11. How we choose a capital structure that will maximize the shareholders wealth? ( Run company from all equity? Or Run company from all debt?) The basic goal of financial managers is to maximize the level of shareholder wealth. Roe (2001,p.2) indicated that the maximization of shareholder wealth is a generally accepted process within the American corporate circles (Friedman,1970). The utilitarian viewpoint is that this is part of the price that is paid for very strong capital markets as well allocative efficiency. These benefits are further argued out to be so powerful that they may surpass the normative benefits enjoyed by employees over the shareholders. After all, employees and shareholders are noted to be better off with liquid and efficient capital markets. In order to choose a financial structure that maximizes shareholder wealth, it is best to run the company from all equity as opposed to all debt. This is because debt increases bankruptcy risks while equity leads to retained earnings. Equity makes a company to develop a solid internal source of finance. The earnings which a given company generates from equity is retained as capital and the company can then use this in financing the increased working capital as well as take care of other fund requirements. This then alleviates the hassles of having to raise funds from other sources. The company can then use equity in the effective achievement of the shareholder's wealth maximization objective by using the funds
Financial Management is an important aspect of how a business operates efficiently. The way that the finances are controlled can determine how successful the company is. The finances of a business allows for the growth of the company. The five practices of financial management: capital structure decision, investment appraisal techniques, dividend policy, working capital management and financial performance assessment are critical when assessing a company. The performance of a company plays a key role on how successful the company is on meeting goals. There are different strategies and tools that a company can implement and if they are used to effectively the company can meet their goals. If a company has good finances, a good
c) Optimization of the capital structure is also consistent with the growth of the company. The optimal capital structure
We would recommend the capital structure with 30% debt. This is because with 30% debt, they would be able to repurchase 19.8 million shares outstanding as well as save 37.8 million in taxes. EBIT is high in this company, and because of this, financial leverage will raise EPS and ROE. However, variability also increases as financial leverage increases, so the company would not want to take on too much debt and become very risky.
According to Gitman, the goal of the firm, and therefore of all managers and employees, is to maximize the wealth of the owners for whom it is being operated (2009). The financial manager is responsible for acquiring sources of financing and allocate amongst competitive investment alternatives. The ultimate goal is to invest in projects yielding higher returns than amount of financing used to invest, so profits can be used satisfy claims and increase shareholder wealth. The issues facing financial managers are therefore to 1) increase sources of financing from investors and 2) increase shareholder wealth while maintaining a
Nevertheless, the use of the Optimal Capital Structure (OCS) is the right techniques to be used in order to acquire the right combination of debt and equity that can maximize the
Generally, firms can choose among various capital structures in order to maximize overall market value of the company. It is proposed however, that
The purpose of the report is to understand the capital structure of the chosen company on the basis of the financial statements of the company which includes the income statement, balance sheet and the cash flow statement of the company and do the capital analysis of the company as well to find out the advantages and disadvantages in working capital of the company and suggest company logical and useful ways for growing their economy.
REFERENCES•Ross, S.A., Westerfield, R.W., Jaffe, J., Jordan, B.D. "Modern Financial Management". McGraw-Hill, Eighth Edition, (2008)•R.A. Brealey and S.C. Myers, "Principles of Corporate Finance", McGraw-Hill, Seventh Edition, (2003).
The first thing that you learn in a financial management course is that the goal of a corporate financial management is to maximize the wealth of the shareholder. However, in more advances classes such as this one we see that there are multiple theories on what is the best way to do this. It should also be obvious by now that there is no one standard way to maximize shareholder wealth that will work for all organizations. While there may be no standardized way for all corporations to maximize shareholders wealth, there are a couple factors that do apply to all corporations. One of these theories that holds true is that a corporation can maximize shareholder wealth by maximizing its revenue and minimizing it expenses. Cutting cost can be
There is no universal theory of the debt-equity choice, and no reason to expect one. In this essay I will critically assess the Pecking Order Theory of capital structure with reference and comparison of publicly listed companies. The pecking order theory says that the firm will borrow, rather than issuing equity, when internal cash flow is not sufficient to fund capital expenditures. This theory explains why firms prefer internal rather than external financing which is due to adverse selection, asymmetry of information, and agency costs (Frank & Goyal, 2003). The trade-off theory comes from the pecking order theory it is an unintentional outcome of companies following the pecking-order theory. This explains that firms strive to achieve an
Capital structure is defined as the mix of the long-term sources of funds that a firm use. It is composed of equity, debt securities and affect long-term financing of the entity. It is made up by shareholder’s funds, long-term debt and preference share capital. The capital structure mostly focus on the proportions of debt and equity displayed in the company financial statements, especially in the balance sheet (Myers, 2001). The value of a firm can be calculated by the sum of the value of its firm’s debt and equity.
Already in 1958, Modigliani and Miller have pointed the discussion of capital structure towards the cost of debt and equity. According to their first proposition, in a world of no corporate taxes and with perfect markets, financial leverage has no effect on a firm’s value. In their second proposition, they state that the cost of equity equals a linear function defined by the required return on assets and the cost of debt (Modigliani and Miller, 1958).
The relationship between capital structure and firm value has been discussed frequently in the literature by different researcher accordingly, in both theoretical and empirical studies. It has also been discussed that whether the firm has any optimal capital structure that has been adopted by an individual firm, or whether the proportions of debt usage is completely irrelevant to the individual firm value.
“Corporate finance theory, teaching and the typically recommended practice at least in the US are all built on the premise that the primary goal of a corporation should be the maximization of shareholder value.”
Harris and Reviv (1990) gave one more reason of using debt in capital structure. They say that management will hide information from shareholders about the liquidation of the firm even if the liquidation will be in the best interest of shareholders because managers want the perpetuation of their service. Similarly, Amihud and Lev (1981) suggest that mangers have incentives to pursue strategies that reduce their employment risk. This conflict can be solved by increasing the use of debt financing since bondholders will take control of the firm in case of default as they are powered to do so by the debt indentures. Stulz (1990) said when shareholders cannot observe either the investing decisions of management or the cash flow position in the firm, they will use debt financing. Managers, to maintain credibility, will over-invest if it has extra cash and under-invest if it has limited cash. Stulz (1990) argued that to reduce the cost of underinvestment and overinvestment, the amount of free cash flow should be reduced to