Confirmation Bias – Understanding Behavioral Biases in Finance

Confirmation bias is the inclination to seek or make sense of news or facts in a way that validates one’s preconceptions. So, during the decision making process for psychologist they will refer to information that supports their decision more favorably. They will rarely give the obvious negative much consideration and since our beliefs and postulations are definitely prejudiced so the tendency to give more attention and weight to data that support our beliefs than we do to contrary data will subtly but gradually have a harmful effect.

An illustration of Confirmation Bias

A very real manifestation of this tendency can be observed in the virtual world. For instance, investors are increasingly turning to message boards or virtual communities to search, clarify, and exchange information before making investment decisions. The volume of discussion on such portals is so intense that it has become possible to sense stock sentiments from here. These message boards have been shown to provide more accurate and timely information than forecasts by analysts.

The reason so many investors even turn to these online communities is to gain an unbiased evaluation of the market conditions, a third-party opinion on something they might not have comprehensive information about, and the 360 degree view of the situation that can help in formulating a successful investment strategy. What in turn happens is that psychological biases, especially in such uncertain and noisy environments, affect the processing of information through these portals leading to short-sighted or impaired decision making.

It can be debated that investment-related message boards and communities do not necessarily benefit potential investors by helping them make unbiased and informed decisions, primarily because investors search for specific information on these portals that align with what they already believe.… Read the rest

Capital Structure Theory – Modigliani Miller Proposition

Capital Structure Decision in Corporate Finance

The corporate finance is a specific area of finance dealing with the financial decisions corporations make and the tools as well as analysis used to make these decisions. The discipline as a whole may be divided among long-term and short-term decisions and techniques with the primary goal being maximizing corporate value while managing the firm’s financial risks. Capital investment decisions are long-term choices that investment with equity or debt, and the short-term decisions deals with the balance of current assets and current liabilities which is managing cash, inventories, and short-term borrowing and lending. Corporate finance can be defined as the theory, process and techniques that corporations use to make the investing, financing and dividend decisions that ultimately contribute to maximizing corporate value. Thus, a corporation will first decide in which projects to invest, then it will figure out how to finance them, and finally, it will decide how much money, if any, to give back to the owners. All these three dimensions which are investing, financing and distributing dividends are interrelated and mutually dependent.

The capital structure decision is one of the most fundamental issues in corporate finance. The capital structure of a company refers to a combination of debt, preferred stock, and common stock of finance that it uses to fund its long-term financing. Equity and debt capital are the two major sources of long-term funds for a firm. The theory of capital structure is closely related to the firm’s cost of capital. As the enterprises to obtain funds need to pay some costs, the cost of capital in the investment activities is also the main consideration of rate of return.… Read the rest

The Performance Prism

The Performance Prism is a second generation performance measurement and management framework that has been developed by Neely, Adams and Kennerley to further aid organisations in their pursuit of measuring the overall performance of their operations. The creators of this model suggest that for organisations operating within almost any given industry, the most important aspect of management is to deliver on the expectations of the stakeholders associated with that organisation. The Performance Prism is designed to help with the complex relationships that organisations often possess with their various stakeholders within the context of its operating environment. It provides an innovative and holistic framework that directs management attention to what is important for long term success and viability and helps organisations to design, build, operate and refresh their performance measurement systems in a way that is relevant to the specific issues that they face within their given industry.

This model attempts to distinguish itself from other similar models such as the Balanced Scorecard by offering a unique perspective on a measuring system that can ultimately be adopted as a way of operating within an industry, rather than just measuring performance of the organisation. The balanced scorecard, with its four perspectives, focuses on finance, customers, internal processes and innovation and learning. In doing so it downplays the importance of other stakeholders, such as suppliers and employees. The business excellence model combines results, which are readily measurable, with enablers, some of which are not. Shareholder value frameworks incorporate the cost of capital into the equation, but ignore all aspects relating to stakeholders.… Read the rest

What is Financial Structure?

Financial structure refers to the way as to how the firm’s assets are financed. It includes both, long-term as well as short-term sources of funds. In other words, it refers to the left hand side of the Balance Sheet as represented by total liabilities. However, a more frequently used term is capital structure which is slightly different from financial structure. If short-term liabilities are removed from firm’s financial structure, what one obtains is its capital structure.

So, financial structure is defined as the amount of current liabilities, long-term debt, preferred stock and common stock used to finance a firm. In contrast, capital structure refers to the amount of long-term debt, preferred stock and common stock used to finance a firm’s assets. Thus, capital structure is only a part of the financial structure and it represents the permanent financing of the company. Another term Capitalization refers to total long-term funds required by the firm. Whereas, capital structure refers to ‘make-up of capitalization’ i.e. types and proportion of different securities to be issued.

There cannot be a uniform financial structure which suits the requirements of all firms. In other words the financial structure has to be formed in such a way that it suits the needs of a particular firm meaning thereby that the firm should seek an optimum or an ideal financial structure for itself. Financial structure particularly the capital structure decision is a significant financial decision since it affects the shareholders’ return and risk and consequently the market value of the firm.… Read the rest

Evaluating a Company’s Capital Structure using Ratios

A business organization may be financially sound today but it may loose strength tomorrow because of losses. Therefore it is necessary to maintain a judicious balance between the owned capital and borrowed capital. The following ratios have been calculated to analyze the capital structure of a company.

1. Capital Gearing Ratio

Capital Gearing Ratio of an organization measures the relationship between equity share capital to preference capital and loan capital. ‘Capital gearing’ refers to the ratio between the variable cost bearing capital and fixed cost bearing capital of the organization and helps to frame the capital structure of the organization. Capital gearing may be of three types:

  1. High Gearing Capital, which indicates the excess of interest bearing long-term finance over the equity funds;
  2. Low Gearing Capital, which indicates the excess of equity funds over the interest bearing long-term finance; and
  3. Evenly Geared, which indicates the equality between the interest bearing long-term finance and equity funds.

As regards the role of capital gearing in the successful operation of the organization, it is as significant as the use of gears in the speed of an automobile. Just as gears are used in an automobile for maintaining the speed because an automobile starts at low gear and when it start running fast, in the same way when an organization is incorporated, it is begun with more equity capital and less interest bearing finance. But as the business moves ahead, fixed cost bearing finance such as preference capital, debentures and term loans etc., increases and the equity capital either remains constant or increases at a very low speed.… Read the rest

Factors Determining Financial Structure of a Company

Capital structure refers to the mixture of long term funds represented by equity share capital, preference share capital and long term debts. As a matter of fact, capital structure planning is one of the major tasks which involve determination of the right proportion of different securities. Each Corporate security has its own merits and demerits. Too much inclusion of any one kind of security in the capital structure of a company may prove unprofitable or subsequently risky. Therefore, a prudent financial decision should be taken after considering all the factors in view.

Capital structure should always be made in the interest of equity shareholders because they are the ultimate owners of the company. However, the interest of other groups, including employees, customers, creditors, society and government should also be duly considered. In this way, efforts should be made to have capital structure most advantageous. Within the constraints, maximum use should be made of leverage at a minimum cost.

As there cannot be uniformity regarding capital structure decision, which suit the requirements of all companies, Capital structure should be formed to suit the needs of every individual company together with giving due place to borrowed funds in its capital structure.

Factors Determining Capital Structure

Capital structure has to be decided initially at the time when a company is incorporated. The initial capital structure should be designed very carefully wherever funds have to be procured, the financial manager should study the pros and cons of various sources of finance and pick up the most advantageous source keeping in view the target capital structure.… Read the rest