Capital Structure
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Capital Structure
In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt (borrowed funds), and preferred stock, and is detailed in the company's balance sheet. The larger the debt component is in relation to the other sources of capital, the greater financial leverage (or gearing, in the United Kingdom) the firm is said to have. Too much debt can increase the risk of the company and reduce its financial flexibility, which at some point creates concern among investors and results in a greater cost of capital. Company management is responsible for establishing a capital structure for the corporation that makes optimal use of financial leverage and holds the cost of capital as low as possible. Capital structure is an important issue in setting rates charged to customers by regulated utilities in the United States. The utility company has the right to choose any capital str ...
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Corporate Finance
Corporate finance is the area of finance that deals with the sources of funding, the capital structure of corporations, the actions that managers take to increase the Value investing, value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to Shareholder value, maximize or increase valuation (finance), shareholder value. Correspondingly, corporate finance comprises two main sub-disciplines. Capital budgeting is concerned with the setting of criteria about which value-adding projects should receive investment funding, and whether to finance that investment with ownership equity, equity or debt capital. Working capital management is the management of the company's monetary funds that deal with the short-term business operations, operating balance of current assets and Current liability, current liabilities; the focus here is on managing cash, inventory, inventories, and short-term borrowing an ...
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Equity (finance)
In finance, equity is ownership of assets that may have debts or other liabilities attached to them. Equity is measured for accounting purposes by subtracting liabilities from the value of the assets. For example, if someone owns a car worth $24,000 and owes $10,000 on the loan used to buy the car, the difference of $14,000 is equity. Equity can apply to a single asset, such as a car or house, or to an entire business. A business that needs to start up or expand its operations can sell its equity in order to raise cash that does not have to be repaid on a set schedule. In government finance or other non-profit settings, equity is known as "net position" or "net assets". Origins The term "equity" describes this type of ownership in English because it was regulated through the system of equity law that developed in England during the Late Middle Ages to meet the growing demands of commercial activity. While the older common law courts dealt with questions of property title, equi ...
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Transaction Cost
In economics and related disciplines, a transaction cost is a cost in making any economic trade when participating in a market. Oliver E. Williamson defines transaction costs as the costs of running an economic system of companies, and unlike production costs, decision-makers determine strategies of companies by measuring transaction costs and production costs. Transaction costs are the total costs of making a transaction, including the cost of planning, deciding, changing plans, resolving disputes, and after-sales. Therefore, the transaction cost is one of the most significant factors in business operation and management. Oliver E. Williamson's ''Transaction Cost Economics'' popularized the concept of transaction costs. Douglass C. North argues that institutions, understood as the set of rules in a society, are key in the determination of transaction costs. In this sense, institutions that facilitate low transaction costs, boost economic growth.North, Douglass C. 1992. “Transa ...
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Information Asymmetry
In contract theory and economics, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. Information asymmetry creates an imbalance of power in transactions, which can sometimes cause the transactions to be inefficient, causing market failure in the worst case. Examples of this problem are adverse selection, moral hazard, and monopolies of knowledge. A common way to visualise information asymmetry is with a scale with one side being the seller and the other the buyer. When the seller has more or better information the transaction will more likely occur in the seller's favour ("the balance of power has shifted to the seller"). An example of this could be when a used car is sold, the seller is likely to have a much better understanding of the car's condition and hence its market value than the buyer, who can only estimate the market value based on the information provided by the seller and their own a ...
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Taxes
A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, or national), and tax compliance refers to policy actions and individual behaviour aimed at ensuring that taxpayers are paying the right amount of tax at the right time and securing the correct tax allowances and tax reliefs. The first known taxation took place in Ancient Egypt around 3000–2800 BC. A failure to pay in a timely manner ( non-compliance), along with evasion of or resistance to taxation, is punishable by law. Taxes consist of direct or indirect taxes and may be paid in money or as its labor equivalent. Most countries have a tax system in place, in order to pay for public, common societal, or agreed national needs and for the functions of government. Some levy a flat percentage rate of taxation on personal annual income, but m ...
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Agency Costs
An agency cost is an economic concept that refers to the costs associated with the relationship between a " principal" (an organization, person or group of persons), and an "agent". The agent is given powers to make decisions on behalf of the principal. However, the two parties may have different incentives and the agent generally has more information. The principal cannot directly ensure that its agent is always acting in its (the principal's) best interests.''Pay Without Performance'' by Lucian Bebchuk and Jesse Fried, Harvard University Press 2004preface and introduction This potential divergence in interests is what gives rise to agency costs. Common examples of this cost include that borne by shareholders (the principal), when corporate management (the agent) buys other companies to expand its power, or spends money on wasteful and unnecessary projects, instead of maximizing the value of the corporation's worth; or by the voters of a politician's district (the principal) whe ...
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Bankruptcy Costs
Within the theory of corporate finance, bankruptcy costs of debt are the increased costs of financing with debt instead of equity that result from a higher probability of bankruptcy. The fact that bankruptcy is generally a costly process in itself and not only a transfer of ownership implies that these costs negatively affect the total value of the firm. These costs can be thought of as a financial cost, in the sense that the cost of financing increases because the probability of bankruptcy increases. One way to understand this is to realize that when a firm goes bankrupt investors holding its debt are likely to lose part or all of their investment, and therefore investors require a higher rate of return when investing in bonds of a firm that can easily go bankrupt. This implies that an increase in debt which ends up increasing a firm's bankruptcy probability causes an increase in these bankruptcy costs of debt. In the trade-off theory of capital structure, firms are supposedly choo ...
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Merton Miller
Merton Howard Miller (May 16, 1923 – June 3, 2000) was an American economist, and the co-author of the Modigliani–Miller theorem (1958), which proposed the irrelevance of debt-equity structure. He shared the Nobel Memorial Prize in Economic Sciences in 1990, along with Harry Markowitz and William F. Sharpe. Miller spent most of his academic career at the University of Chicago's Booth School of Business. Biography Early years Miller was born in Boston, Massachusetts to Jewish parents Sylvia and Joel Miller, a housewife and attorney. He attended Harvard University as an undergraduate student. He worked during World War II as an economist in the division of tax research of the Treasury Department, and received a Ph.D. in economics from Johns Hopkins University, 1952. His first academic appointment after receiving his doctorate was Visiting Assistant Lecturer at the London School of Economics. Career In 1958, at Carnegie Institute of Technology (now Carnegie Mellon University) ...
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Franco Modigliani
Franco Modigliani (18 June 1918 – 25 September 2003) was an Italian-American economist and the recipient of the 1985 Nobel Memorial Prize in Economics. He was a professor at University of Illinois at Urbana–Champaign, Carnegie Mellon University, and MIT Sloan School of Management. Early life and education Modigliani was born on 18 June 1918 in Rome, Lazio, Italy, to the Jewish family of a pediatrician father and a voluntary social worker mother."Franco Modigliani" by Daniel B. Klein and Ryan Daza, inThe Ideological Migration of the Economics Laureates, ''Econ Journal Watch'', 10(3), September 2013, pp. 472-293 He entered university at the age of seventeen, enrolling in the faculty of Law at the Sapienza University of Rome.Parisi, Daniela (2005) "Five Italian Articles Written by the Young Franco Modigliani (1937–1938)", ''Rivista Internazional di Scienze Sociali'', 113(4), pp. 555–557 (in language) In his second year at Sapienza, his submission to a nationwide conte ...
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Modigliani–Miller Theorem
The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is an influential element of economic theory; it forms the basis for modern thinking on capital structure. The basic theorem states that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the enterprise value of a firm is unaffected by how that firm is financed. This is not to be confused with the value of the equity of the firm. Since the value of the firm depends neither on its dividend policy nor its decision to raise capital by issuing shares or selling debt, the Modigliani–Miller theorem is often called the capital structure irrelevance principle. The key Modigliani–Miller theorem was developed in a world without taxes. However, if we move to a world where there are taxes, when the interest on debt is tax-deductible, and ignoring other frictions, the value of the company increases in proportion to the amount of debt used.Fernandes, Nuno. Fi ...
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Debenture
In corporate finance, a debenture is a medium- to long-term debt instrument used by large companies to borrow money, at a fixed rate of interest. The legal term "debenture" originally referred to a document that either creates a debt or acknowledges it, but in some countries the term is now used interchangeably with bond, loan stock or note. A debenture is thus like a certificate of loan or a loan bond evidencing the company's liability to pay a specified amount with interest. Although the money raised by the debentures becomes a part of the company's capital structure, it does not become share capital. Senior debentures get paid before subordinate debentures, and there are varying rates of risk and payoff for these categories. Debentures are freely transferable by the debenture holder. Debenture holders have no rights to vote in the company's general meetings of shareholders, but they may have separate meetings or votes e.g. on changes to the rights attached to the debentures ...
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Debt-to-equity Ratio
The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. Closely related to leveraging, the ratio is also known as risk, gearing or leverage. The two components are often taken from the firm's balance sheet or statement of financial position (so-called book value), but the ratio may also be calculated using market values for both, if the company's debt and equity are publicly traded, or using a combination of book value for debt and market value for equity financially. Usage Preferred stock can be considered part of debt or equity. Attributing preferred shares to one or the other is partially a subjective decision but will also take into account the specific features of the preferred shares. When used to calculate a company's financial leverage, the debt usually includes only the Long Term Debt (LTD). Quoted ratios can even exclude the current portion of the LTD. The composition of eq ...
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