McAfee SECURE sites help keep you safe from identity theft, credit card fraud, spyware, spam, viruses and online scams

Impact of Capital Structure on the Market Value

Introduction

A capital structure is nothing one can touch or see in reality, but it is measured using according and financial information. It can hence be calculated for organisation sophisticated enough to portray their operations in the form of balance sheet. From this it follows that the capital structure is socially constructed and thus not always an objective and uncontroversial measure. On capital structure decision Miller and Modigliani use the terminology of debt and equity when categorising companies’ liabilities. Debt then refers to liabilities bearing a residual, or implicit, cost. Debt, as it is used here, refers to interesting to risk bearing capital. The fundamental deference between debt and equity is that debt financing is based on a contractual relationship the debt holder and the as a legal entity. This provides the debt holder with certain legal right. The investor provide equity to the company and unlike debt holder, investor lack contractual relationship with other stakeholder (including debt holder) have been fulfilled. Because share holders are not garneted anything they take a greater risk and hence we can expect them to ask for a higher return than debt holders.

In essence, equity consists of capital invested by investor (typically common stock and preferred stock) and earning after dividends from previous year (retained earnings). Debt consists of numerous different items such as for example bank loan, issued corporate bonds, convertible securities, deferred tax liability, and supplier credits. Often the debt liability is subdivided into short term and long term debt. It’s based on Solvency, Debt ratio, and Interest rate. The balance sheet presented in the annual report contains the book values of assets and liabilities. The market value stems from trading in financial markets where investor estimated future cash flows from the company’s current and expected future project. Existing assets might be worth more than their historical acquisition cost, and they can be expected to generate substantial future cash flows. The market value of debt can differ from book value, usually to a much lesser extent.

Research problem and why this research problem is important.

This problem is of vital importance because; imagine if the circumstances were such that capital structure did not matter. That would suggest that wealth could be created in the board room irrespective of efficient production and logistics etc. This could be done through the manipulation of the gearing ratio at the board level by releasing debt and equity as appropriate. However, this would not be in the long term benefit of shareholders. By insinuating that capital structure is important, indeed, vital to wealth creation, that requires managers to perform well, ensure efficient management and production and the long term success of the company. That is why capital structure is important!

Aim and Objectives

Utilising the classical theories as started by Modigliani and Miller (1958) et al, this paper looks to consider the impact of changes in capital structure (also referred to as leverage,) and attempts to correlate these changes with market value impacts. Further, the practical implications of the notion of optimal capital structure are considered as proposed by BHP Billiton plc. The research seems to suggest that a strong business model, coupled with a constant and healthy cash flow remain the fundamental determinants of a company’s long term success.

The role of finance methodology and the different requirements of stake holder, this method in sequence and efficient market hypothesis have to fulfil. And analyse between capital value and market value, with taxation and bankruptcy theory. Aim of research in this area which capital structure model is use full for BHP Billiton plc, long term success, and how much exact label of gearing is required because this is mining company.

Literature Review

There is an Extensive theoretical literature concerning optimal capital structure of BHP Billiton plc. However, there is little empirical evidence of a relation between changes in capital structure and firm value. In the best known test of an optimal capital structure model, Miller-Modigliani reported evidence of a positive relationship between firm value and leverage which they attributed to a debt tax shield effect of this firm. Their results are suspect, however, because of statistical problems they encountered when attempting to adjust for differences in the firms' asset and capital structures. Since only regulated firms were examined, there is also some concern that their empirical findings were caused by the regulatory environment in which these firms operate. No strong evidence of a relation between a firm's value and the size of its debt tax shield and controversy between debt and equity ratio has been uncovered since the Miller-Modigliani study. This study estimates the impact of a change in debt level on firm values. Two forms of capital structure change are examined: issuer exchange offers, and recapitalizations. The results indicate that both stock prices and firm values are positively related to changes in debt level and leverage; senior security prices are negatively related to these capital structure change variables. This evidence is consistent with models of optimal capital structure and with the hypothesis that debt level changes release information about changes in firm value.

Cost of capital

In percent

Ke.

(A) (C) WACC

(B)

Kd

0 x Label of gearing

The traditional approach to capital structure

In tradition approch we evaluat the financial assets and analys between cost Equity and cot of Debt.

And when we calculate the WACC in this area i find the exact label of capital structure.

The static capital structure model

Market Value of Share

PV cost of financial distress

PV interest tax shields

Firm value all - equity financing

0

Optimum Debt

The static theory of capital structure

A firm's optimal debt ratio is usually viewed as determined by tradeoffs of the costs and benefits of borrowing, holding the firm's assets and investment plans constant. The firm is portrayed as balancing the value of interest tax shields against various costs of bankruptcy or financial embarrassment. Of course, there is controversy about how valuable the tax shields are, and which, if any, of the costs of financial embarrassment are material, but these disagreements give only variations on a theme. The firm is supposed to substitute debt for equity, or equity for debt, until the value of the firm is maximized.

Other capital structure

The packing order hypothesis

Packing order hypothesis is based on three observation / assumption

Management prefer internal financing. (c.f. Dnaldson,1984)

Since management prefer internal financing to external financing the dividend policy changes so that cash flows from past investments match the expected future investment needs.( Lintner, 1956)

When force to use external financing management choose the safest and least demanding source first and as they are forced to obtain more external financing, they will do so by working their down the packing order. (Myers and Majluf, 1984).

The signalling hypothesis

The capital structure based on Signalling Hypothesis (Ross, 19979, Blazenko, 1987) the origin of theory is somewhat as same as for the packing order hypothesis, namely asymmetric information problem between well-informed managers and poorly informed shareholder. When management signal to share holders using the capital structure they will accept more debt, with its adjoin fixed capital cost, than poorly performing company can afford to risk. The dead -weight costs of bankruptcy will thus on the marginal inhibit some companies from certain capital structure. One of the most prominent patterns of corporate, and is that more profitable companies would not be signalling to share holders that they are better than average –quit the contrary. Issuance of equity often signals that management think that the company is valued at par, or above, its intrinsic value (e.g. Daniel, Hirshleifer and Subrahmanyam, 1998). While it makes intuitive sense, the packing order hypothesis has much stronger empirical support.

Research Question

How does the capital structure irrelevance theorem regard the level of competition in product markets as compared to the level of the markets Share price?

"How does a business respond to the knowledge that capital structure are not precisely known and that from time to time major needs will arise that have not been fully anticipated?”

Research Methodology and Method(s)

In this reaserch area i am using two type of approch income approch and market approch. Through this approch i am taking 100% Equity, Equity with tax , and debt finance with equity and tax.

And taking bankroptcy and agency cost how company manage their gearing in this area. In this scenario i alocate the exact label of dividend.

Income Approach: Estimating future cash flow that could be taken out of the business without impairing future operations are: Net Present Value, Equity Cash Flow, Capital Cash Flow, WACC and CAPM.

Cost of Capital (%) Ke

A WACC

Kd

0 Label of Gearing

Miller and Modigliani’s net operating income approach to capital structure

Under the income approrch i analyse the cost of earning on equity and cost of debt with exact lable of gearing. The cost of equity ray shows the cost of capital in the income of the firm . that means a high profit margine earened company have a high equity finance and their lable of debt is in risk free covrage area and wacc ray mantion the the exact lable of capital structure and the label of gearing shows the effect of market share price.

Market Approach: Estimates the value of a going concern business by comparing with firms whose stock is publicly traded. And their Market Approach is used as a secondary valuation method to verify the estimates derived from the Income Approach.

I will analys and reserch how capital stracture working and whats their impact of company value and whats the effect of market share price during three scenario the first one is 100% Equity finance , Second one is Equity finance with tax, third one is Debt finace with equity and Tax.

Data Collection for Research

I am going to collect my data (previous ten years) from secondary data sources, and doing a quantitative, Analytical/explanatory research. Through Financial Times, interview, Yahoo Finance & Annual report of BHP Billiton plc, I would collect financial databases – e.g. daily share prices, Income statements, mergers & acquisitions. Data Stream & FAME, etc.

Data analysis

I will analyse my ten years data of BHP Billiton plc. And allocate what’s the impact of its capital structure and their value firm. In this circular what’s the effect of market share price.

Financial ratio-

Current Ratio

Liquidity Ratio, b) Shareholders Liquidity Ratio

Solvency Ratio (%), d) Asset Cover

Gearing (%), f) Shareholders’ Funds per Employment. (Unit)

Working Capital per Employee (Unit), h) Total Assets per Employee (Unit)

Financial Trends & Changes in percent-

Profitability Ratios-

Profit Margin (%).B) Return on Shareholders’ Funds (%).C)Return on Capital Employed(%)

Return on Total Assets (%). E) Interest Cover. F) Stock Turnover. G) Debtors Turnover

Debtor Collection (days). I) Creditors Payment (days). J) Net Assets Turnover.

Fixed Assets Turnover. L) Salaries/Turnover (%). M) Gross Margin (%)

Berry ratio. O) EBIT Margin (%). P) EBITDA Margin (%)

Turnover per Employee (Unit). R) Average Remuneration per Employee (Unit)

Profit per Employee (Unit). T) Profit per Employee (Unit)

Profitability Trends & Changes in Trend Percent-

Structure and Plan

My dissertation topic is Impact of Capital Structure on the Market Value and an Analysis of BHP Billiton plc. I am going to research which capital structure model is best for my company, i will describe Determinants Of Capital structure policy, Capital structure under the influence of corporate taxes, Introducing Bankruptcy and agency costs, and what’s the exact label of Dividend is best for our firm and in this area. I will focus the best controversy, how capital structure singling the market value of share. For this all dissertation i will take estimated time.

Abstract

List of Exhibits One week

List of Tables

Chapter (1) Introduction

Part (I) Theoretical Framework

Chapter (2) Meaning of Capital Structure Three weeks

Chapter (3) Measurement of Capital Structure

Chapter (4) Objective and Content of Capital Structure

Chapter (5) Literature Review

Part (II) Research Methodology and Methods’

Chapter (6) Research Problem and Strategy Two weeks

Chapter (7) Data Collection Methods

Part (III) Analysis and Interpretation of the Data

Chapter (8) Data Processing

Chapter (9) Characteristics of the Sample

Chapter (10) Results and Conclusions [I] Three weeks

Chapter (11) Results and Conclusions [II]

Chapter (12) Results and Conclusions [III]

Chapter (13) Final Conclusions and Major Implications of the Study

References and Appendices