Dividend Policy & Capital Structure

Table of contents

“Comparative Analysis of Dividend Policy & Capital Structure” Prepared For: Lutfur Rahman Senior Lecturer, Department of Business Administration, East West University. Course Code: FIN-435 Course Title: Managerial Finance Prepared By: Md. Habibur Rahman Utpal Kumar Ghosh ID: 2006-2-10-175 ID: 2006-2-10-179 Date of Submission: August 11, 2009 East West University 43, Mohakhali C/A, Dhaka-1212 Introduction .

Objectives of the Report: The broad objective of the report is to build a strong familiarity about the Dividend policy & Capital Structure to measure the performance of the company. By preparing this report we are trying to acquaintance of the overall dividend policy & capital Structuring. Moreover the superficial objective of the report is to acquire knowledge about the insights of interpreting the ratios. Preparing this report such kind of topic is extremely beneficial for us as the students of finance. Scope of the Report: This report is based on the dividend policy & capital Structuring.

Through this report we are try to focus on the area related to the financial performance of the companies. We particularly focus on dividend policy & capital Structuring and related ratios; as those are the major indicator of the performance assessment of a firm. Methodology: For execution of the report we use MS office software. Topic of the report is not permitting us to input data from primary sources. As the report must be factual, the data source of this report is basically secondary sources. We gathered our relevant data from the different periodicals published by the two cement companies.

We also collect our relevant information from different books as well. We also collected some data from the internet to broaden our scope of analysis. Dhaka Stock Exchange websites, Meghna Cements mills website, Confidence Cement Ltd, websites are few of them.

Limitations:

  1. Inadequate knowledge in studying reports.
  2. Lack of in-depth understanding of certain terms and concepts prevented us from going into details.
  3. Lacks of research.
  4. Unavailability of updated data.
  5. Time limitation is also been there.
  6. Lack of information and coordination. Confidentiality of data was another imperative barrier that was faced during the conduct of this study.

Dividend: Dividends are payments made by a corporation to its shareholders. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be paid to the shareholders as a dividend. Many corporations retain a portion of their earnings and pay the remainder as a dividend.

For a joint stock company, a dividend is allocated fast as a fixed amount per share. Therefore, a shareholder receives a dividend in proportion to their shareholding. For the joint stock company, paying dividends is not an expense; rather, it is the division of an asset among shareholders. Public companies usually pay dividends on a fixed schedule, but may declare a dividend at any time, sometimes called a special dividend to distinguish it from a regular one. Cooperatives, on the other hand, allocate dividends according to members’ activity, so their dividends are often considered to e a pre-tax expense. Dividends are usually settled on a cash basis, as a payment from the company to the shareholder. They can take other forms, such as store credits (common among retail consumers’ cooperatives) and shares in the company (either newly-created shares or existing shares bought in the market. ) Further, many public companies offer dividend reinvestment plans, which automatically use the cash dividend to purchase additional shares for the shareholder.

Such dividends are a form of investment income and are usually taxable to the recipient in the year they are paid. This is the most common method of sharing corporate profits with the shareholders of the company. For each share owned, a declared amount of money is distributed. Thus, if a person owns 100 shares and the cash dividend is $0. 50 per share, the person will be issued a check for 50 dollars. ? Stock dividends are those paid out in form of additional stock shares of the issuing corporation, or other corporation (such as its subsidiary corporation).

They are usually issued in proportion to shares owned (for example, for every 100 shares of stock owned, 5% stock dividend will yield 5 extra shares). If this payment involves the issue of new shares, this is very similar to a stock split in that it increases the total number of shares while lowering the price of each share and does not change the market capitalization or the total value of the shares held. ? Property dividends are those paid out in the form of assets from the issuing corporation or another corporation, such as a subsidiary corporation.

They are relatively rare and most frequently are securities of other companies owned by the issuer, however they can take other forms, such as products and services. ? Other dividends can be used in structured finance. Financial assets with a known market value can be distributed as dividends; warrants are sometimes distributed in this way. For large companies with subsidiaries, dividends can take the form of shares in a subsidiary company. A common technique for “spinning off” a company from its parent is to distribute shares in the new company to the old company’s shareholders. The new shares can then be traded independently.

Types of Dividend Policies:  Constant-Payout-Ratio Dividend Policy: A dividend policy based on the payment of a certain percentage of earnings to owners in each dividend period.

Regular Dividend Policy: A dividend policy based on the payment of a fixed-dollar dividend in each period. Often firm that use this policy increase the regular dividend once a proven increase in earning has occurred.

Low-Regular-and-Extra Dividend Policy: A dividend based on paying a low regular dividend, supplemented by an additional dividend when earnings are higher than normal in a given period. Argument for Dividend Relevance : Gittman (10th edition) divided stock into two types, such as common stock and preferred stock. He also showed that dividends are the outcome of investment. So, common stocks are an ownership claim against primarily real or productive asset (Higgins, 1995), but he also said that if the company prospers, stockholders are the chief beneficiaries, if it falters, they arc the chief losers. Smith (1988) presented that stocks arc one of the most popular forms of investment.

People buy stocks for various reasons: Some are interested in the long-term growth of their investment by buying low priced stock of a new company in the hope of substantially growth of share price over the next few years. Another reason he suggested that in a well established firm stockholders expect the stock growth will be stable over the long run. (Smith. 1988). Stockholders expect dividend but it is not promised (Gitman, 10th edition). Common stocks are hold by true owners of the business. Sometimes they are known as residual owners’ as they receive whatever left after winding up of the company (Gitman, 10th edition; Higgins 1995).

Another type of stock is known as publicly owned stock. Common stock owned by a broad group of unrelated investors or institutional investors is called as publicly owned stock. However, all common stock of a firm owned by a small group of investors is denoted as closely owned stock. When all the stock is owned by a single person is known as privately owned stock. Due to the limit of number of share, stock can be classified in to four types. Such as authorize share, outstanding share, treasury stock and issued stock (Gitman, 10th edition). Authorized shares represent the maximum number of shares a firm allows to issue.

Outstanding shares are hold by public. Treasury stock is repurchased by firm itself and it is no longer considered as outstanding share. Issued shared are the shares that have been put into circulation. Recently stock repurchase option is very popuLar as it is able to increase stock value by decreasing outstanding stock number (Port. 1976). Port also suggested that firms should avoid issuing stock to pay dividend as they slow down company growth. According to Short and Wclsch (1990), Johns (1998) and Port (1976), a dividend is a usually distributed in cash form to stock holders of a corporation approved by the board of director.

It may also include stock dividend or other forms of payment. A stock dividend represents a distribution of additional shares to common stockholders (Higgins, 1995). On the other hand. Ross et al. (2005) divided earnings into two parts; either it is retained or paid as dividend. Whereas Wild et al. (2001), Johns (1998) and Kieso et al. (2004) argued that retained earnings are the primary source of dividend distribution to the stockholder. Dividends are only cash payments regularly made by corporations to their stockholders (Johns, 1998).

He also specified that they are decided upon the declaration by the board of the directors and can range from zero to virtually any amount the corporation can afford to pay. 4|Page Jones (2005) said that dividends are the only cash payment a stockholder receives directly from firm and these are the foundation of valuation for common stocks. Stock price response to an unexpected dividend change announcement is related to the dividend preferences of the marginal investor in that firm where other things remaining same (Denis et al. , 1994). In addition, a company. Which changes dividend policy, is expected to xperience upward or downward trends in share returns (Gunasekarage et al. , 2006). They also said that for the initiating firms, the share prices continued to rise even after the initial public offering (IPOs). Higgins (1995) said that if the company will have less money to invest or it will have to raise more money from external sources to make the same investments stockholders claim on future cash flow, which reduces share price appreciation. Moreover, during dividend announcement period stock price also fluctuate due to announcement of dividend. Mulugetta et al. 2002) examined the impact of Standard and Poor are ranking changes on stock prices. In addition, Affleck-Graves & Mendenhall (1992) found that stock price reacts after 8 days on average up to 54 days of such earning announcement. With this believe, Hampton (1996) said that value of stock increase by more dividend and share remain undervalued by lower dividend policy. In addition, he also showed that there are two schools of thought regarding with the effect of dividend on stick price, one is dividends do not affect market price and the another one is dividend policies have profound effects on a firm’s position in the stock market. Benartzi et al. (1997), Ofer and Siegel’s (1987) and Bae (1996) found a positive correlation between share price and dividend. Furthermore. Campbell and Shiller (1988) found a relationship between stock prices, earnings and expected dividends and he drives a conclusion that earnings and dividends is powerful in predicting stock returns over several years. Wilkic analyzed a 76 months share price index and dividend announced. He found a correlation coefficient. Which was under 0. 7 for the period 76 months and he also get that the maximum value of the regression coefficient being reached after 79 months.

Moreover. ShilLer (1984. 1989) recommended investors in his study to buy the stocks when price is low relative to dividends and to sell stocks when it is high payoffs. On the other hand to their opinion, Jensen and Johnson (1995) suggested that, dividend cut results reduction in share price. More interesting matter is that if capital markets are perfect, dividends have no influence on the share price (MilLer and Modgliani, 1961). MiLler and ModgLiani (1961) also states that if the market is imperfect, dividend may affect stock price.

Current Practices of Dividend Policy in Bangladesh:

As Bangladesh is a developing country, the corporate culture is growing very slightly in our country. Dividend policy is a major financing decision that involves with the payment to shareholders in return of their investments. Every firm operating in a given industry follows some sort of dividend payment pattern or dividend policy and obviously it is a financial indicator of the firm. Thus, demand of the firm’s share should to some extent. Dependant on the firm’s dividend payment pattern. Many investors like to watch the dividend yield, which is calculated as the annual dividend income per share divided by the current share price.

The dividend yield measures the amount of income received in proportion to the share price. If a company has a low dividend yield compared to other companies in its sector, it can mean two things: (1) the share price is high because the market reckons the company has impressive prospects and isn’t overly worried about the company’s dividend payments, or (2) the company is in trouble and cannot afford to pay reasonable dividends. At the same time, however, a high dividend yield can signal a sick company with a depressed share price.

Dividend yield is of little importance for growth companies because, retained earnings will be reinvested in expansion opportunities, giving shareholders profits in the form of capital gains. 5|Page MEGHNA CEMENT limited (MCML) ? OVERVIEW OF THE COMPANY The Meghna Cement Mills Limited (MCML) was the first undertaking Bashundhara Group in the manufacturing sector. This enterprise produces world-class cement and, as a testimony to this, stands the fact that the concern has been awarded the ISO-9001 certification for sustained quality control effort. The Company markets its cement under the registered trademark of King brand”.

Interpretation:

According to the above information it is visible that the company is following regular dividend policy (according to definition as given above). From 2004-2007 though the profit has increased subsequently but it was not sufficient for payment of dividend at a rate of the preceding years to all share holders of the company.

For upholding the benefit and interest of general public the sponsors shareholders/Directors have decided to give up their dividend during those years under review of maintaining 31 consistent dividend policy for the 30 general public shareholders. So the 29 board of directors of the company 28 pleased to recommend cash dividend 27 26 @ 25% on par value of shares for the 25 public share holders taking into 24 consideration the profit and liquidity 23 position of the company during that 22 period under reviewed. 004 2005 2006 2007 2008 But In 2008, the EPS increased by almost Total Dividend 25 25 25 25 30 Paid 50% from previous year. So the directors ? Dividend decided to increase the dividend percentage to 30% instead of 25%. The company paid 25tk per share as dividend from 2004-2007 but in 2008 as the income increased by almost 50% than the previous year it paid a dividend of 30tk for the earnings of 2008. Total Dividend Paid Share Price(MKT. ) 400 350 Share Price (MKT. ) 300 250 200 The dividend policy that followed by the company has an impact on its share price. 150 As the graph shows the share price has 100 an increasing trend.

As the company 50 declared 25% dividend per share from 0 2004-2005 this was more than its EPS so 2004 2005 2006 2007 2008 the share price increased and reached to Share Price(MKT. ) 279 348 246 277 352 350tk. But in 2006- 2007 the dividend was lower than its EPS so the share price declined and again increased in 2008 with an increase in dividend. 7|Page Confidence Cement Limited (CCL)

Overview of the companies

Confidence Cement Limited is the first private sector cement manufacturing company in Bangladesh established in early 90’s with having 4,80,000 M/T annual production capacity at Chittagong, 16 K.

M away from Chittagong port, besides Dhaka Chittagong highway. CCL is the first ISO-9002 certified cement manufacturing in Bangladesh. It has a unique management system in quality Assurance, Marketing, Sales, and Procurements. It manufactures ordinary Portland cement. Our company aims to be the number one cement manufacturing company in Bangladesh, through continuous development and by producing high & consistent quality cement to meet all customers requirement at all time.

To achieve these objectives CCL uses modern machineries, calibrated testing equipment’s, computerized packing & raw materials mixing devices in its production process. Additionally the company frequently arranges internal & external training program for the staff of all level to develop the potentiality and skill of its human resources. CCL is always keen to keep the customers satisfied by proving the best possible service.

Basic Information: Market Category:

Listing Year:1995 Authorized Capital in BDT (mn) Outstanding Capital in BDT (mn) Face Value Total no. of Securities Share Percentage Graph 2: The Market price of share of MCML in 2008-2009 (Highest Value: 627. 25, Lowest Value: 268. 5) 8|Page ? Dividend Policy Followed By Confidence Cement Ltd: Earnings per share .

Year End P/E -9. 50 10. 78 6. 40 13. 30 n/a % Dividend % Dividend Payout Ratio 46% 69% 54% Year 2004 2005 2006 2007 2008 5. 00 5. 00 15. 00 15. 00 10%B Interpretation From the above information it is visible that the company follows the regular dividend policy. That is the policy of the company is to pay a perticular dividend amount and if there’s higher earning for perticular year and if earning per share increases they also increase their Dividend amount. In 2004, due to tough competition the company couyld not earn desiered profit. This year EPS is tk(12. 65).

However considering the 16 interest of shareholders the board of 14 directors decleared 5% dividend from 12 dividend equalization fund. In 2006 and 10 2007 , as the EPS increases than the 8 previous year so the board of director 6 decided to pay dividend of 15% per 4 share. But in 2008 the company 2 decleared a 10% bonous dividend which indicates the company has used 0 2004 2005 2006 2007 their earnings for farther investment so the company didn’t give any cash % Dividend 5 5 15 15 dividend. Dividend From the graph it is easily indentifiable that the share price had strong relationship with dividend.

In 2004 the company decleared a dividend of 5% per share when it had a EPS of (12. 65) the increased. In 2006-2007 for an increased dividend of 15% the share price also maxmized and again declined in 2008 due to 10% Bonous dividend decleared by the company. Share Price (MKT) 400 350 300 250 200 150 100 50 0 Share Price (MKT) 2004 289 2005 250 2006 225 2007 368. 8 2008 318 9|Page Capital Structure Capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities.

A firm’s capital structure is then the composition or ‘structure’ of its liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm’s ratio of debt to total financing, 80% in this example, is referred to as the firm’s leverage. In reality, capital structure may be highly complex and include tens of sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e. g. by taking a long term loan etc.

The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it assumes away many important factors in the capital structure decision. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result provides the base with which to examine real world reasons why capital structure is relevant, that is, a company’s value is affected by the capital structure it employs.

These other reasons include bankruptcy costs, agency costs, taxes, information asymmetry, to name some. This analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of the firm. 10 | P a g e Capital Structure Meghna Cement Mills LTD. Items Total Current Asset Fixed Asset Total Asset Current Liability Long term Debt Total Debt/ Total Liability Total Equity Share Outstanding Net Income Earnings Before interest and tax Retained Earnings Interest Charges/ Financial Expenses Market Price Per Share Debt to Total Assets  Year 2004

Interpretation:

According to the above information we can say that the company has a higher debt in its capital structure. As its Debt/Asset ratio shows from 2004-2008 it has been maintaining almost same amount of debt which is 75% of total assets in its capital structure. It indicates the company is a highly leveraged firm and more risky in terms of debt.

According to Long term debt ratio the company maintained a long term debt of around 33% from 2004 – 2008, which also indicates that the company had higher short term debt than it’s long term debt. Time interest earn ratio indicates that the company has enough liquid asset to payback its interest expenses. However Debt/Equity ratio shows the company had a capital structure containing higher debt than its equity. The total debt amount fluctuates throughout this given 5 years but it remains almost three times than its total equity.

Capital Structure: Confidence Cement Mills LTD.

Total Current Asset Fixed Asset Total Asset Current Liability Long term Debt Account Payable/ Trade Creditors Total Debt/ Total Liability Total Equity Share Outstanding Net Income Earnings Before interest and tax Retained Earnings Interest Charges/ Financial Expenses Market Price

Interpretation:

According to the above information we can say that the company has a lower debt in its capital structure.

As its Debt/Asset ratio shows from 2004-2008 it has been maintaining increasing amount of debt in its capital structure which was 35. 1% in 2004 & reached to45. 5% in 2008. It indicates the company is a moderately levered firm and risky in terms of debt. According to Long term debt ratio the company maintained nonexistence long term debt only 2% in 2006, which also indicates that the company had higher short term debt than it’s long term debt. Time interest earn ratio indicates that the company has did not had enough earning to payback of its interest other than the year of 2006 &2007.

However Debt/Equity ratio shows the company had a capital structure containing lower debt than its equity. The total debt amount remained almost constant throughout this given 5 years which is very negligible than its total equity.

Comparative Analysis

Divedend Policy Comparative Financial Data Analysis The financial data we gathered to find out the relationship between various variables with price of two different cement companies arc given. We attempted to explore some conclusion on the behavioral pattern of changing the share market price due to dividend, dividend policies followed.

The data are extracted from annual reports of two selected companies that are The Meghna Cement Mills Limited (MCML) and Confidence Cement Limited . The annual data of these companies has been taken from the annual reports and other annual publications of Dhaka Stock Exchange. Confidence Cement Ltd Net Net Year % Asset Profit End Dividend Value After P/E Per Tax Share (mn) Meghna Cement Ltd Net Year % Profit End Dividend After P/E Tax (mn) Industry Average Net Year % Profit End Dividend After P/E Tax (mn) Year Earning per share % Dividend Payout Ratio Earning per share Net Asset Value Per Share Dividend Payout Ratio Earning per share Net Asset Value Per Share % Dividend Payout Ratio .

Interpretation: Earnings Per Share: The industry average of EPS is tk. for the year 2004, 2005,2006,2007,2008 consecutively. In 2004 EPS of Meghna Cement Ltd was 11. 57 & after that EPS has increased and reached up to 65. 86 in 2008, So that, the graph shows that the EPS of Meghna Cement is well above of the industry average EPS. In 2004 EPS of Confidence Cement Ltd was (12. 65) & after that EPS has increased and reached up to 27. 63 in 2007. After that EPS has decreased again and reached to (14. 8)So that, the graph shows that the EPS of Confidence Cement is well below of the industry average EPS. Comperative EPS

Confidence – Cement Ltd Industry Average -44 So, according to our Comparative EPS analysis, we can easily say that Meghna Cement Ltd. is in the best position where Confidence Cement Ltd is the worst position.  In 2004 P/E ratio of Meghna Cement Ltd was 24. 21 & after that P/E has decreased gradually and reached to 5. 35 in 2008, so according to Industry average, the graph shows that the P/E ratio of Meghna Cement is well above up to 2006 of the industry average P/E, then in 2007 it’s ratio falls below the industry average and in 2008 equal to industry average due nonexistence of P/E ratio of Confidence Cement in 2008. Comparative P/E Ratio  Confidence Cement Ltd 2004. Average (9. 5), after that EPS has increased to 10. 78 in 2005, then again decrease in 2006 and in 2007 it has increased to 13. 3. In 2008 there is no existence of P/E due to no cash dividend declared by the company. So, according to Industry average, the graph shows that the P/E ratio of Confidence Cement is well below up to 2006 of the industry average P/E, then in 2007 its ratio rise above the industry average and in 2008 no P/E as discussed earlier.

So, according to our Comparative P/E ratio analysis, we can easily say that Meghna Cement Ltd. is in the best position where Confidence Cement Ltd is the worst position.

Comparative Dividend Dividend Per Share: The industry average of DPS is tk. and 30 for the year 2004, 2005,2006,2007,2008 consecutively. From 2004 to 2007 DPS of Meghna Cement Ltd was 25 & after that DPS has increased to 30 in 2008 due to extra earning as discussed before. So according to Industry average, the graph shows that the DPS of Meghna Cement is well above up to 2007 of the industry average DPS.

In 2008 DPS is equal to industry average due nonexistence of Dividend of Confidence

From 2004 to 2005 DPS of Confidence Cement Ltd was 5 & from 2006-2007 DPS has increased to 15 in 2008 due to extra earning as discussed before. So according to Industry average, the graph shows that the DPS of Confidence Cement is well below up to 2007 of the industry average DPS.

In 2008 there in no DPS of Confidence Ltd. due nonexistence of Dividend. So, according to our Comparative DPS analysis, we can easily say that Meghna Cement Ltd. is in the best position where Confidence Cement Ltd is the worst position. Dividend Payout Ratio: The industry average of Payout ratio is 216, 105, 72, 54, and 46 for the year 2004, 2005,2006,2007,2008 consecutively. In 2004 Payout ratio of Meghna Cement Ltd was 216 which is equal to the industry average payout ratio because of non existence of payout ratio of Confidence Cement Ltd. in 2004.

After that payout ratio has decreased gradually and reached to 46 in 2008, so according to Industry average, the graph shows that the payout ratio of Meghna Cement is equal to the industry average payout ratio in 2004, then it’s ratio rise above the industry average up to 2006 and in the last two years equal to industry average. Compative Payout Ratio Compative Payout Ratio 250 250 200 200 150 150 100 100 50 50 00 Confidence Confidence Cement Ltd Cement Ltd Meghna Meghna 216 216% Cement Ltd Cement Ltd Industry Industry 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008 46 46 164 164 69 69 75 75 54 54 54 54 46 46 46 46 16 216 105 105 72 72 54 54 Average Average In 2004 there was no Payout ratio of Confidence Cement Ltd as mentioned earlier. After that payout ratio has increased in 2006 and then again decreased in 2007. In 2008 there is no payout ratio because there is no cash dividend. So according to Industry average, the graph shows that the payout ratio of Confidence Cement is well below compare to the industry average payout ratio in 2005 & 2006, and then its ratio is equal to the industry average in 2007. In 2008 there is no payout ratio as discussed before.

So, according to our Comparative DPS analysis, we can easily say that Meghna Cement Ltd. is in the best position where Confidence Cement Ltd is the worst position.

Debt/equity Ratio of Meghna Cement Ltd is 368%, and Confidence Cement Ltd. is 1%. So, according to industry average Confidence Cement is in the best position Meghna Cement Ltd is in the worst position. Time Interest Earned: The industry average of Time Interest Earned for the year 2008 is 0. 5385. Time interest earned for Meghna Cement Ltd is 2. 79; Confidence Cement Ltd. is -2. 0823. So, according to industry average Meghna Cement is in the best position and Confidence Cement Ltd is in the worst position. Return on Assets: The industry average of Return on Assets for the year 2008 is 2%.

Return on Assets of Meghna Cement Ltd is 5. 1%, and Confidence Cement Ltd. Is (2. 5%). So, according to industry average Meghna Cement is in the best position Confidence Cement Ltd is in the worst position. Return on Equity: The industry average of Return on equity for the year 2008 is 0. 26%. Return on Equity of Meghna Cement Ltd and Confidence Cement Ltd. Is (4. 5%).

References

Intermediate Accounting ( 11th Edition),Donald E. Kieso ? The Analysis and Use of Financial Statements(3rd Edition),Gerald I. White ? Scott Besely & Eugene F. Brigham, “Essentials of Managerial Finance”, Thirteenth Edition,  Thomson South-Western, Ohio, 2006 www. bashundharagroup. com/mcml/ www. confidencegroupbd. com/cement/ www. dsebd. org www. wikipedia. com 19 | P a g e

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Verizon Communications Inc.: Capital Structure Choices

Verizon raise funds through internal and external means. Internal means is through the allocation of net cash generation from its operations for allocation on investments and expansion. External means involves debt financing and equity financing. Debt financing refers to taking out loans from financial institutions using its assets and financial/business standing to support its credit rating. Equity financing refers to the sale of shares or stocks to investors and partners who become part owners of the company.

To a certain extent, Verizon also utilizes mergers and acquisitions to boost its capital. Verizon merged with GTE in 2000 and acquired MCI in 2005 to increase its capital assets. (Verizon, 2009a) 2. Where do they fall in the continuum between debt and equity? The long-term debt-equity ratio of Verizon is 3. 85 as of December 2008. This value represents total liabilities of Verizon at USD160. 646 million and total shareholder’s equity of USD41. 706 million (Hoovers, 2009; Verizon, 2009b). The debt-equity ratio determines the extent that the company utilizes debt or equity financing in raising funds.

A high value means greater debt financing relative to equity financing while a low value indicates greater equity financing when compared to debt financing. Since Verizon has more funds raised through debt financing, then the company falls nearer debt financing. 3. How large, in qualitative or quantitative terms, are the advantages to this company from using debt? Debt financing enabled Verizon to generate a greater amount of funds. Its debt-equity ratio indicates that funds raised through debt represent an amount nearly four times greater relative to equity financing.

Majority of the funds raised through debt go to capital expenditures, such as the acquisition of Alltel in 2008 through a USD17 billion worth of credit obtained by the company (Verizon, 2009a). Verizon was also able to pay the outstanding debt of Alltel. Although, Verizon acquired a huge debt, the acquisition made Verizon the largest telecommunications company in the country ousting AT&T. This represents an expansion in customers and service capability that would translate into revenue generation extending towards the long-term to allow Verizon to pay-off its debt and gain profit.

4. How large, in qualitative or quantitative terms, are the disadvantages to this company from using debt? Debt financing also involves risks. Verizon utilized cash generated from its operations to pay off its debt, particularly its short-term debt. The company’s ability to pay off its debt lies in the expectation of continuous increases in its cash from operating activities, which is USD26. 2 million in 2008 up from USD25. 74 million in 2007 (Verizon, 2009c). So far, Verizon has been able to meet its debt obligations (Verizon, 2009a).

However, any downturn in cash generation would pose risks to its ability to pay off its debt. Its acquisitions that eat up most of its acquired credit may not be able to actualize the expected potential since competitors, especially AT&T would respond to the competitive merger. There are also problems in managing a large organization and Verizon already faced a number of controversies with customers involving products and services leading to lawsuits and uncompleted contracts. 5.

From the qualitative trade off, does this firm look like it has too much or too little debt? By comparing the qualitative advantages and disadvantages, Verizon appears to have too little debt. Its debt financing enabled Verizon to become the largest telecommunications company in the United States. When considered on its own, this is a gargantuan achievement when considered relative to the risk involved in debt financing. To date, Verizon has a high credit rating and it continues to meet its debt obligations.

There appears to be no major negative changes in its cash flow given the current developments. The extent of debt relative to the expected returns from investing in mergers and acquisitions also overshadows the risks. The acquisition of Alltel represents a significant growth in Verizon’s customer base and expected to usher revenue growth in the long-term.

References

Hoovers. (2009). Verizon Communications Inc. Retrieved June 21, 2009, from http://www. hoovers. com/verizon/–ID__10197,period__A–/free-co-fin-balance. xhtml?ID=10197&period=A&which=balance&currency=1 Verizon. (2009a). Management’s discussion and analysis of financial condition and results of operations. Retrieved June 21, 2009, from http://investor. verizon. com/financial/annual/2008/mda05_01. html Verizon. (2009b). Selected financial data. Retrieved June 21, 2009, from http://investor. verizon. com/financial/annual/2008/fin01. html Verizon. (2009c). Consolidated statements of cash flows. Retrieved June 21, 2009, from http://investor. verizon. com/financial/annual/2008/fin05. html

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Capital stracture

Key factors that affect structure choice 5. 1. 1 Profitability and variation of profitability Profitability is one of the most tested company characteristics In empirical research regarding companies choice of capital structure. The trade-off theory predicts that higher profitability is associated with Increased debt levels and the reason for this Is twofold.

First, companies achieving high profitability have less risk of financial distress and bankruptcy, so the cost of debt Is lower. Second, higher profitability means that companies can achieve higher utilization of the Interest tax shield by Increasing the amount leverage and hence the promised Interest payments each period. Similarly, Increased debt will serve as a adolescently factor for managers when free cash flow likely Increase with Increased profitability.

However, as dynamic trade- off theory predicts adjustment costs will prevent companies from adjusting the capital structure immediately and the unlikelihood of companies being at their refinancing points at the time of measurement causes the prediction of the found allegations between leverage and profitability to be negative due to the static nature of the determinant analysis. Retained earnings are the favored financing according to the pecking order theory which contradicts the predictions made by trade-off theory.

Higher profitability should enable the company to retain more earnings which is the preferable source of funding, and as such, the amount of leverage needed by the company should decrease. Empirically, profitability is consistently found to be negatively related to leverage, as predicted by both theories. Therefore the following hypothesis is made 5. 1. Asset Tangibility (Asset in place) The thought behind asset tangibility as a determinant is that tangible assets provide more security for potential investors as assets can serve as collateral.

This will reduce the risk for debt holders and ultimately reduce the cost of debt for the companies and they will be able to operate with higher leverage ratios without Incurring higher financial distress costs. Accordingly, the trade-off theory predicts that companies In which tangible assets accounts for a large part of the asset structure should Include larger debt levels than companies with a relatively larger amount of Intangible assets. Furthermore, collateralized debt makes It difficult for Investors to conduct asset substitution as the debt holders have collateral In specific assets.

Therefore agency costs should be lower between shareholders and debt holders, and companies should use more debt relative to the amount of tangible assets they own. The pecking order theory makes the opposite prediction as It suggest that tangibility will generate less information asymmetries between potential Investors and shareholders, and hence the cost of issuing equity will fall, resulting in lower levels of used to predict that the cost of debt will fall as they will now be able to have alliterated debt.

So unless the cost of equity falls below the cost of debt, the pecking order theory implies that companies will use the cheapest sources of funding, debt would still be the preferred funding to equity, at least for moderate amounts of debt. Therefore the prediction of the pecking order theory might not be as unambiguous as some researchers argue. Based on predictions of these theories and the consistent findings in previous empirical research the following relationship between asset tangibility and leverage is expected. 5. 1. Growth Opportunity Growth opportunities calls for a similar reasoning as previously used to explain the predictions of asset tangibility effect on leverage, although with opposing conclusions. The first notion of the relationship between growth opportunities and leverage is made by Myers, who states that the problem of shareholders making suboptimal investment decisions is more severe when a company has more growth opportunities as potential investors cannot value or decide which growth opportunities the company should follow.

The value of a company’s growth opportunities are most likely only valuable to the individual company, or at least less liable to other companies, in which case the costs of financial distress and bankruptcy will be higher for companies with many growth opportunities. With this consideration the trade-off theory suggests a negative relationship between growth opportunities and leverage.

Similarly, with many investment opportunities the earnings before taxes is assumed to be lower in which case companies will not be able to fully utilize the interest tax shields associated with high amounts of leverage. Furthermore, companies having more investment opportunities likely value financial legibility highly, which also reduce the optimal leverage ratio. Contrasting this prediction is once again the pecking order theory, as it predicts a positive relationship between debt and growth opportunities.

The argumentation behind is that growth opportunities involves higher information asymmetries as shareholder are not willing to reveal much information about their investment opportunities, and given that investment opportunities requires investment outlays and thus increasing a company’s financing deficit, companies will issue debt financing and preferable worth-term financing when they experience finance deficits. The empirical results show consistent behavior of the relationship between leverage and growth opportunities and it is expected that this behavior is also present for Danish companies.

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M&M Theory or Capital Structure Irrelevancy Theory

Modigliani and Miller (1958) stated that M&M theory also known as capital structure irrelevancy theory. It stated that financial leverage does not affect the firm’s value in perfect market because without taxes, transactions cost or bankruptcy costs in perfect market and all information are symmetries. (Faruk Ahmeti and Burim Prenaj, 2015) Thus, value of levered firm is same as the value of unlevered firm (Abeywardhana, 2017; Michael, 2017) and financial leverage is direct proposition to cost of equity which risk increase commensurate with high cost of equity.

However, world without taxes were impossible in reality so Modigliani and Miller (1963) introduced Tradeoff Theory of Leverage which emphasised firm’s value increase with leverage in presence of taxes due to tax shield. (Alifani et al., 2013; Borad, 2018) When debt percentage in capital structure increases, WACC can be decreased (Brigham and Ehrhardt, 2010) because interest payment of debt is tax deductible. As a result, ratio of corporate tax is equal to current value of savings from taxes due to WACC decrease whereas firm’s value will increase but high debt may cause high probability in bankruptcy.

As we can see that, Ireka’s debt to equity in year 2017 has increased from 13% to 20% in order to deduct more tax from its debt’s interest payment. Thus, WACC can be reduced by issuing more debt and Ireka’s value was increasing as well. However, Ireka’s high degree financial leverage (DFL) is higher than its leader company of industry-Gamuda. Therefore, it caused increasing in bankruptcy cost due to its debt are unable to covered by its total assets.

Pecking Order Theory is suggested by Donaldson but modified by Myers and Majluf in 1984. Myers and Majluf (1984) stated that pecking order assumes target capital structure is absence and managers rely on internal funds before they consider issuing any securities (Abosede, Adebiyi Julius, 2012) because managers have more insider information than investors and benefit old shareholders. Some company with less accounting transparency will have high asymmetry of information because investors may not know all information about the firm and caused high risk in company.

Information of asymmetries, scrutiny of suppliers of capital and floatation costs can be prevented by using retained earnings to support investment opportunities (Li-Ju Chen and Shun-Yu Chen, 2011) unless its retained earnings is not enough to support the investment. If external funds are required, debt will be chosen before equity to avoid selling under-priced securities and cost of debt is less than equity. (B.T Matemilola and A.N. Bany-Ariffin, 2011)

Ireka had retained earning in year 2015 which is RM13,732,811 so Ireka use its internal fund to expand business and support investments but Ireka did not have any retained earnings in year 2016 and 2017. Ireka had accumulated loss in year 2016 and 2017 which is – RM 30,949,239 and -RM 26,754,578 respectively. Thus, Ireka will prefer to issue more debt in year 2016 to raise its source of capital instead of equity because debt’s cost is lower than equity and ownership of Ireka will not be diluted due to bondholder without voting right.

Capital Asset Pricing Model (CAPM) is developed by William Sharpe (1964) and John Lintner (1965). CAPM attempts to describe the relationship between the investment risk and the investment expected return in order to decide a suitable price for the investment. (Eugene et al., 2004; Yang, 2013) CAPM is an integral part of WACC as CAPM used to calculate cost of equity (David W, 1982; CFI, 2018) and a project-specific discount rate to use in investment appraisal. CAPM-derived project-specific discount rate is used and caused the project IRR lies below the SML of the CAPM. (ACCA, 2018)

Thus, project IRR offers insufficient return to compensate for its level of systematic risk. Hence, project unable to generate profit that can cover its it cost so the profitability of firm will be affected and decrease shareholder’s wealth. Ireka’s rate of return on sales showed that it decreased from -0.57 to -15.03 in 2016. Not only that, ROA and ROE also decrease very much in 2016 due to slow efficient of total assets turnover and receivable turnover.

The decrease in total assets turnover and receivable turnover lead to insufficient of fund and profitability issues. Ireka’s inefficient investment in construction projects will cause decrease in sales and directly lower down the profit. The beta of CAPM increase and investors will feel risky, so cost of equity will increase as well due to investors expect more return to compensate the risk. Therefore, high cost of equity will increase the WACC but low IRR unable to cover the WACC so Ireka has profitability issues.

Osuji and Odita (2012) studied the effects of capital structure on the financial performance of Nigerian organisations and companies’ capital structure had strongly negative related on firm’s financial performance. (Zeitun et al. ,2007; Omorogie at al., 2010) Not only that, a negative correlation between capital structure and firm performance in US and UK corporation. (Abeywardhana and Krishanthi, 2016) Thus, the higher the capital structure, the poorer the financial performance of firm in developing countries and developed countries. However, Abor (2005) and Saeedi et al. (2011) argued that capital structure has positive relationship with ROA which proxy the firms’ performance in Ghana and Tehran.

Effect of capital structure and financial leverage on the performance of Jordanian firms and Canadian firms showed that capital structure was negatively associated with firm performance. (Soumadi et al., 2011; Gill et al., 2011) but it also found that there was no significant difference between high financial leverage and low financial leverage on firm performance. Thus, firms with lower leverage performs better thereby supporting the pecking order theory from the point of view that profitable firms use their earnings to finance their new projects and in so doing reduce their level of debt.

However, financial leverage of firm in developed and developing countries will not affect the company profit due to the result show it has insignificant relationship. (Obehioye et al., 2013) On the other hand, some studies argued that financial leverage is has significant positive effect on performance of firms in Nigeria and US. (Gill et al., 2011; Akhtar, et al., 2012; Akinmulegun, 2012) Therefore, it can be indicated that financial leverage will impact the profitability of firms in developing countries and developed countries as well.

As we know that, steel is one of the main raw material that used in construction so price of steel play significant role in the cost of the construction project. China as the leader in steel production and China decided to shift away its economy from manufacturing to services in last year. (General Steel, 2018) Thus, China announced that production of steel will decrease more than 165 million tons by 2020 (Lapo et al, 2018) and this will affect the price of steel increases rapidly due to demand exceed supply. World Steel Association stated the price of steel will be increased 8% due to a prediction increase in global steel demand up to 0.5%.

As Ireka is a construction and engineering company, all the cost of construction projects will increase due to the increase in global price of steel. Steel can consider as a fixed cost because steel is the main raw material of construction so expenses will increase and profit will decrease slightly. As a consequence, Ireka need to invest in a higher IRR projects to cover the cost or else it will affect the profitability and liquidity of Ireka.

Besides that, economy of Malaysia able to affect the real estate price and construction industry. In the past two years, economy of Malaysia was slowing down and ringgit is depreciating due to the high debt and scandal of 1MDB. (Lim, 2016) As the house prices continue to rise, demand for house is dropping. Hence, property transactions and building construction activities are slowing down dramatically. However, economy start to recover and ringgit will start to appreciating again after the election of 2018.

Valuation and Property Services Department (JPPH) stated that residential property transactions improved about 4% compared to last year. (Mahalingam, 2018) As economy grow, interest rate falls and demand for properties will increase due to easy to obtain mortgage loan. High demand in properties will encourage Ireka to construct and develop more residential projects. This will increase the revenue and share price of Ireka.

Moreover, growth of industry also will affect Ireka Corporation by increasing in constructing more mega projects. The Construction Industry Development Board (CIDB) expected the booming in construction industry in 2018 with the real growth at 9% on the back of Malaysia’s overall GDP growth of 5.3%. (Bernama, 2018) Construction industry’s growth was driven by infrastructure project and follow by residential project and these project will brings positive growth in construction industry then boost the economy. (The Star, 2017)

There are numerous mega projects has developed in Malaysia such as Mass Rapid Transit 2 (MRT2), Pan Borneo Highway and Petroliam Nasional Bhd’s refinery and petrochemical. Ireka Corporation also affected by the growth of construction sector which Ireka had bid for a few projects that worth RM1.2 billion.

Current construction order book includes Imperia Puteri Harbour in Nusajaya, Johor and MRT Package V7. Ireka Corporation is one of the subcontractors of the MRT project which built from Bandar Tun Hussein Onn to Taman Mesra. According to research analyst InsiderAsia, Ireka’s next major catalyst will be the condominium and RuMa hotel residences project at Jalan Kia Peng in the KLCC area. (The Edge, 2013) This will increase the revenue of Ireka and the stock price may increased as well due to anticipated by the investor towards the future development of the company.

Ireka should improve collection of accounts receivable to reduce high financial leverage ratio because prevent risk of bankruptcy. Ireka should communicate with customers about the period of time to make payments and both parties agree to make payment in a certain time. Ireka may implements new policy and regulations where Ireka will give some discount to customers if customers pay their bills within 2 months.

Ireka also should remind the customers before the payment date to prevent become bad debt and follow up with customers in order to keep track of the payment of customers. Besides that, Ireka should restructuring debt to reduce the debt to equity ratio. (Maverick, 2018) Company can seek to refinance its existing debt if firm is paying high interest rates on its loans. This will reduce both interest expenses and improve company’s bottom-line profitability. As a result, liabilities can be decreased and capital of investors can be use to invest other assets.

One of the strategies to improve profitability of the firm is create business strategies plan and financial plan. Ireka should refer to leader company of industry as a benchmark revenue because the leader company provide a blueprint and strategies to increase the profit. (Amos et al., 2009) Thus, Ireka should amend strategies plan of leader company according to its current situation and include a minimum five-year outlook strategies plan with short and long-term goal. As a construction company, most of its revenue is from project-based so it is crucial to have a clear vision about the type of most profitable projects for its bottom-line growth. Therefore, Ireka need to analyse projects and give up 10% of unprofitable projects in strategic plan so capital. (In.Corp, 2018).

Thus, Ireka also should created financial plan so budget of firm can be monitored. Ireka should develop a cost accounting system such as Enterprise Resource Planning (ERP) to determine the rate of required return of projects. This allows Project Managers (PMs) to adjust budget and actual cost on time. (Torrance, 2013) Budget able to keep track on its expense and reduce the unnecessary expenses. Budget also need to be reviewed monthly in order to remain aligned with growth of business. As a result, the profit of firm can be maximized in long-term.

Furthermore, Ireka can increase its profit by expanding its market at developing countries such as Indonesia, China and Japan. Ireka enter into joint venture or strategic alliances with their suppliers or customers to market each other’s products. Ireka had joint venture with Beijing-based CRRC Urban Traffic Co Ltd into urban rail projects and they signed share subscription agreement which Ireka holding 51% and CRRC UT holding 49%. (Eusoff, 2017) Ireka partner with CRRC UT to explore more business opportunities in areas of logistics, building materials and specific rail projects. Joint venture able to provide more opportunities to Ireka and reduce the uncertainty risk in the sector that are not familiar by Ireka.

Corporate Social Responsibilities (CSR) is another important strategy because CSR able to motivate employees by providing extra training and workshop. Ireka should spend extra time to train and educate its employees in order to increase ability and skills of employees.(Pajo and Lee, 2011; Jones et al., 2014) As a result, employees understand the expectation of firm and become more productive. Although training may increase expenses of Ireka but company can operate well in long-term and increase reputation in return.

Furthermore, reward and compensation will encourage and increase motivation of employees.(Caligiuri et al., 2013; Glavas and Kelley, 2014) Ireka should reward employees who have outstanding performance in company by providing promotion or bonus. When employees get rewarded, employees will work harder and increasing the work-ethic within company. As a consequence, high productivity will affect improve profitability and maximised the shareholder’s wealth in long term.

Net income will affect retained earning significantly so Ireka should increasing the liquidity by having an effective asset management. Ireka should sell off idle assets and increase the efficiency of assets to generate profit. (Fernandez, 2006) Assets will be depreciated so sell off not useful assets to decrease the losses. Besides that, inventory can take up a very sizable amount of a company’s working capital so Ireka should evaluate their efficiency of inventory being managed which monitor the days sales of inventory ratio (DSI) by reordering inventory when firm are nearing redline level of available and the cash conversion cycle (CCC). (Morah, 2018)

In additional, cost of gold sold should be reduced by decreasing the cost of raw material and labour cost. Labour cost can be reduced by outsourcing and replace with part-time workers. As cost and expense decrease, more profit can be generated if assets are fully utilised. As consequence, Ireka’s cash flow is more liquid and retained earning can be increased.

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Importance of Financial Structure and Statements

Introduction

This essay discusses the role of financial structures on the profitability and stability of companies and the role of financial statements prepared using historical cost convention and accruals concept in the decision making process. Both aspects of companies discussed here are of much importance as they directly affect companies, their financial condition and the representation of facts to the relevant users. The financial structure of a company reflects various sources the company has used to finance its operations. The financial statements provide vital information to users such as shareholders, managers, banks, tax authorities and research analysts to make important decisions.

Financial Structure

The financial structure of a firm is the way the assets and operations are financed. A company employs various modes of financing to acquire assets and support its operations. The financial structure includes components such as short term liabilities, long term debt and shareholders’ equity. Financial structure is different from capital structure as the capital structure only includes long term debt and shareholders’ equity and ignores short term liabilities. More successful companies focus more on financial structure rather than capital structure as the analysis of financial structure reveals both the short term and long term aspects of the company in terms of profitability and stability, whereas capital structures focus mainly on long term stability of the company.

Short term liabilities include but are not limited to accounts payables, accrued liabilities and short term loans. The financial structure is affected by various elements such as market competition, utilization of assets, behavior and decisions of managers and the level of sales. The existence and stability of companies depends on profitability as it would be illogical to operate a company for an extended period without making any profit. The profitability of a company is dependent on the financial structure as a company would not be able to operate without finances and it would have nothing to offer or sell to its customers.

Profitability and Value Creation

The objective of company management is the creation of value for shareholders. This value can be created through various methods but the most important component of value is the actual ability of the company to generate profits. The effect and role of financial structures on the profitability of the firm is quite significant. Successful companies continuously strive to increase the profitability of the company as higher profitability means higher value for the firm and eventually the shareholders.

 The profitability is dependent on many factors including financial structure, sales volume and cost structure. The compensation of managers in many companies is linked with their ability to surpass budgeted sales and profits levels. The value of a firm for shareholders is measured through various tools including Economic Value Added and Market Value Added and Return on Invested Capital.

Importance of Financial Structure

Financial structure of a company is important for the management and shareholders as it defines the various modes of financing the company uses to support its operations.  The two main components of a financial structure; short term and long term components, help in identifying two different aspects of a business. The liquidity ratios of a business indicate the ability of a firm to meet short term obligations. These ratios depend on the short term borrowings or liabilities of the company. The liquidity ratios also indicate the current stability of the firm. The level of working capital of a company also affects the profitability of a company.

The optimum level of working capital is the point where working capital requirements maximize the profitability of the firm. The level of working capital is dependent on the level of current assets and current liabilities. The three major current assets and liabilities other than cash which affect the level of profitability are accounts receivable, accounts payable and inventories. The cash conversion cycle depends on these three components and this cycle can be amended by changing the levels of current liabilities to maximize the returns of the company. Managers of many companies try to attain a level of cash conversion cycle where maximum profit is attained.

Many companies use accounts payable as a short term financing tool although the cost of using it is quite high but it directly affects the level of working capital and cash conversion cycle. The cash conversion cycle denotes the time period between collection of receivables and payment of payables. At an optimum level the cash is collected early on receivables and payment is deferred on payables which frees up a considerable amount of cash which can be reinvested in the business to maximize profitability. Credit and finance managers are continuously involved in evaluating this optimum level of cash conversion cycle and working capital to increase the growth rate and returns of the company.

Companies with high growth potentials and high profitability use accounts payables as a means to increase working capital efficiency and cash cycle (Lazaridis & Tryfonidis, 2007). The other important component of the financial structure is the long term component which also makes up the capital structure of a firm. The capital structure which is different than the financial structure includes long term debt and shareholders’ equity. The profitability of a firm is highly dependent on the capital structure. The firms with stable sale revenues can incorporate debt to their capital structure and can use this debt to match the increasing demand.

Companies with high rates of return usually do not use high levels of debt financing as the higher rate of return makes internal sources of funds more feasible (Brigham & Ehrhardt, 2001).  The reliance of a company on equity or debt increases or decreases the rate of Return On Investment. The value of a firm to shareholders is also dependent on the capital structure as the use of debt for financing can cause the value of Earnings Before Interest and Taxes – EBIT to decrease or increase. The financial leverage also plays a very important role in the capital structure. The more debt company uses in the capital structure the higher is the interest expense for the company which means a lower amount of distributable profit to the shareholders.

If the capital structure consists of a larger portion of equity and the weight of debt is very low, the shareholders are exposed to a larger part of the business risk. An optimal capital structure not only contributes to the profitability of a firm, the required rate of return also increases for the shareholders. The important aspect to consider in the capital structure is the relative cost of equity and debt. The cost of debt for any company is quite low than that of equity, so the managers may choose to finance more through debt, but too much reliance on debt would result in an increase in interest expenses and lower distributable profits.

The long term stability of a firm is also very closely linked to the capital structure as it depends on the eventual wealth maximization of shareholders. In order to maximize shareholders wealth the managers of a company have to select an optimal capital structure which entails the estimation of interest payments, cost of equity, weighted average cost of capital, discounted free cash flows for value of the firm and deducting the amount of debt from these cash flows to arrive at the amount of shareholders’ wealth (Rao, 1989).

The growth rate of a company is also very closely linked to the capital structure, companies with higher growth rates rely more on debt due to the lower cost of debt in order to achieve higher returns but the long term stability would be affected immensely due to greater reliance on debt. Further understanding of debt and equity relationship can be achieved from the following illustration.

Suppose ABC Inc. has two options of using debt and equity in different scenarios. EBIT of the company is assumed to be $500,000. The capital requirement for the company is $10 million; the interest rate and tax rate is 7% and 40% respectively. The cost of debt after tax is 5% whereas the cost of equity is 8%. The effects of two different scenarios of financing through debt and equity are illustrated.

Scenario 1     Scenario 2  
30% debt and 70% Equity     70% debt and 30% Equity  
         
Weight of Debt 30%   Weight of Debt 70%
Weight of Equity 70%   Weight of Equity 30%
Cost of Debt 5%   Cost of Debt 5%
Cost of Equity 8%   Cost of Equity 8%
Interest Rate 7%   Interest Rate 7%
Tax Rate 40%   Tax Rate 40%
         
  $     $
Capital Requirement 10,000,000   Capital Requirement 10,000,000
Debt 3,000,000   Debt 7,000,000
Equity 7,000,000   Equity 3,000,000
         
EBIT 500,000   EBIT 500,000
Less: Interest Expense (210,000)   Less: Interest Expense (490,000)
EBT 290,000   EBT 10,000
Less: Tax (116,000)   Less: Tax (4,000)
EAT 174,000   EAT 6,000
         
WACC 7.1%   WACC 5.9%

Scenario 1 of the illustration entails 30% reliance on debt and 70% on equity, whereas scenario 2 entails 70% reliance on debt and 30% on equity. The WACC of scenario 1 is 7.1% as the component of equity is higher in this case and the Earning After Tax which is distributable to shareholders is $174,000 while in scenario 2 the WACC has dropped to 5.9% but it has also decreased the value of EAT which is now $6,000. Although the cost of capital has decreased in scenario 2 the amount distributable to shareholders has also dropped. This shows that a greater reliance on debt would in fact decrease the cost of capital but it would also reduce profit for shareholders.

Financial Statements

Accountants prepare financial statements to be used by management, shareholders, creditors, customers, banks and government for various decision making purposes. As the decisions made by these parties are very crucial, the information these decisions are based on should be reliable and relevant for each user. The International Accounting Standards Board – IASB provides a guideline to accountants for preparing financial statements to present information that is relevant and reliable to all these users and specially shareholders.

The financial statements used for decision making and stewardship purposes are usually the income statement, balance sheet and statement of cash flows.  The IASB provides various concepts, assumptions, principles and measurement standards for various elements of financial statements through the International Financial Reporting Standards – IFRS. The preparation of financial statements under the historical cost convention and accrual concept of accounting is discussed here. If both of these concepts are not applied by accountants in preparing financial statements, there can be a significant variation in the balances of different items reported on the financial statements.

Historical Cost Convention

Historical cost is the cost originally incurred for the purchase of an asset or any other transaction. The historical cost does not include any adjustments for inflation or current changes in price. Historical cost helps accountants and users of financial statements to distinguish between the current or market cost and the cost originally incurred to purchase an asset.

The historical cost convention explains to an accountant that all assets should be presented on the balance sheet according to the historical purchase price including all the capital expenditures incurred for acquiring it (Meigs, Williams, Bettner, & Haka, 2002). As an example suppose a company purchased an equipment worth $50,000 in 2003, the 2009 balance sheet reports the cost of the asset at this same amount of $50,000 instead of its replacement cost or market price which could be higher or lower than the original cost.

Accrual Basis of Accounting

The cash basis of accounting includes the presentation and recording of transactions when cash is paid or received whereas in the accrual basis of accounting the expenses are recorded as and when they are incurred irrelevant of the timing of cash payment and revenues are recorded as and when they are earned irrelevant of the timing of cash receipt. This reflects all the revenues earned and expenses incurred on the income statement irrelevant of the cash flows. The accrual basis of accounting also enables the matching of revenue and expenses in a specific period of time. For example a company manufactures products and delivers the same to its customer but the customer will pay the amount due on these products 1 month later in the next year.

At the end of the year this revenue will be recorded as accrued revenue even though the amount has not been received from the customer yet. If the company has used utilities like electricity or telephone in a given year and the amount outstanding on the bills will not be paid until the next year, the outstanding amount will be booked as an expense in the income statement of the current fiscal year as accrued expenses. It should also be noted that the accrued revenue and expenses are also reflected on the balance sheet. The accrued revenues are presented as receivables and accrued expenses are treated as liabilities on the balance sheet (Sangster & Wood, 2007).

 Financial Statements Prepared under Historical Cost and Accrual Concepts

The information contained in the financial statements is vital not only for external users such as shareholders, creditors, banks and government it is quite important for the internal users such as the management of the company as well. The management of the company uses this information to make financial and economic decisions about relevant to the future stability of the company. These decisions may include fixing prices, manufacturing of new products and modes of financing.

The external users make decisions based on the information about lending, investing and selling to the company. The information contained in the financial statements should be reliable and relevant. This means that the information should reflect a true reflection of the company’s past and should be relevant to make economic decisions about the future (Ireland, 2005). The financial statements prepared under the accrual basis of accounting report an accurate amount of net income or net loss during a specific period but under the cash system this amount would not be accurate.

In order for the information reported in the financial statements to be relevant for stewardship and decision making purposes, the financial statements should be prepared using the accrual basis of accounting. The historical cost concept presents the actual cost of assets which is more reliable and relevant as the market or replacement value keeps fluctuating and the necessary adjustments required would have to be implemented each time to make the amount reliable. Recording the assets on historical costs renders the balance sheet more transparent and reliable for both the internal and external users.

The historical cost concept is simple and does not need any referencing to market prices and the fluctuations related to the market. The values of assets recorded under the historical cost concept are most common and can be understood easily by people. When a company uses the historical cost concept for reporting assets it does not need to record any gain or loss of revaluation until the gain or loss is realized. Although the accrual basis of accounting is sometimes difficult for some people to understand but the financial statements prepared under this system measure profit and loss more accurately than the cash system.

The financial position of a firm is more accurately presented and is realistic for users who base their decisions on these statements. This accurate information can also be used to accurately approximate the future financial position and growth of the company.

Conclusion

After the analysis of two different scenarios and the evaluation of current and long term components of the financial structure it can be concluded that the profitability and future stability of the firm is very much dependent on its financial and capital structure. The management of the company tries to achieve an optimal financial structure to increase the value and worth for shareholders. It can be concluded from the second part of this paper that the financial statements prepared under the historical cost concept and using the accrual basis of accounting provide both internal and external users with more relevant and reliable information in making proper decisions about the future.

References

Brigham, E., & Ehrhardt, M. (2001). Financial Management: Theory and Practice 11th Edition. Florence: South-Western Educational Publishing.

Ireland, J. (2005). Principles of Accounting. London: The London School of Economics and Political Science.

Lazaridis, I., & Tryfonidis, D. (2007). The Relationship Between Working Capital Management and Profitability of Listed Companies in The Athens Stock Exchange. Macedonia: University of Macedonia.

Meigs, R., Williams, J., Bettner, M., & Haka, S. (2002). Financial Accounting. Columbus: McGraw-Hill Companies.

Rao, R. (1989). Fundamentals of Financial Management. New York: Macmillan Publishing Company.

Sangster, A., & Wood, F. (2007). Business Accounting. Essex: Pearson Education Limited.

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Market Timing and Capital Structure for Baker and Wurgler

The results suggest the theory that capital structure is the cumulative outcome of past attempts to time the equity market. Introduction Equity market timing” refers to the practice of Issuing shares at high prices and repurchasing shares at low prices. Equity market timing appears to be an important aspect of real corporate financial policy. In this paper, ask how equity market timing effects capital structure and whether It has a short-run or long-run Impact. The variation in market-to-book ratio is a proxy for managers perceptions of installation.

The main finding is that low leverage firms are those that raised funds when their market valuations were high (measured by the book-to-market ratio), while high leverage firms are those that raised funds when their market valuations were low. The influence of past market valuations in capital structure is economically significant and statistically robust. The influence of past market valuations on capital structure is also quite persistent, this means that they have a long-run impact.

The tradeoff theory predicts that temporary fluctuations In the market-to-book ratio or any other variable should have temporary effects. The evidence however indicates long-term effects as well. The standard pecking-order theory implies that periods of sigh Investment will push leverage higher toward a debt capacity, not lower as the results in this paper suggest. The theory of entrenched managers suggests that managers exploit existing investors ex post by not refinancing the capital structure with debt, this may be an explanation of the findings In this paper. . Capital structure and past market valuations Individual financing decisions depend on market-to-book ratios. Does market-to-book affects capital structure through net equity issues as market timing implies? And does market-to-book has persistent effects that help to explain the cross section of average? Data and summary statistics Table I shows that book leverage decreases sharply following the PIP_ Over the next 10 years, it rises slightly, while market value leverage rises more strongly. The book leverage trend is an age effect, not a survival effect.

Most notable is the sharp switch activity, the change in assets is equal to the sum of net debt issues, net equity issues, and newly retained earnings. The concurrent increase in equity issues is suggestive of market timing. Determinants of annual changes in leverage B&W document the net effect of market-to-book on the annual change in leverage. Then they decompose the change in leverage to examine whether the effects comes through net equity issues, as market timing implies. Three control variables are used that have been found to be correlated to leverage: Asset tangibility, profitability, and firm size.

B&W regress each component (equity issues, debt issues, and newly retained earnings) of changes in leverage on the market-to-book ratio and other independent variables. This allows them to determine whether market-to-book affects leverage through net equity issues, as market timing implies. The effect of market-to-book on hanged in leverage does indeed come through equity issues. Panel C shows that market-to-book is not strongly related to retained earnings, ruling out the possibility that market-to-book affects leverage because it forecasts earnings.

The effect of profitability on changes in leverage arises primarily because of retained earnings. Firm size plays an important role at the time of the PIP. Determinants of leverage If managers do not rebalanced to some target leverage ratio, market timing may have persistent effects, and historical valuations will help to explain why leverage ratios fifer. The relevant historical variation in market valuations is measured by the “external finance weighted-average” market-to-book ratio. This variable takes high values for firms that raised external finance when the market-to-book ratio was high and vice-versa.

The intuitive motivation for this weighting scheme is that external financing events represent practical opportunities to change leverage. It therefore gives more weight to valuations that prevailed when significant external financing decisions were being made, whether those decisions ultimately went toward debt or equity. This weighted average is better than a set of lagged market-to-book ratios because it picks out, for each firm, precisely which lags (intervals) are likely to be the most relevant. Intuitively the weights correspond to times when capital structure was most likely to be changed.

When firms go public, their capital structure reflects a number of factors, including market-to-book, asset tangibility, size, and research and development intensity. As firms age, the cross-section of leverage is more and more explained by past financing opportunities, as determined by the market-to-book ratio, and past opportunities to accumulate retained earnings, as determined by profitability. Historical within-firm variation in market-to-book, not current cross-firm variation, is more important in explaining the cross section of leverage.

The results from Table Ill and IV show that effects documented in prior literature. Persistence So far two main results have been documented. First, high market valuations reduce leverage in the short run. Second, historically high market valuations are associated with lower leverage in the cross section. By measuring changes from the leverage prevailing in the year before the PIP, the pendent variable includes the effect of the PIP itself. This is useful because the PIP is a critical financing event known to be connected to market value.

Historical market valuations have large and very persistent effects on capital structure. This effect is independent of various control variables. 2. Discussion Tradeoff theory In perfect and efficient markets capital structure is irrelevant. Some of the imperfections that lead to an optimal tradeoff are as follows: Higher taxes on dividends indicate more debt, higher non-debt tax shields indicate less debt, higher sots of financial distress indicate more equity, agency problems can call for more or less debt.

The market-to-book ratio can be connected to several elements of the tradeoff theory but it is most commonly attached to costly financial distress. The key testable prediction of the tradeoff theory is that capital structure eventually adjusts to changes in the market-to-book ratio. However, evidence indicated that variation in the market-to-book ratio has a decades-long impact on capital structure. B&W’s results make the point that a considerable fraction of cross-sectional variation in average has nothing to do with an optimal leverage ratio.

Pecking order theory In the pecking order theory there is no optimal capital structure. The static model predicts that managers will follow a pecking-order (internal, debt, equity). The pecking order theory regards the market-to-book ratio as a measure of investment opportunities. Periods of high investment opportunities will tend to push leverage higher toward a debt capacity. However, to the extent that high past market-to-book actually coincides with high past investments, B’s results suggest that such periods tend to push leverage lower.

The dynamic version predicts a relationship between leverage and future investment opportunities. B&W’s results control for current market-to-book and show that leverage is much more strongly determined by past values of market-to-book. Managerial entrenchment theory High valuations and good investment opportunities facilitate equity finance, but at the same time allow managers to become entrenched. They may then refuse to raise debt to rebalanced in later periods. Capital structure evolves as the cumulative outcome of past attempts to time the equity market. There are two versions of equity market timing.

The first is a dynamic form with rational managers and investors and adverse selection costs that vary across firms or across time. Temporary fluctuations in the market-to-book ratio measure variations in adverse selection (information asymmetry). The second version of equity market timing involves irrational investors or managers and time-varying misprinting. If managers try to exploit too-extreme expectations, net equity issues will be positively related to market-to-book. The critical assumption is that markets need not be inefficient, managers may simply believe that they can time the market.

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Capital structure analysis

 STRATEGIC ANALYSIS OF TELUS IN THE CANADIAN CONFERENCING MARKET Robbin S. Stephens Bachelor of Commerce, University of British Columbia, 1980 PROJECT SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIRMENTS FOR THE DEGREE OF Master of Business Administration In the Faculty Of Business Administration ORobbin S. Stephens 2002 Simon Fraser University August 2002 All rights reserved. This […]

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