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

Ethics in Financial Reporting

Integrity is of utmost importance for a successful career in business and finance in the long run. Some believe that the world of finance lacks ethical considerations. Whereas the truth is that such issues are prevalent in all areas of business.

The business environment in much of the world is reeling from the revelation of several financial scandals in the past few years. The optimism of the turn of the century has been replaced by scepticism and distrust. It will be discussed as to how we landed ourselves in this situation, what is being done to correct it, and what the future holds for us. Though Enron has been used as the poster-child for this purpose, breakdowns in accounting and corporate governance in Enron as well as in other companies will be discussed.

Some companies that have encountered financial reporting problems will be discussed along with the role of auditors (including Andersen’s role in Enron), the regulatory environment, some of the causes of the problems, and the current and possible future outcomes.

Ethics and Accounting

Ethics (maintaining fair and true statements) is a key part of financial reporting. For shareholders to trust a company with money, they must feel confident in the company’s financial reporting. Financial reporting presents all data relating to the entity’s current, historical and projected health meaning investors and shareholders rely upon the financial data available for making informed and educated decisions. To help entities comply with business regulations and maintain financial reporting, shareholders can trust the existing organizations designed to monitor different aspects of the accounting world.… 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

Credit Management – Managing Trade Credit and Accounts Receivable in Business

“The purpose of any commercial enterprise is the earning of profit, credit in itself is utilized to increase sale, but sales must return a profit.” – Joseph L. Wood

The primary objective of management of receivables should not be limited to expansion of sales but should involve maximization of overall returns on investment. So, receivables management should not be confined to mere collection or receivables within the shortest possible period but is required to focus due attention to the benefit-cost trade-off relating to numerous receivables management.

Principles of Credit Management

In order to add profitability, soundness and effectiveness to receivables management, an enterprise must make it a point to follow certain well-established and duly recognized principles of credit management. The first of these principles relate to the allocation of authority pertaining to credit and collections of some specific management. The second principle puts stress on the selection of proper credit terms. The third principles emphasizes a through credit investigation before a decision on granting a credit is taken. And the last principle touches upon the establishment of sound collection policies and procedures.

In the light of above discussion, the principles of credit management can be stated as:

1. Allocation or Authority

The determination of sound and effective credit collection policies management. The efficiency of a credit management in formulation and execution of credit and collection policies largely depends upon the location of credit department in the organizational structure of the concern. The aspect of authority allocation can be viewed under two concepts.… Read the rest