Finance and risk management..bethen lloyd jones

8/7/2019 Finance and risk management..bethen lloyd jones

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QUESTION 1:

INTRODUCTION

Capital is regarded as the backbone of any business. Black (2005) noted that for anybusiness to grow and develop, selection of the ways in which finance is raised plays a

vital and a significant part. The most important financial decision an organization has

makes is choosing varying levels of debt or equity (Glen and Pinto, 1994). Myers(1984)

pointed out that although advice from financial economists has been a part and parcel

of designing an optimal capital structure but the basis of which a capital structure is

designed still remains a puzzle. They argued that the theories developed to predict

financial behavior lacked evidence.

CRITICAL EVALUATION OF ALTERNATIVES AVAILABLE:

EQUITY FINANCING:

Brain et al pointed out that equity share holding does not form any kind of economic

burden on the resources of a company. Further long term capital can be mobilized

through equity capital without any financial burden on the assets of the company.

(Myers,1977 ). Rao(2001) placed his argument in favor of equity share holding pointing

out that credit worthiness of a company is enhanced by equity shares. Many

researchers like Kuhn (2006), have pointed out that equity share capital eliminates the

liability of repayment at the time of liquidation. Also Kuhn (2006) pointed out that it does

not involve obligatory dividend payment. Pride et al. (2000b) note that retained earning

can also be used as a source of equity financing, thereby increasing the range of

sources of capital generation (Institutional Investors, Partnership, Joint venture, Public

and Retained earnings). Siedman (2002) argued that investing through equity leaves aorganizations assets available for other financial needs.

However Ramoset al(2000) pointed out that as a compensation to higher risk, the rate

of return paid to shareholders increases many fold. Again noted that because equity

dividends are non-tax deductible, they are paid as post-tax profits. Also issuing equity is


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far more expensive as compared to issuing of debentures. Glen (2002), Also rights issue

of equity can result in centralized control of an organization. Hanief (2001b) pointed out

that in the period of boom appreciation in the value of shares is consequent of higher

dividend payments which lead to ample speculation. Black, (2005) argued that because

of the uncertainty of returns investors are speculative over investing in equity shares.

Whaite (2005) argued that a higher amount of risk is associated with investment of

equity as they tend to be volatile to market fluctuations. Again Khan and Jain(2002)

noted that because of public issue of shares, scattered and unorganized shareholders

do not exercise proper control over a PLC. Stock dilution is another potential

disadvantage of issuing shares. Also in absolute money terms and percentage basis , if

the investment turns out to be successful, may turn out to be a lot more than actually

invested thereby increasing stake in a business organization. (Vance ,2005)

RIGHTS ISSUE:

The advantages of public issue are mainly directed towards achieving liquidity and

diversification of the current shareholders base, creation of a negotiable instrument by

creating visible market value. Further stated that equity financing flexibility is increased

by public issue and public issue enhances public image of the firm. This can be justified

as standards of investment bankers are high before agreeing for public issue ( Lasher

2007).However Brayshaw, (2000b) pointed out that the main disadvantages include

extended time of share selling process completion. Also rights issues eliminate the

possible cost saving as blocks of shares are not sold in bulk to selling institutions.


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DEBT FINANCING:

Weaver and Wetson, (2000) refer debentures as a long term bond that is guaranteed by

a pledge of any specific property. In other words debenture holders are general

creditors whose claim is protected by unpledged property of a business Organization.

Debt finance is usually raised by means of bonds, loan, deep discounted bonds( issued

at less than nominal value, redeemed at nominal value). Further debt is paid following

and defined interest rate and agreed repayment schedule.

Banerjee (2000) points out that in the calculation of taxable income debentures tend to

be an admissible charge as against revenue thereby enforcing that cost of this source of

finance tends to be lower than that of the ownership capital. Also Horne (2002)pointsout that by offering convertible debentures, an organization creates an opportunity to

sell shares at a premium owing to the current market value. Hanif (2001) argues that

dilution of control is void as a direct consequence of non-transfer of ownership in case

of debentures. Sofat and Hiro (2000) noted that during inflation issuing debentures is

advantageous to a company as only a fixed amount of interest obligations need to be

met. Blackwell and Kidwell (1988) argued that PLC's are more likely to benefit from

public issue of debt. They based their argument on the "Floatation Cost Hypothesis"

which states economies of scale can be achieved through substantiated amount of

public debt. Fabozzi and Nevitt (2000)pointed out that debt can be raised throughvaried means as against equity which has numerous shortcomings

However Banerjee and Jain (2000) also noted that interest payments to the

shareholders account for a large chunk of pre-tax earnings, and a consequence rate of

dividends paid to the shareholders will be less. Again Fried et al. (2007) note that bonds

can have an adverse effect on the credit rating of an organization and can make future

borrowing's difficult. In case of unstable earnings presence or issue of new debt capital

increase the financial leverage of the Organization is seen, as payment of interest on

low earnings becomes burdensome. Pinto (1994) points out that cash outflow at the
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time of maturity of debentures can hinder the working capital requirements of an

organization to a large extent. Chemmanur and Fulghieri, (1994) argue based on

"liquidation and renegotiation hypothesis" that firms generally tend to avoid public debt

because renegotiation can be costly and difficult.

CONCLUSION:

As seen financing from both the sources have its pros and cons. DeGarmo et al. (1984)

argued that selecting a source of financing is dependent on a host of factors for a PLC.

They may be shareholder expectations, growth, current market trends, market position

of the organization and expansion. They further argued that these dynamics along with

the best suited option at that point of time (Debt or Equity) influence the decision of

choosing and formulating a capital structure.

QUESTION 2:

COMPARISON OF TRADITIONAL THEORY OF GEARING AND M-M THEORM: The

traditional view encompasses that careful use of gearing can amplify the overall value of

the firm. Further the view assumes an optimal capital structure. The approach

underlines that initially a downturn in the cost of capital is noted when firm raises its

value through gearing. As a consequence rate of return on equity (ke) increases. The

approach assumes that cost of equity rises with the increasing rate of gearing and yield

on debt increases after a significant level of gearing takes place. Erlhardt and Brigham

(2002) argued that initially WACC declines because rise in cost of equity is cancelled by

cheap debt funds. But after a certain point increase in cost of equity offsets the use of

cheap debt funds and consequently overall cost of capital begins to rise. This is the

point of optimal capital structure. Thus the traditional view confirms the inter-

dependence of cost of capital and capital structure.

However Modigliani and Miller postulate that in a non-tax circumstances, for a firm of an

agreed risk set, capital costs are steady despite the varying financial risk. The model
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argues that substitution of financial risk and cost of capital is unitary. Modigliani and

Miller (1958) argue that the weighted cost of capital remains constant as the cost of

debt and return on equity increases proportionately. The argument which Arnold (2002)

brought forward is that the benefits of raising capital cheaply through debt will exactly

offset the increasing returns demanded by the shareholders. Mcleney, (2006) pointed

out that the theory is based on the assumption that the value of a business is

determined by the future income and risk of investments rather than the way in which

finance is raised. This approach suggests that financial structuring decisions are not

important and optimal capital structure does not exist.

TRADITIONAL VIEW

Cost of Ordinary Share capital

Cost Overall cost of capital

Of

capital Cost of Debt Capital

Level of Borrowing

Optimal capital Structure.


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Assumptions: Unvarying Earnings and matching investor expectations of future

earnings, Taxation is Ignored, Constant Risk, And Full Earnings paid out in dividends.

MODERNIST VIEW

Cost of Cost of Equity

Capital

Overall cost of Capital

Cost of Loan Capital

Level of Borrowing

Assumptions: Taxation is Ignored, existence of a perfect capital market, Information

readily available, Similar expectations of Investors.


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CONTRASTING FEATURES OF THE MODELS:

Samuels et al. (1995) pointed out that the irrationality of the traditional model of gearing

is that equity shareholders tend to ignore an imperative element of risk involved. Further

they questioned as to whether or not investors would accept identical rate of return in

similar industries at different levels of gearing. However this is the base of MM theorem.

Pike and Neal noted that a severe drawback of this model is its failure to pin point a

specific optimal gearing ratio regardless of the circumstances. Key points over looked

by this model are marketability of a company's assets, market expectations and interest

rates. Samuels et al. chances of finding identical companies and of the same risk set

are austere. Further the assumption that personal borrowing can be regarded as an

alternative for corporate borrowing is weak. The principal factor here is corporation'sability to buy at cheaper rates with limited liability. In the MM model distinction between

long term and short term debt are imprecise and are deemed to be eternal. Further

Grant and Miller (2000) argued that proper mixture of carefully selected source of

finance with a positive investment opportunity lead to the creation of wealth. Further

they argue that integration of corporate debt policy with investment decisions impact

discounted economic returns and consequently shareholder value. However Grant and

Miller (2000) further in their argument they state that MM propositions can give critical

insight on the available financing opportunities. They argued comparing the effect of

NPV theory in investment decisions (positive NPV generally means higher shareholder

utility). Hoffman (2000) pointed out that the traditional view provides clarity in impact of

gearing over capital. However the counter argument is that impact of gearing on cost of

capital is not quantifiable because specification of its presupposition is ambiguous.

Lumby (2000) pointed out that several attempts to show the traditional theory in an

algebraic form as to why the cost of capital should have a non- linear relationship with

the gearing ratio but no satisfactory results were achieved as compared to the M&M

model did use the existence arbitrage transactions. Further with the periodic increase in

debt levels and consequent tax payment by corporations (modified M&M model with

taxes), governments would provide increasing subsidies and consequently enhance the


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firm's value. This is in steep contrast with the traditional theory which considers

increasing levels of debt as risky.

SIMILARTIES OF THE MODELS:

A major similarity between both the models arises in a situation of extreme debt

financing. Hypothetically if the debt holders keep on increasing in a firm then M&M

theory and the traditional model of debt stand a common ground. This is because with

the increase in the number of debt holders and commitment to pay interest, financial

risk shoots up. Further Ogilvie (2006) pointed out that with the inclusion of corporate tax

in a perfect market both the models implied an optimal capital structure. Also the

assumptions taken in both the models match to an extent. For example assumptions

like absence of taxation and rational behavior of investors.

QUESTION 3:

EXPLINATION OF GEARING:

Elliot and Elliot (2007) stated that gearing is essentially a measure of a firm's financialleverage. This essentially refers to the proportion to which firms activities are funded by

owner's funds as against creditors' funds. Arnold (2005) points out that gearing is said

to have taken place if a firm chooses borrowings as a source of finance. In capital

structure gearing is synonymous with terms like growthand risk. Stowe et al.(2004)

argues that the there are two situations in which a firm tends to borrow and gear highly.

These are arisen either when a company is looking to yield higher returns or has

insufficient funds. The latter is a forced upon choice while the former is when a

company is seeking growth.

An organization is referred to being highly geared when the proportion of is high in

context with equity in a capital structure. Ostring (2004) argues that a organization is


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deemed to be highly geared when the proportion of debt overlaps or is more than the

proportion of debt in an organization.

APPROACHES TO FINANCIAL GEARING:

McAulay and Dixon (1995) described two approaches of financial gearing. The first

approach used is capital gearing. The first approach involves using ratio of prior charge

capital against shareholders' funds. This ratio tries to ascertain the level of debt

financing to equity financing as already discussed. The second approach is known as

Income gearing. This ratio involves profits before interest and tax against interest

payable. The lesser the ratio, the lesser is the firms capability to pay off its interests and

hence increased chances of liquidation.

CRITICAL EVALUATION OF HIGH GEARING:

Nobes (1992) argued that high gearing increases the value of a firm through tax

advantage as interest payment is a tax deductible expense. Also EPS should be

increased if the fixed interest capital is used to earn returns that are in excess of the

interest charge thereby a benefit to the real owners (equity share) of the firm. Moreover

Bedward and Stredwick (2004) argue in favor of gearing. His based his argument on the

rationale that creation of new equity increases the risk of potential/dilution loosing of

control. Further Elearn (2008) argued that creation of income generating assets can be

financed without any immediate reference to equity shareholders and moreover the cost

of gearing is comparatively lower than that of the equity capital. Whittington(1997)

argues that in periods of inflation high level of gearing is preferable. This is because

profits might increase owing to the fact that interest payment's value can relatively

diminish. The rationale behind his argument is that earnings during these periods can

be retained and used as a major source of funding later on.

However Berry (2005) in a high gearing scenario if the earnings are not sufficient to

cover up the expenses then effectively the firm can face bankruptcy. Also many


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researchers have pointed out that profits must always be thrice than that of the interest

payments due. Adding market fluctuations into picture the expense of debt during

turbulent times can have adverse effects on the firm's financial structure. Also

Whittington (1997)noted that in a scenario of liquidation companies will try to borrow

still more and consequently aggravating the already precarious of a company. He

further pointed out that a firm may consequently find it increasingly harder to get loans

as there is a chance that investors might be put off owing to the already high gearing

levels. Armstrong (2010) pointed out that further venturing through equity as owing to

high gearing precarious equity investors might well not invest or the existing

shareholders would tend to sell off their shares. He argued that in this scenario further

problems are aggregated for the firm. Pizzery (2001) states that the fall of profits can

largely upset the shareholders during turbulent times, as a major chunk of the earnings

will go towards the payment of interests. Also Tracy (2002) lenders only lend a

particular amount of money to a business. This is measured by valuation of assets,

sales revenue and history. It is just like a collateral security and upon reaching this level

no more debts is available to the organization and lending terms remain prohibitive.

Further if an organization reaches this level and profit margins diminish the level of risk

increases celestially. In this scenario the organization may well become bankrupt.

EXAMPLE:

Scenario A (p=0.25) Scenario B(p=0.50) Scenario C(p=0.25)

Net operating Income 5m 20m 35m

Zero Gearing(100m

equity)

Shareholder earning 5m 20m 35m

ROE 5% 20% 35%


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25% Gearing (75 m

equity and 25m debt)

Debt Interest @10% 2.5m 2.5m 2.5m

Shareholders Earnings 2.5m 17.5m 35m

ROE 3.3% 23.3% 43.3%

50% Gearing (50 m

equity and 50m debt)

Debt Interest @10% 5m 5m 5m

Shareholders Earnings 0 15m 30m

ROE 0 30% 60%

(Adapted from Capital structure and required return, Pike and Neal, 1995, p564)

From the above example certain valid conclusions can be made. The example reflects

an earnings of 5 million, 20 million and 35 for scenarios A, B and C respectively. It

can be noted from the example that with 25% gearing, if NOI increases by 300% (5m

to 30m), then an increase of 600% is noted in the earnings of the shareholders.(2.5 to

17.5m). This shows that the shareholders earnings increase with considerable gearing.

However when 50% of the capital is geared under scenario A then all the earning are

wiped owing to prior Interest charges. Also it can be assumed that at any further level of

gearing the return on equity would be negative.


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GENERAL IMPLICATIONS TAKEN FROM THE EXAMPLE

The spectrum of probable return on equity is wider and this may concern the risk

averting shareholders. This effectively means that shareholders enjoy a profitable return

when the market is good but serve huge losses in case of turbulence and hence risk is

always associated with gearing.

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Finance and risk management..bethen lloyd jones