On the other hand, the benefit of using stock issue is that dividend payments are not compulsory (in the case of common stock) (Guerard and Schwartz, 2007). As a result, companies can keep the profit to reinvest if it fits their business strategy.
- Retained earnings
Retained earnings are profit from past years which are kept within the company for reinvestment instead of being distributed to shareholders (Pride, Hughes and Kapoor, 2008). This type of finance virtually has no cost if leaving out the opportunity cost of not satisfying shareholders in the immediate term (Baker and Martin, 2011).
- COST OF CAPITAL AND CAPITAL STRUCTURE
As far as companies are concerned, cost of capital and capital structure are two subjects that attract a lot of attention (Frank and Goyal, 2008).
- Importance
Brigham and Houston (2012) define capital structure as the mix of different capital sources used by the company. For example, a company may use 40% shares capital and 60% from bond issue. Meanwhile, cost of capital refers to the cost of obtaining those sources of funds (Öztekin, 2011) (see app. 1.1). Therefore, the two elements are supposed to have a close relationship in terms of financial management.
However, this view is rejected by the Modigliani-Miller theory as it asserts that the cost of capital is not affected by the capital structure used by the company (Frank and Goyal, 2008). In other words, the theory denies the importance of capital structure in the corporate finance (Megginson and Smart, 2008). Yet it seems to be inappropriate since the statement is made under unrealistic assumption of a perfect market with no inefficiencies such as transaction costs or taxes (Sheeba, 2011) (see app. 1.2a). Indeed, MM theory does prove that capital structure may matter in the imperfect real world (Frank and Goyal, 2008).
Despite the exception of MM theory, the majority of theories such as pecking order or trade-off theory do recognise the importance of having a capital structure (Sheeba, 2011).
Hence, the importance of capital structure and cost of capital can be discussed interactively and linked to the notion of optimal capital structure. Firstly, as any other activity done in the course of doing business, the use of various types of finance needs to be planned since the company must be aware of the benefits it could bring as well as the risk associated (Melicher and Norton, 2011). Moreover, a capital structure is also needed to calculate the overall cost of capital which in turn is needed to determine the rate of return required to satisfy the company’s shareholders and/or creditors. Finally, the cost of capital and capital structure are critical factors in indentifying the optimal capital structure that maximises the firm’s value while minimising the overall cost of capital (Baker and Martin, 2011).
Yet there are different theories that promote different viewpoints on the existence of an optimal structure.
For example, the trade-off theory is only concerned with debt finance and focuses on the balance between the benefits and costs of using debt (Brigham and Hoston, 2012). While using debts brings the benefit of tax deductibility, it also associates with the cost of financial distress (Frank and Goyal, 2008) (see app. 1.2b). According to the theory, an optimal capital structure does exist when increases in tax shield are offset by increases in distress costs (Megginson and Smart, 2008).
By contrast, the pecking order theory suggests that internal source of fund is preferred over external sources as managers want to avoid asymmetric information and issuing costs (Sbeiti, 2010) (see app. 1.2c). Besides, when more capital is needed, debt would precede stock issue since the cost of debt is lower. Therefore, this theory implies that there is no optimal capital structure but corporate finance is purely based on the availability of internal sources of funds (Melicher and Norton, 2011).
Meanwhile, stock issue is the centre of the market timing theory as it asserts that companies try to time the market by issuing share at high price and repurchasing at low price (Baker and Wurgler, 2002). The rationale is that mispricing does exist and managers can detect mispricing better than the market does. Therefore, an optimal capital structure does not exist but companies simply choose the form of capital that is more valued by the market at that point in time (Melicher and Norton, 2011).
-
Optimal capital structure
Based on the review, it can be seen that none of the theories is exhaustive and fully applicable in the real world since all of them are developed under unrealistic assumptions. However, one thing can be derived is that companies should use both equity and debt financing in their capital structure.
Meanwhile, reconciling those theories and with reference to the empirical evidence it seems that the capital structure is influenced by various factors, at both firm-specific and macroeconomic levels (Shahjahanpour, Ghalambor and Aflatooni, 2010). Examples of firm-specific factors could be management strategies, firm’s size and ownership patterns while macroeconomic factors may include politic environment, tax system and form of market (Sbeiti, 2008).
For instance, differing industries may choose varying amounts of debt and equity to use when financing (Boone and Kurtz, 2011).
Figure 1: Capital structures of firms in different industries
Source: Honda (2012); Walt Disney (2012)
As illustrated in the graph, while Honda, which operates in the motor industry, relies mainly on retained earnings and debt (both long and short term) (99%) and common stock only makes up a tiny 1%; Walt Disney, which is an animation company, uses common stock as one of its main source of capital (38%).
Besides, even firms in the same industries often have different capital structure (Keown et al, 2003)
Figure 2: Capital structures of firms in the same industry
Source: YUM! (2012); McDonald’s (2012)
It can be seen that although both companies operate in the fast food industry, their capital structures differ dramatically. While more than half of YUM!’s capital (56%) is in the form of long term debt, it is retained earnings that accounts for the vast majority of McDonald’s capital structure (75%) .
In addition, even a firm’ capital structure changes overtime (Brigham and Houston, 2012).
Figure 3: Walmart’s debt to equity ratio over years
Source: Walmart (2012)
Based on the graph, it is observed that the debt to equity ratio of Walmart in the 2007 – 2012 period was fluctuating though the range was narrow (between 0.58 and 0.75).
To sum up, the most likely conclusion is that there is no exact optimal capital structure that can be applied for every company in the long term. Meanwhile, companies tend to keep the proportion of different sources of capital from varying too significantly.
- CONCLUSION
To sum up, major sources of capital available for large companies include debt (loans and bonds) and equity (stock and retained earnings), each of source has both benefits and costs that a company needs to take into consideration. Therefore, cost of capital and capital structure are of great importance as they both affect the firm’s value. However, it seem unlikely that an optimal structure exists that maximises the firm’s value while minimising the cost of capital. Hence, managers are recommended to use both debt and equity and to try to keep a balance between cost and value.
PART B
- INTRODUCTION
The efficient market hypothesis (EMH) developed in 1965 by Eugene Fama is the main economic and financial theory concerning about how the market is operated. As the validity of EMH is still a subject of debate among economists, it is undeniable that the hypothesis has certain impacts on people who participate in the market. In consequence, it plays an important role in the decision making process of those participants.
Hence, this paper is prepared to review the hypothesis and discuss its implications for two main participants in the market including investors and company’s managers.
- NATURE
While there are three types of market efficiency including operational, allocative and informational efficiency EMH only deals with the third one that refers to the way information is used in the market (Strong, 2009) (see app. 2.1). It states that in an efficient market current stock prices fully reflect all available information (Reilly and Brown, 2009).
First of all, it is worth noting that the hypothesis is developed under a set of assumptions (Brigham and Daves, 2007). The very initial premise is that the majority of investors act rationally and independently of each other (Aronson, 2011). Regarding the information concerned, it is assumed to come to the market in a random fashion and independent of each other (Cuthbertson and Nitzsche, 2004). Another crucial assumption is decisions to buy or sell of investors cause security prices to adjust rapidly to reflect the new information (Reilly and Brown, 2009).
Based on the range of information made available, the EMH is divided into three forms including weak, semi-strong and strong as indicated in the table below (Redhead, 2008).
Table 1: Forms of efficiency
Source: Pompian (2012)
It can be seen that the strong form is very demanding but it is not impossible indeed (Henderson, 2003). That kind of information might be accessed by the company’s CEOs or some special analysts who quickly react to it by buying or selling the shares to gain excess returns (Ilmanen, 2011). According the EMH, their behaviour will immediately cause the price to adjust leading to the state when the price reflects all available information.
- IMPLICATIONS FOR MANAGERS AND INVESTORS
As the main players in the financial market, the EMH has significant implications for both large companies and investors (Burton, Nesiba, Brown, 2010). Entering the market, companies are seeking for capital while investors are investing to make profit (Choudhry, 2001). Though their purposes are different, both expect to beat the market and other players to gain excess benefits. To investors it means to gain abnormal returns from their investments while businesses aim to get access to capital at such a low cost as possible (Redhead, 2008). Yet the EMH implies that it would be impossible for either one.
As far as managers are concerned, it is suggested that there is no point in using market timing when issuing new shares as information is fully known by the market (Shanken and Smith, 1996). For example, even if a company chooses to launch the new issue of share after releasing its positive income statement, it would not help increase the share value any further as the news has been already incorporated into the current price by the time the preparation of the statement was finished.
Furthermore, the EMH also implies that managers cannot defraud investors by giving out false information (Brigham and Daves, 2007). Therefore, it is suggested that managers would better focus on improving its operating activities in order to increase its share value instead of using those techniques.
From the investors’ viewpoint, it implies that the share price reflects accurately the company’s performance. Hence, if they are expecting to earn profit purely from its intrinsic value and dividend payments, they can base on the market price to make investment decisions (Henderson, 2003).
Furthermore, another fundamental implication of the EMH is that investors cannot gain abnormal return by exploiting information searching for mispriced stocks since they are fairly priced (Howells and Bain, 2005). In addition, various techniques to analyse the information are of no use (Ang, Goetzmann and Schaefer, 2011). For instance, technical analysis is useless in the weak form efficient market while fundamental analysis does not have any value if the semi-strong form holds (Ilmanen, 2011) (see app. 2.2).
What’s more, even the use of professional investment management would be unnecessary if the strong form holds (Reilly and Brown, 2009). However, it might be useful in the weak form or semi-strong form efficient markets where knowing private information is still an advantage.
Finally, there is no value of trading stock back and forth while all security is fairly priced (Cuthbertson and Nitzsche, 2004). Hence, it can be suggested that “buy and hold” is the best strategy since it helps minimise the transaction costs (Strong, 2009).
- IMPORTANCE
Based on the implications of EMH, it is likely to be of great importance for both company’s managers and investors to take the theory into account when making decisions (Wärneryd, 2001). As far as they are concerned, it is critical to determine the form of efficiency of the market in order to develop appropriate responses. For example, it would help investors to choose the most appropriate option among different investment strategies that ensures the same returns while minimising the cost incurred.
- CONCLUSION
It can be said that to some extent the efficient market hypothesis has helped explain the way the financial markets work in regards to the use of information. It is stated that in the efficient market, the security price reflects all available information. Besides, the amount of information concerned increases in three forms of EMH including weak form, semi-strong form and strong form. Though the effect cannot be exactly the same as described in theory since in reality the markets are not as perfect as it is assumed in the EMH.
Furthermore, the hypothesis has significant implications for two main players in the market including companies and investors. The main idea is that both companies and investors cannot beat the market to gain excess benefits by exploiting information. In the former’s case, it means that companies cannot increase the market value of their shares to attract investors by using market timing or manipulating information. In fact, it is suggested to improve its performance to increase the real share value. Meanwhile, investors do not need to use active investment strategies to analyse information searching for abnormal return opportunity from mispriced stock. Instead, they are advised to use buy and hold strategy to minimise the transaction cost.
REFERENCES
Books
Ang, A., Goetzmann, W. N. and Schaefer, S. M. (2011) The Efficient Market Theory and Evidence: Implication for Active Investment Management. Hanover: now Publishers Inc.
Aronson, D. (2011) Evidence-Based Technical Analysis. New York: John Wiley & Sons Ltd.
Bailey, R. E. (2005) The Economics of Financial Markets. New York: Cambridge University Press
Baker, H. K. and Martin, G. S. (2011) Capital Structure and Corporate Financing Decisions. New York: John Wiley & Sons, Inc.
Bierman, H. (2003) The capital structure decision. Norwell: Kluwer Academic Publishers
Block, C. D. (2008) Corporate Taxation: Examples and Explanations. New York: Aspen Publishers. 3rd ed.
Boone, L. E. and Kurtz, D. L. (2011) Contemporary Business. 14th ed. John Wiley & Sons Inc.
Brigham, E. F. and Daves, P. R. (2007) Intermediate Financial Management. Mason: Thomson Higher Education. 9th ed.
Brigham, E. F. and Houston, J. F. (2012) Fundamentals of financial management. Mason: South Western Cengage Learning. 7th ed.
Burton, M., Nesiba, R. and Brown, B. (2010) An Introduction to Financial Markets and Institutions. New York: ME Sharpe, Inc.
Choudhry, M. (2001) The bond and money markets: strategy, trading, analysis. Oxford: Butterworth-Heinemann
Cuthbertson, K. and Nitzsche, D. (2004) Quantitative Financial Economics: Stocks, Bonds and Foreign Exchange. Chichester: John Wiley & Sons Ltd. 2nd ed.
Frank, M. Z. and Goyal, V. K. (2008) Tradeoff and Pecking Order Theories of Debts in Eckbo, B. E. (ed.) Handbook of corporate finance: empirical corporate finance. Amsterdam: North-Holland
Graham, J., Smart, S. B. and Megginson, W. L. (2010) Corporate Finance: Linking Theory to What Companies Do. Mason: South Western Cengage Learning. 5th ed.
Gray, G., Cusatis, P. and Woolridge, J. R. (1999) Streetsmart guide to valuing a stock. New York: The McGraw-Hill Companies, Inc.
Guerard, J. B. and Schwartz, E. (2007) Quantitative Corporate Finance. New York: Spring Science and Business Media, Inc.
Hawawini, G. and Viallet, C. (2011) Finance for Executives: Managing for Value Creation. Mason: South Western Cengage Learning. 4th ed.
Henderson, T. M. (2003) Fixed Income Strategy: A Practitioner's Guide to Riding the Curve. Chichester: John Wiley & Sons Inc.,
Howells, P. and Bain, K. (2005) The Economics of Money, Banking and Finance. Harlow: Pearson Education Ltd.
Ilmanen, A. (2011) Expected Returns: An Investor's Guide to Harvesting Market Rewards. Chichester: John Wiley & Sons Inc.,
Jennings, M. (2006) Business: its legal, ethical, and global environment. 7th ed. London: Thomson Learning
Keown, A. J., Martin, J. D., Petty, J. W. and Scott, D. F. (2003) Foundations of finance: the logic and practice of financial management. Harlow: Pearson Education, Inc. 4th ed.
Koller, T., Goedhart, M. and Wessels, D. (2010) Valuation: Measuring and Managing the Value of Companies. Hoboken: John Wiley & Sons, Inc., 5th ed.
Martynova, M. and Renneboog, L. (2011) Sources of Financing and Means of Payment in M&A in Baker, K. and Kiymaz, H. (eds.) The Art of Capital Restructuring. Hoboken: John Wiley & Sons, Inc.
Megginson, W. L. and Smart, S. B (2008) Introduction to Corporate Finance. Mason: South Western Cengage Learning
Melicher, R. W. and Norton, E. A. (2011) Introduction to Finance: Markets, Investments, and Financial Management. New York: John Wiley & Sons, Inc.
Monks, R. and Lajoux, A. R. (2011) Corporate Valuation for Portfolio Investment. Hoboken: John Wiley & Sons, Inc.
Pompian, M. (2012) Behavioral Finance and Wealth Management. Hoboken: John Wiley & Sons Inc., 2nd ed.
Pride, W. M., Hughes, R. J. and Kapoor, J. R. (2008) Business. Boston: Houghton Mifflin Co.
Redhead, K. (2008) Personal Finance: A Guide to Money Management. New York: Routledge
Reilly, F. K. and Brown, K. C. (2009) Investment Analysis and Portfolio Management. Mason: South Western Cengage Learning. 10th ed.
Sheeba, K. (2011) Financial Management. New Delhi: Dorling Kindersley Pvt Ltd.
Shim, J. K. and Siegel, J. G. (2008) Financial Management. New York: Barron Educational Series, Inc. 2rd ed.
Strong, R. A. (2009) Portfolio Construction, Management, and Protection. Mason: South Western Cengage Learning. 5th ed.
Wärneryd, K. E. (2001) Stock-Market Psychology: How People Value and Trade Stocks. Cheltenham: Edward Elgar Publishing Ltd.
Working papers
Altunbaş, Y., Kara, A. and Ibáñez, D. M. (2009) Large Debt Financing: Syndicated Loans Versus Bonds. Working paper No. 1028
Öztekin, Ö. (2011) Capital Structure Decisions Around the World: Which Factors are Reliably Important? Working paper 08/2011
Journal articles
Baker, M. and Wurgler, J. (2002) Market Timing and Capital Structure. The Journal of Finance (01). pp.1-32
Sbeiti, W. (2010) The Determinants of Capital Structure: Evidence from the GCC Countries. International Research Journal of Finance and Economics. 47. pp.54-79
Shahjahanpour, A., Ghalambor, H. and Aflatooni, A. (2010) “The Determinants of Capital Structure Choice in the Iranian Companies”. International Research Journal of Finance and Economics. 56
Shanken, K. and Smith, C. W. (1996) Implications of Capital Markets Research for Corporate Finance. Financial Management. 25. pp. 98-104
Websites
Forbes (2012) Google’s Annual Data. Available at: (Accessed 15 April 2012)
Honda (2012) Annual Report 2011. Available at: (Accessed 15 April 2012)
McDonald’s (2012) Annual Report 2011. Available at: (Accessed 8 April 2012)
Walt Disney (2012) Annual Report 2011. Available at: (Accessed 16 April 2012)
YUM! (2012) Annual Report 2011. Available at: (Accessed 8 April 2012)
APPENDICES
- Part A
- Cost of capital
In order to calculate the overall cost incurred from its capital structure, a common method is to use WACC (weighted average cost of capital). As Bierman (2003) states, it is “the sum of after tax costs of different types of capital each weighted by its proportion in the capital structure”.
The cost of different sources of capital and the WACC are calculated as below
Where I is interest, T is tax rate
-
Cost of common stock: KE=D/Pe
Where D is the annual dividend payment, PE is the market price of the share
-
Cost of preferred stock: Kp = D/PP
Where D is the annual dividend payment, PP is the market value of the share
- Cost of retained earnings
Kr = KE
Note: retained earnings are kept within the company to reinvest instead distributing to shareholders so it can still be considered as their investment in the company. Therefore, the cost of retained earnings is equal the cost of common stock.
WACC = [KE * E/C] + [KL * D/C]
Where E is the market value of the firm's equity,
D is the market value of the firm's debt
C = E + D
E/C = percentage of financing that is equity
D/C = percentage of financing that is debt
- Theories
- MM theory
There is a range of assumptions set in the MM theory including:
- The market is perfect and there are no inefficiencies such as transaction costs and taxes
- Both companies and investors can borrow at the same rate (Frank and Goyal, 2008).
- A company has a particular set of expected cash flows and investors and firms have equal access to the financial market (Bailey, 2005). Hence, choosing different sources of capital for use simply means dividing cash flows between investors
- Trade-off theory
According to the theory, the costs and benefits of using debt include:
- Tax deductibility of interest rates
- Mitigate manager-shareholder conflict/ agency problem (control the use of free cash flow of managers – reduce the amount of cash under management control)
- Cost of financial distress:a firm uses excessive debt and is unable to meet the interest and principal payments
- Agency cost (of debt and of equity) triggered by conflicts between shareholders and debtors: Because the profit of investors is fixed regardless of the firm’s performance they only want managers to take safe projects. However, managers want to take high risk in order to earn high return (Melicher and Norton, 2011).
- Pecking order theory
According to the pecking order theory, managers are assumed to know the true future value of the firm better than anyone else (Melicher and Norton, 2011). Furthermore, it is believed that managers tend to act in the interest of old shareholders who are assumed to be passive.
- Data
- Honda and Walt Disney
- YUM! and McDonald’s
Note: Both companies use stock issue but it only amounts for a tiny proportion of capital, which is virtually 0% (YUM! And McDonald’s, 2012).
- Walmart
Note: the figures were recorded in March each year (Walmart, 2012).
- Part B
- Types of efficiency
Market efficiency can be divided into three types including operational, allocative and informational efficiency (Redhead, 2008).
- Operational efficiency: relates to costs and risks involved in the process of carrying out the transactions
- Allocative efficiency: concerned with whether funds are allocated to its most productive use
- Informational efficiency: refers to the way in which information is used
- Technical and fundamental analyses
Technical analysis is a method of forecasting the price movements of securities by studying their movements in the past (Monks and Lajoux, 2011).
Fundamental analysis is a method used to determine the value of a stock by analysing the financial data that is fundamental to the company such as business ratios (Gray, Cusatis, and Woolridge, 1999).