZAX | Pyne Gould Group Ltd (PGC) | JASONS TRAVEL MEDIA LIMITED (JTM) | Summerset Group Holdings Limited (SUM) | New Zealand Wool Services International Limited (WSI) | 3) Food & Beverages | 9)Ports | Delegat's Group Limited (DGL) | Auckland International Airport Limited (AIA) | 4) Investment | Port of Tauranga Limited (POT) | ASB Capital Limited (ASB) | 10) Property | Kingfish Limited (KFL) | Kiwi Income Property Trust (KIP) | 5) Leisure & Tourism | Augusta Capital Limited (AUG) | SKYCITY Entertainment Group Limited (SKC) | 11) Transport | Tourism Holdings Limited (THL) | Air New Zealand Limited (AIR) | 6) Media & Telecommunications | Freightways Limited (FRE) | Telecom Corporation of New Zealand Limited (TEL) | 12). Overseas | | Oceana Gold (OGC) | 2. Purpose The purpose of this report is to analyse and evaluate the changes of capital structure......

Words: 7174 - Pages: 29

Premium Essay

Capital Structure

...UNDERSTANDING CAPITAL STRUCTURE As discussed in the previous section, a DCF requires a discount rate. The discount rate is a function of the risk inherent in any business and industry, the degree of uncertainty regarding the projected cash flows, and the assumed capital structure. In general, discount rates vary across different businesses and industries. The greater the uncertainty about the projected cash stream, the higher the appropriate discount rate and the lower the current value of the cash streams. STEP 6 – EXTRACT THE CAPITAL STRUCTURE FROM ANNUAL REPORT For calculating the discount rate, we require the proportion of Equity and Debt in the capital structure using our ABC example. For the capital structure calculations, annual reports of ABC have provided us with the following information on Debt and the Equity related items from the footnotes. The capitalization table of ABC company is as per below. ($ in MM) Short term Borrowings Revolver Bonds Of which Convertible Bonds Convertible Preferred Stock Due Date 15-Aug-09 31-May-10 31-Dec-12 31-May-10 1-Aug-12 31-Mar-14 31-Dec-10 5.2 14.2 80.0 12.0 7.0 Notes 3.2% coupon Due 5/31/2010 7.5% coupon, amortizing Bond Amortizing portion 4.5% coupon, conversion price $25, 1 bond of Fair value $100 converts into 4 shares 9.0 3% coupon, conversion price $20, 1 preferred stock of Fair value $18 converts into 1 share UNDERSTANDING THE CAPITAL STRUCTURE OF THE FIRM Short Term Borrowings: Short term borrowings is an......

Words: 2396 - Pages: 10

Premium Essay

Capital Structure

...Factors Influencing Corporate Capital Structure in Three Asian Countries: Evidence from Japan, Malaysia and Pakistan Muhammad Mahmud and Gobind M. Herani and A.W. Rajar and Wahid Farooqi KASBIT, KABIT, Sindh University, Indus Institute of Higher Education 20. April 2009 Online at MPRA Paper No. 15003, posted 4. May 2009 07:34 UTC Indus Journal of Management & Social Sciences, 3(1):9-17 (Spring 2009) Economic Factors Influencing Corporate Capital Structure in Three Asian Countries: Evidence from Japan, Malaysia and Pakistan Muhammad Mahmud*, Gobind M. Herani** A. W. Rajar*** and Wahid Farooqi**** ABSTRACT This study is an attempt to determine the factors that influence a firm’s choice of capital structure in three Asian countries: Japan, Malaysia and Pakistan. The specific objective is to investigate if country’s economic factors play a significant role in determining capital structure between markets. These countries are chosen in order to represent three different stages of economic development. Literature review reveals that considerable research has been made in the industrialized countries on the similar topic. Capital structure is one of the most complex areas of strategic financial decision making due to its interrelationship with macroeconomic variables. This study reveals that per capita GNP growth for Japan and Malaysia is significantly related to capital structure of firm and......

Words: 4126 - Pages: 17

Premium Essay

Capital Structure

...Theory of Capital Structure Relevance Under Imperfect Information Author(s): Robert Heinkel Reviewed work(s): Source: The Journal of Finance, Vol. 37, No. 5 (Dec., 1982), pp. 1141-1150 Published by: Blackwell Publishing for the American Finance Association Stable URL: . Accessed: 19/05/2012 14:37 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact Blackwell Publishing and American Finance Association are collaborating with JSTOR to digitize, preserve and extend access to The Journal of Finance. THE JOURNAL OF FINANCE * VOL. XXXVII, NO. 5 * DECEMBER 1982 A Theory of Capital Structure Relevance Imperfect Information ROBERT HEINKEL* under ABSTRACT Firms raise debt and equity capital to finance a positive net present value project in perfectly competitive capital markets; firm insiders know the function generating the random firm cash flow but potential capital suppliers do not. Taking into account the incentives of insiders to misrepresent their firm type,......

Words: 4499 - Pages: 18

Premium Essay

Capital Structure

...In 1958, Franco Modigliani and Merton Miller revolutionized the whole area of corporate finance with their article “The cost of capital, corporate finance and the theory of investment”. Before Modigliani’s and Miller’s article, literature on the topic mainly focused on descriptions of methods and institutions. Theoretical analysis was very rare (Pagano 2008). Under the assumption of perfect capital markets, the Modigliani-Miller Proposition I states that “the average cost of capital to any firm is completely independent of its capital structure and is equal the capitalization rate of a pure equity stream of its class” (Modigliani, Miller 1958). In Proposition II, Modigliani and Miller argue that “that the expected yield of a share of stock is equal to the appropriate capitalization rate for a pure equity stream in the class, plus a premium related to financial risk equal to the debt-equity ratio times the spread between” the capitalization rate and the return on debt. The most important implication of this theory is that if there is an optimal capital structure for a firm, this has to be the result of market imperfections. The Modigliani-Miller Theorem has thus become a starting point for further research and a benchmark for testing new theories on capital structure, that incorporate the impact of different market imperfections. The following text will focus on two of these theories, the static trade-off theory and the pecking order theory. The first part will contain a......

Words: 1173 - Pages: 5

Premium Essay

Capital Structure

...Capital Structure Stewart C. Myers The Journal of Economic Perspectives, Vol. 15, No. 2. (Spring, 2001), pp. 81-102. Stable URL: The Journal of Economic Perspectives is currently published by American Economic Association. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. The JSTOR Archive is a trusted digital repository providing for long-term preservation and access to leading academic journals and scholarly literature from around the world. The Archive is supported by libraries, scholarly societies, publishers, and foundations. It is an initiative of JSTOR, a not-for-profit organization with a mission to help the scholarly community take advantage of advances in technology. For more information regarding JSTOR,......

Words: 12907 - Pages: 52

Premium Essay

Capital Structure

...Vol. 2 No. 19 [Special Issue - October 2011] Perceived Relationship between Corporate Capital Structure and Firm Value in Nigeria Semiu Babatunde ADEYEMI Department of Accounting University of Lagos Lagos, Nigeria Collins Sankay OBOH Department of Accounting University of Lagos Lagos, Nigeria Abstract This study examined the empirical effects of corporate capital structure (financial leverage) on the market value of a selection of firms listed on the Nigerian Stock Exchange. Both primary and secondary data were obtained for analysis employing both descriptive and inferential statistics for analysis. A sample size of 150 respondents and 90 firms were selected for both primary data and secondary data respectively. Descriptive statistics was used to analyse the primary data, while Chi-Square was used to draw inference of perceived relationship between capital structure and firm value. The results of the study suggested that a positively significant relationship exists between a firm’s choice of capital structure and its market value in Nigeria. The study suggested that listed firms in Nigeria should strategically plan and manage their capital structure in order to maximize their market values. Keywords: Capital structure, market value, Nigeria, debt, equity. 1. Introduction 1.1 Background to the Study After the Modigliani-Miller (1958 and 1963) paradigms on firms’ capital structure and their market values, there have been considerable debates, both in theoretical and......

Words: 7951 - Pages: 32

Premium Essay

Information Asymmetry

...Information asymmetry is an overarching theme in accounting theory, which plays a significant role in the issues developed in this article. Asymmetry affects the reliability of information that will be delivered to other people. The managers of Diamond Foods were providing information to some people that they were not willing to share with people on the outside of the organization and to some extent people on the inside as well. For example, Diamond Foods was moving grower payments into different periods, so the growers did not even know what they are being paid for. Also investors and the public always believed that the company way reaching its growth targets, managers were actually engaging in income manipulation. This embodies the idea of moral hazard, where the investor cannot determine whether a manager is shirking their role or acting with the investors' best interests in mind. Investors rely on financial information to tell them what is going on internally, and make decisions based on the good news or bad news presented by these statements, and other sources to information from the company. As demonstrated, an investor cannot learn everything there is to know about a company from the financials; as a result, investors will assess the firm with an amount of estimation risk, lowering the price they will pay for the stock. Diamond Foods' admission of incorrect accounting will mislead speculation of stock and the performance of the whole firm. The lack of reliable......

Words: 383 - Pages: 2

Premium Essay

Asymmetric Information and Capital Structure

...Assignment 4 FIN 534 Rafael Diaz Strayer University 08/25/2010 PROBLEM 28 ASYMMETRIC INFORMATION AND CAPITAL STRUCTURE Info Systems Technology (IST) manufactures microprocessor chips for use in appliances and other applications. IST has no debt and 100 million shares outstanding. The correct price for these shares is either $14.50 or $12.50 per share. Investors view both possibilities as equally likely, so the shares currently trade for $13.50. IST must raise $500 million to build a new production facility. Because the firm would suffer a large loss of both customers and engineering talent in the event of financial distress, managers believe that if IST borrows the $500 million, the present value of financial distress costs will exceed any tax benefits by $20 million. At the same time, because investors believe that managers know the correct share price, IST faces a lemons problem if it attempts to raise the $500 million by issuing equity. Question a. Suppose that if IST issues equity, the share price will remain $13.50. To maximize the long term share price of the firm once its true value is known, would managers choose to have equity or borrow the $500 million if i. they know the correct value of the shares is $12.50? SOLUTION If the firm knows that the correct value of the shares is $12.50, the correct thing to do to raise the $500 million would be by issuing equity. The share price would be overpriced at $13.50 so by issuing......

Words: 734 - Pages: 3

Premium Essay

Capital Structure

...Capital Structure Capital Structure is the proportion of debt, preference and equity capitals in the total financing of the firm’s assets. The main objective of financial management is to maximize the value of the equity shares of the firm. Given this objective, the firm has to choose that financing mix/capital structure that results in maximizing the wealth of the equity shareholders. Such a capital structure is called as the optimum capital structure. At the optimum capital structure, the weighted average cost of capital would be the minimum. The capital structure decision influences the value of the firm through its cost of capital and can affect the share of the earnings that pertain to the equity shareholders. Introduction to Capital Structure Theories There are 4 basic Capital Structure theories. They are: 1. Net Income Approach 2. Net Operating Income Approach 3. Modigliani-Miller (MM) Approach and 4. Traditional Approach Generally, the capital structure theories have the following assumptions: 1. There are no corporate taxes (this assumption has been removed later). 2. The firms use only 2 sources of financing namely perpetual debts ad equity shares 3. The firms pay 100% of the earnings as dividend. This means that the dividend pay-out ratio is 100% and there are no earnings that are retained by the firms. 4. The total assets are given which do not change and the investment decisions are assumed to be constant. ...

Words: 8178 - Pages: 33

Premium Essay

Capital Structure

...Bachelor of Finance & Banking Thesis -------------------------------------- The impact of capital structure on profitability of listed construction companies on Hanoi Stock Exchange from 2008 to 2013 FALL 2014 Instructor Mr. Tran Viet Dung Group members Nguyen Thi Thanh Tam (FB00464) Nguyen Thi Viet Chinh (FB00405) Hoang My Linh (FB00073) Dang Thi Hong Hanh (FB00253) Nguyen Thi Kieu Trang (FB00078) Hanoi, December 2014 Table of Contents List of tables 3 List of figure 4 Abstract 5 Chapter 1: Introduction and Thesis Outline 6 1. Background 6 2. Research objective 8 3. Research question 8 4. Data and methodology 8 4.1 Data 8 4.2 Methodology 9 5. Thesis outline 9 Chapter 2: Literature Review and theoretical models 10 1. Theorem review 10 1.1. Modigliani- Miller theorem review 10 1.2. Agency theory 12 1.3. Trade-off theory 14 1.4 Pecking Order Theory 19 1.5 Market-timing theory 20 2. Variable review 22 2.1. Return on Asset and Return on Equity 22 2.2. Capital structure 23 3. Empirical studies 24 3.1. Relationship between capital structure and firm performance 24 3.2. Empirical studies of relationship between determinants of capital structure and profitability 28 4. Summary of the empirical studies 30 Chapter 3: Methodology 31 1. Introduction 31 2. Data collection methods 32 2.1. Sampling techniques 32 2.2. Data collection procedure 34 3. Variables and......

Words: 20311 - Pages: 82

Premium Essay

Capital Structure

...Miller's Capital-Structure Irrelevance Proposition Modigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely. From their analysis, they developed the capital-structure irrelevance proposition. Essentially, they hypothesized that in perfect markets, it does not matter what capital structure a company uses to finance its operations.  The MM study is based on the following key assumptions: * No taxes * No transaction costs * No bankruptcy costs * Equivalence in borrowing costs for both companies and investors * Symmetry of market information, meaning companies and investors have the same information * No effect of debt on a company's earnings before interest and taxes In this simplified view, it can be seen that without taxes and bankruptcy costs, the WACC should remain constant with changes in the company's capital structure. For example, no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes/benefits to the WACC. Additionally, since there are no changes/benefits from increases in debt, the capital structure does not influence a company's stock price, and the capital structure is therefore irrelevant to a company's stock price. However, as we have stated, taxes and bankruptcy costs do significantly affect a company's stock price. In additional papers, Modigliani and Miller included both the effect of taxes and bankruptcy costs. The MM Capital-Structure......

Words: 373 - Pages: 2

Premium Essay

Capital Structure

...Capital Structure – Chapt. 16 in text Does Capital Structure affect firm value? MM Proposition I (No Taxes): The value of a levered firm is equal to the value of an unlevered firm. VL = VU. i.e., Financing Choices do not add value. Why? Because you can create homemade leverage if you wish. • Unlevered Firm vs. a Levered Firm with the same assets. Recapitalization of Trans Am Corporation. Debt issue of $4,000,000 at 10% to buy back equity. Alternatively, you may view them as two companies that differ only in their capital structure. Current Proposed Assets $8,000,000 8,000,000 Debt 0 4,000,000 Equity 8,000,000 4,000,000 Shares Outstanding 400,000 200,000 Share price $20 $20 Trans Am Corporation - without debt Recession Expected Boom Earnings: 400,000 1,200,000 2,000,000 Interest: 0 0 0 Earnings after interest: 400,000 1,200,000 2,000,000 Return on equity (ROE): 5% 15% 25% EPS: $1.00 $3.00 $5.00 Trans Am Corporation - with debt Recession Expected Boom Earnings: 400,000 1,200,000 2,000,000 Interest: 400,000 400,000 400,000 Earnings after interest: 0 800,000 1,600,000 Return on equity (ROE): 0% 20% 40% EPS: $0 $4.00 $8.00 Payoffs with Levered Firm and Homemade Leverage Recession Expected Boom Buy 100 shares of Levered Equity at Cost of $2,000 EPS ......

Words: 1526 - Pages: 7

Schach Chess Afghanistan Block 87 postfris Schachfiguren Läufer Turm Pferd Dame | Beginner's Guide to Metal Detecting | Hong Seo-beom