Cost Of Capital And Capital Structure Finance Essay
Capital, in the most basic terms, is money. All businesses must have capital in order to purchase assets and maintain their operations. Business capital comes in two main forms: debt and equity. Debt refers to loans and other types of credit that must be repaid in the future, usually with interest. In contrast, equity generally does not involve a direct obligation to repay the funds. Instead, equity investors receive an ownership position which usually takes the form of stock in the company.
The capital formation process describes the various means through which capital is transferred from people who save money to businesses that require funds. Such transfers may take place directly, meaning that a business sells its stocks or bonds directly to savers who provide the business with capital in exchange. Transfers of capital may also take place indirectly through an investment banking house or through a financial intermediary, such as a bank, mutual fund, or insurance company. In the case of an indirect transfer using an investment bank, the business sells securities to the bank, which in turn sells them to savers. In other words, the capital simply flows through the investment bank. In the case of an indirect transfer using a financial intermediary, however, a new form of capital is actually created. The intermediary bank or mutual fund receives capital from savers and issues its own securities in exchange. Then the intermediary uses the capital to purchase stocks or bonds from businesses.
1.1 Capital Structure
Since capital is expensive for small businesses, it is particularly important for small business owners to determine a target capital structure for their firms. The capital structure concerns the proportion of capital that is obtained through debt and equity. There are tradeoffs involved: using debt capital increases the risk associated with the firm's earnings, which tends to decrease the firm's stock prices. At the same time, however, debt can lead to a higher expected rate of return, which tends to increase a firm's stock price. As Brigham explained, "The optimal capital structure is the one that strikes a balance between risk and return and thereby maximizes the price of the stock and simultaneously minimizes the cost of capital."
Capital structure decisions depend upon several factors. One is the firm's business risk—the risk pertaining to the line of business in which the company is involved. Firms in risky industries, such as high technology, have lower optimal debt levels than other firms. Another factor in determining capital structure involves a firm's tax position. Since the interest paid on debt is tax deductible, using debt tends to be more advantageous for companies that are subject to a high tax rate and are not able to shelter much of their income from taxation.
A third important factor is a firm's financial flexibility, or its ability to raise capital under less than ideal conditions. Companies that are able to maintain a strong balance sheet will generally be able to obtain funds under more reasonable terms than other companies during an economic downturn. Brigham recommended that all firms maintain a reserve borrowing capacity to protect themselves for the future. In general, companies that tend to have stable sales levels, assets that make good collateral for loans, and a high growth rate can use debt more heavily than other companies. On the other hand, companies that have conservative management, high profitability, or poor credit ratings may wish to rely on equity capital instead.
1.2 The Modigliani and Miller Theorem
The Modigliani–Miller theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, a company’s value is unaffected by how it is financed, regardless of whether the company’s capital consists of equities or debt, or a combination of these, or what the dividend policy is. The theorem is also known as the capital structure irrelevance principle.
A number of principles underlie the theorem, which holds under the assumption of both taxation and no taxation. The two most important principles are that, first, if there are no taxes, increasing leverage brings no benefits in terms of value creation, and second, that where there are taxes, such benefits, by way of an interest tax shield, accrue when leverage is introduced and/or increased.
The theorem compares two companies - one unlevered (i.e. financed purely by equity) and the other levered (i.e. financed partly by equity and partly by debt) - and states that if they are identical in every other way the value of the two companies is the same.
As an illustration of why this must be true, suppose that an investor is considering buying one of either an unlevered company or a levered company. The investor could purchase the shares of the levered company, or purchase the shares of the unlevered company and borrow an equivalent sum of money to that borrowed by the levered company. In either case, the return on investment would be identical. Thus, the price of the levered company must be the same as the price of the unlevered company minus the borrowed sum of money, which is the value of the levered company’s debt. There is an implicit assumption that the investor’s cost of borrowing money is the same as that of the levered company, which is not necessarily true in the presence of asymmetric information or in the absence of efficient markets. For a company that has risky debt, as the ratio of debt to equity increases the weighted average cost of capital remains constant, but there is a higher required return on equity because of the higher risk involved for equity-holders in a company with debt.
1.2.2 Advantages and Disadvantages of Modigliani and Miller’s Theorem
Advantages: In practice, it’s fair to say that none of the assumptions are met in the real world, but what the theorem teaches is that capital structure is important because one or more of the assumptions will be violated. By applying the theorem’s equations, economists can find the determinants of optimal capital structure and see how those factors might affect optimal capital structure.
Disadvantages: Modigliani and Miller’s theorem, which justifies almost unlimited financial leverage, has been used to boost economic and financial activities. However, its use also resulted in increased complexity, lack of transparency, and higher risk and uncertainty in those activities. The global financial crisis of 2008, which saw a number of highly leveraged investment banks fail, has been in part attributed to excessive leverage ratios.
SOURCES OF CAPITAL
2.1 Debt Capital
Small businesses can obtain debt capital from a number of different sources. These sources can be broken down into two general categories, private and public sources. Private sources of debt financing, according to W. Keith Schilit in The Entrepreneur's Guide to Preparing a Winning Business Plan and Raising Venture Capital, include friends and relatives, banks, credit unions, consumer finance companies, commercial finance companies, trade credit, insurance companies, factor companies, and leasing companies. Public sources of debt financing include a number of loan programs provided by the state and federal governments to support small businesses.
There are many types of debt financing available to small businesses—including private placement of bonds, convertible debentures, industrial development bonds, and leveraged buyouts—but by far the most common type of debt financing is a regular loan. Loans can be classified as long-term (with a maturity longer than one year), short-term (with a maturity shorter than two years), or a credit line (for more immediate borrowing needs). They can be endorsed by co-signers, guaranteed by the government, or secured by collateral—such as real estate, accounts receivable, inventory, savings, life insurance, stocks and bonds, or the item purchased with the loan.
When evaluating a small business for a loan, Jennifer Lindsey wrote in her book The Entrepreneur's Guide to Capital, lenders ideally like to see a two-year operating history, a stable management group, a desirable niche in the industry, a growth in market share, a strong cash flow, and an ability to obtain short-term financing from other sources as a supplement to the loan. Most lenders will require a small business owner to prepare a loan proposal or complete a loan application. The lender will then evaluate the request by considering a variety of factors. For example, the lender will examine the small business's credit rating and look for evidence of its ability to repay the loan, in the form of past earnings or income projections. The lender will also inquire into the amount of equity in the business, as well as whether management has sufficient experience and competence to run the business effectively. Finally, the lender will try to ascertain whether the small business can provide a reasonable amount of collateral to secure the loan.
2.1.1 Cost of Debt
The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since, ceteris paribus,"all other things being equal", the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be written as:
(Rf + credit risk rate)(1-T)
where T is the corporate tax rate and Rf is the risk free rate.
2.2 Equity Capital
Equity capital for small businesses is also available from a wide variety of sources. Some possible sources of equity financing include the entrepreneur's friends and family, private investors (from the family physician to groups of local business owners to wealthy entrepreneurs known as "angels"), employees, customers and suppliers, former employers, venture capital firms, investment banking firms, insurance companies, large corporations, and government-backed Small Business Investment Corporations (SBICs).
There are two primary methods that small businesses use to obtain equity financing: the private placement of stock with investors or venture capital firms; and public stock offerings. Private placement is simpler and more common for young companies or start-up firms. Although the private placement of stock still involves compliance with several federal and state securities laws, it does not require formal registration with Securities and Exchange Commission. The main requirements for private placement of stock are that the company cannot advertise the offering and must make the transaction directly with the purchaser.
In contrast, public stock offerings entail a lengthy and expensive registration process. In fact, the costs associated with a public stock offering can account for more than 20 percent of the amount of capital raised. As a result, public stock offerings are generally a better option for mature companies than for start-up firms. Public stock offerings may offer advantages in terms of maintaining control of a small business, however, by spreading ownership over a diverse group of investors rather than concentrating it in the hands of a venture capital firm.
2.2.1 Cost of Equity
Cost of equity = Risk free rate of return + Premium expected for risk
The expected return (or required rate of return for investors) can be calculated with the "dividend capitalization model", which is:
That equation is also seen as: Expected Return = dividend yield + growth rate of dividends.
THE COST OF CAPITAL
“Capital is a necessary factor of production and, like any other factor, it has a cost,” according to Eugene F. Brigham in his book Fundamentals of Financial Management. In the case of debt capital, the cost is the interest rate that the firm must pay in order to borrow funds. For equity capital, the cost is the returns that must be paid to investors in the form of dividends and capital gains. Since the amount of capital available is often limited, it is allocated among various businesses on the basis of price. “Firms with the most profitable investment opportunities are willing and able to pay the most for capital, so they tend to attract it away from inefficient firms or from those whose products are not in demand,” Brigham explained. The good thing is that in most industrialised countries (like USA, Germany, Japan, UK, etc.) government agencies exist which help individuals or groups to obtain credit on favourable terms. Among those eligible for this kind of assistance are small businesses, certain minorities, and firms willing to build plants in areas with high unemployment.
As a rule, the cost of capital for small businesses tends to be higher than it is for large, established businesses. Given the higher risk involved, both debt and equity providers charge a higher price for their funds. A number of researchers have observed that portfolios of small-firm stocks have earned consistently higher average returns than those of large-firm stocks; this is called the small-firm effect. In reality, it is bad news for the small firm; what the small-firm effect means is that the capital market demands higher returns on stocks of small firms than on otherwise similar stocks of large firms. Therefore, the cost of equity capital is higher for small firms. The cost of capital for a company is a weighted average of the returns that investors expect from the various debt and equity securities issued by the firm, according to Richard A. Brealey and Stewart C. Myers in their book “Principles of Corporate Finance”.
Table 1 – Cost of Capital
3.1 Capital Asset Pricing Model
The capital asset pricing model (CAPM) is used in finance to determine a theoretically appropriate price of an asset such as a security.
3.1.1 The Expected Return on Equity According to the Capital Asset Pricing Model
The market risk is normally characterized by the β parameter. Thus, the investors would expect (or demand) to receive:
Es: The expected return for a security
Rf: The expected risk-free return in that market (government bond yield)
Βs: The sensitivity to market risk for the security
RM: The historical return of the stock market/ equity market
(RM-Rf): The risk premium of market assets over risk free assets.
The expected return (%) = risk-free return (%) + sensitivity to market risk * (historical return (%) - risk-free return (%))
Put another way the expected rate of return (%) = the yield on the treasury note closest to the term of your project + the beta of your project or security * (the market risk premium)
The market risk premium historically has been between 3-5%
The models state that investors will expect a return that is the risk-free return plus the security’s sensitivity to market risk times the market risk premium.
The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds.
The risk premium varies over time and place, but in some developed countries during the twentieth century it has averaged around 5%. The equity market real capital gain return has been about the same as annual real GDP growth. The capital gains on the Dow Jones Industrial Average have been 1.6% per year over the period 1910-2005. The dividends have increased the total “real” return on average equity to the double, about 3.2%.
The sensitivity to market risk (β) is unique for each firm and depends on everything from management to its business and capital structure. This value cannot be known “ex ante” (beforehand), but can be estimated from ex post (past) returns and past experience with similar firms.
3.2 Cost of Retained Earnings/Cost of Internal Equity
We must remember that retained earnings are a component of equity, and therefore the cost of retained earnings (internal equity) is equal to the cost of equity as explained above. Dividends (earnings that are paid to investors and not retained) are a component of the return on capital to equity holders, and influence the cost of capital through that mechanism.
3.3 Weighted Average Cost of Capital
What Does Weighted Average Cost Of Capital - WACC Mean? It is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.
The total capital for a firm is the value of its equity (for a firm without outstanding warrants and options, this is the same as the company’s market capitalization) plus the cost of its debt (the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes). Also we must note that the “equity” in the debt to equity ratio is the market value of all equity, not the shareholders’ equity on the balance sheet. To calculate the firm’s weighted cost of capital, we must first calculate the costs of the individual financing sources i.e. :
Cost of Debt
Cost of Preference Capital
Cost of Equity Capital.
Calculation of WACC is an iterative procedure which requires estimation of the fair market value of equity capital.
The formula for WACC is:
[Rd x D/V x (1-5)] + [Re x E/V]
Rd = Bond’s yield to Maturity (I/Y in Calculator)
D = Market Value (Present Value) of Bonds
(1 - t) = 1 - tax rate = Interest tax shield deductibility of interest expense
Re = Shareholder’s return requirement
V = Total value of all capital (Debt + Equity)
Broadly speaking, a company’s assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.
As a firm’s WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.
3.3.1 Example of Weighted Average Cost of Capital (WACC)
“A” Corp. has issued 10,000 units of bonds that are currently selling at 98.5. The coupon rate on these bonds is 6% per annum with interest paid semi-annually. The maturity left on these bonds is 3 years.
The company has 2,000,000 common shares outstanding with the current stock price at $10 / share. The stock beta is 1.5, risk free rate for government bonds is 4.5% and the Expected Return on the Stock Market is 14.5%.
The tax rate for the corporation is 30%
Table – 2 Bond and Stock Calculations
N = 3 x 2 = 6
I/Y = ? (Rd)
PV = 0.985 x 10,000 x $1000 = $9,850,000 (D)
PMT = (-10,000,000 x 0.06) / 2 = $-300,000
FV = $-10,000,000
P/Y = 2
C/Y = 2
Solution: I/Y = 6.56%
Re = Rf + B[Rm - Rf]
Re = 0.045 + 1.5 [0.145 - 0.045]
Re = 0.045 + 0.15 = 0.195 (19.5%)
Market Value of Equity = E
Stock price x common shares O/S
$10 x 2,000,000 = $20,000,000
V = Total Capital Structure
V = 9,850,000 (bonds debt) + 20,000,000 (equity of common shares)
V = 29,850,000
3.4 Cost of Capital in Islamic Banking
The use of proper investment criteria is essential to industry and agriculture both. Furthermore, although appraisal can be used both in public and private sectors of the economy, public sector has its own additional special problems to be taken into account; like social costs and benefits. Therefore, we will be concerned with the private sector and the problems involved in evaluating different industrial investment projects.
Controversies abound on the relative merits of different investment appraisal methods. However, most of the essential differing points can properly be reconciled.
It is worth noting that almost all economists consider the use of “discounting” as a method of appraisal, as the only possible way to choose between different investments. There are essentially two methods generally used by economists, namely Net Present Value (NPV) and extended Internal Rate of Return (IRR). The term Internal Rate of Return (IRR) was termed by J.M. Keynes (this is perhaps more familiar as the marginal efficiency of capital MEC) schedule; sometimes referred to as marginal efficiency of investment (MEI). It is defined as the rate, which makes the present value of the future income streams exactly equal to the market price of the project. In other words, it is the rate of return that is being earned on capital tied up. That is, while it is tied up it allows for recoupment of the project. NPV of a project is defined formally as the value today of the surplus that the firm makes over and above what it could make by investing at its marginal rate.
The basis of the extended IRR is that the negative cash flows are discounted back at the firm’s cost of capital until they are offset by positive cash flows. Both of these methods (extended IRR and NVP) have their own common shortcomings; e.g., neither NVP nor IRR can be applied in the normal way to give the correct ranking of projects in situations where the rationing of an input is involved. Nevertheless, there are ways of removing these shortcomings and rendering them to be suitable methods of investment appraisal.
We will concentrate on extended IRR, which is simply referred to as IRR. The decision rule in simple cases where the decision is of “all or nothing” type; in deciding which project is to be chosen amongst various investment alternatives, is to undertake all projects which have an IRR greater than the cost of capital.
Cost of capital, in capitalistic system, is the rate a firm can borrow and, presumably, invest which is simply the “rate of interest”. In other words, in such as “cut - off rate”; in the context of the IRR rule, it also appears in the literature as “hurdle rate”. Note that, in NPV approach to investment appraisal, it is necessary for the decision maker to have some explicitly predetermined discount rate; which, as said above, is nothing but the going rate of interest in the money market. However, these is no need, whatsoever, to see any predetermined rate in IRR method except when the time comes where debt- capital is to be rationed among different projects. This makes IRR approach to be rather independent of the rate of interest and also quite appropriate to be used for investment projects in an interest-free Islamic setting, whose discussion will follow.
In case of capitalism if the IRR is greater than or equal to the market rate of interest, then the project will be undertaken. Project maximization will push the firm to the margin where the last undertaken project has IRR equal to the rate of interest. Evidently, the IRR schedule is a decreasing function of investment projects; i.e., the more projects that will be undertaken the lower would be the IRR (in the same industry or activity, of course).
It has been agreed upon (by western economists) that the rate of interest plays the crucial role in determining which project is to be undertaken, and that also how much capital is to be invested in different projects. The role of interest rate in these two aspects seems to have been exaggerated. Given that there is only one project, the criteria given above are quite valid and applicable as to the optimal amount of capital that has to be undertaken. Nevertheless, as the number of projects increase, each IRR that has to be calculated for every single project increases as much. Additionally, there happens to be points of intersection between every two IRR’s. This will complicate the problem and it will drastically reduce the importance of the rate of interest, especially in cases where interest rate happens to be well below the IRR of the last feasible project under consideration.
Given that an investor is a risk-taking entrepreneur, he is normally faced with arrays of investment opportunities from which he is supposed to first select the one whose IRR is the highest. Assuming that he is able to finance many projects, there may be tens of different projects whose IRR are higher than the going rate of interest. Undoubtedly, all these projects are attractive, although in different degrees, to the entrepreneur and will be chosen in descending order rate. This being the case in real business life, the role of the rate of interest becomes rather passive and even redundant. This is so because under such circumstances, projects IRR’s reach the rate of interest. It is beyond this point that the role of interest rate becomes sensible and plays its role as cut-off rate. In other words, it takes a long process before the existence of interest rate becomes relevant because IRR of each pair of adjacent projects are to be compared with each other due to interdependencies of investment projects with no reference to the rate of interest at all.
Rate of interest being exogenous to the real sector (especially, investment) it is ironically proposed, in capitalistic system, to be used to determine the level of optimal investment. Moreover, speculators, whose demands in the money market produce the rate of interest, are allowed to lead the decisions of entrepreneurs whose actions are so important to the economy. It seems rather more reasonable to have the relation other way around; i.e., given the rate of interest, however hypothetical, it should be the real sector to lead the monetary sector, if any.
With the abolishment of interest rate in an Islamic state, there would be no exogenous variable, like interest rate, to determine the kind and level of investment. Investment projects, in such a framework, compete with each other and investments will be undertaken as much as needed to reach full employment; that is, as long as there are unused factors of production in the economy.
This is especially true of human resources that due to their vital and intrinsic importance, as viewed in Islam, authorities are not allowed to keep people unemployed for the sake of interests of capitalists.
It can easily be demonstrated that in an Islamic framework, every piece of money (i.e. potential capital) coming out of interest-free banks in order to finance different projects under various modes of contracts, becomes a permit to directly produce goods and/or services.
A caveat in order here and that is: one of the prerequisites of an Islamic state is to strictly prohibit and prevent speculation to emerge in any market (be it either money or commodity). There has long been misunderstanding among some Islamic economic scholars advocating that speculation can take place and is permissible even under interest abolishment. It is easy to show that there is a one-to-one correspondence between interest (rate) and speculation. Interest (rate) is necessary and sufficient condition for speculation to take place. Even in the absence of apparently forbidden-interest-rate-framework, if speculation is permitted in any market, it will definitely produce interest rate of its own nature. Therefore, interest prohibition will logically lead to the prohibition of speculation. This mutual interdependence between interest and speculation is not only very rare in economic literature but its negligence also has been the source of serious misunderstandings. Relationships in economics are rarely of one-way direction.
The array of IRR’s can be calculated both by an Islamic Central Bank , and independent licensed agencies in order to provide Islamic banks the appropriate guidelines as to the nature and profitability of projects. It is a measure to be used so that the expected profits could be divided between an Islamic bank and the firm demanding finance. The array is also quite useful in determining how much financing should be allocated to the projects which are in the priority list of economic development plan. To determine the firm’s share of profit, different factors, such as the following, can be taken into account: risk premium, degree of deprivation of different regions of the country, priorities in economic development plans, the degree of capital intensity, tax provisions, employment considerations, burden on foreign exchange rates, and the like. Each of these factors or any combination of them can influence the demanding firm’s (the fiancée’s) share of profit that can be safely manipulated without having to interfere in the market mechanism. This gives the IRR method in interest-free banking system, an absolute advantage over artificial manipulation in the interest rate, which is quite often practiced in capitalistic countries, and which is an obvious interference in market mechanism. This is contrary to the position often held by Western economists professing avoiding interference in market mechanism. Added to this, the presumably negative relationship between rate of interest and investment as advocated by both classical economists and Keynes has been empirically proven to be inconclusive. This is so while a proposition can be made to regard a positive relationship between rate of profit and investment. This proposition not only takes care of interest cost in capitalistic system but also it is consistent with the profit maximization goal of any individual firm. Surprisingly though, this goal, at micro level, in capitalistic textbooks has been changed without any logical explanation as to negative relationship between interest rate investment at macro level.
Using IRR method in an Islamic state is not only compatible with the goal of profit maximization (if proven to be appropriate in such a system) - as well as avoidance to interfere in market mechanism - but also it has another absolute advantage of bringing the opportunity cost of capital down to zero. The logic is simple. In the absence of interest, all projects compete with each other (with due consideration of their respective priorities) on the basis of their IRR. Furthermore, the fact is that investment projects are interdependent vis-à-vis one another , and there is no need to bring in any exogenous factor in order to determine the same rate as opportunity cost of capital for all projects. In capitalistic system the going interest rate is logically taken as “the next best alternative” or cost of capital for all projects. The logic concerns its independence with IRR’s of the projects.
The phrase “next best alternative “does not render meaning to the effect that the IRR of a project adjacent to the one under consideration shall be taken as its opportunity cost of capital. This is because the interdependency of all projects does not qualify any one of the IRR’s as suitable for opportunity cost of the remaining projects; otherwise there would be hundreds of opportunity costs in a capitalistic framework whereas the rate of interest is taken to measure the opportunity cost of all capital investments. In other words, in order to have opportunity cost, the condition of independence has to be met. The negligence to consider the interdependencies of the projects and also the independency of the rate of interest from IRR’s of investment projects has led many writers to form misconception about opportunity cost capital.
In the absence of interest there is nothing to compare IRR’s of various projects with (except IRR’s of the projects with themselves). Being interdependent and shared upon by Islamic banks, these projects cannot logically be used to measure the opportunity cost of capital. This simply means nothing but the opportunity cost of capital being zero. This conclusion is in complete agreement with both accounting standards and with economic logic. On this score, two points are mentioned here. First, accountants use, quite often, the historical cost. In PLS contracts the profit share of one partner cannot be considered cost of the other partner; accounting treatment in such cases is same as dividends paid to the shareholders. Second, accountants never agree with economists’ search for a theoretical opportunity cost of capital, which has to be independent from IRR’s. Despite this great debate between accountants and economists, the economists use and base their own economic analysis upon the financial statements prepared by accountants with due consideration given to accounting standards without having to adjust these statements by norms and standards suggested by them. Furthermore, these statements are used to calculate appropriate taxes and are accepted by tax authorities without any objection about their validity.
In sum, tax authorities of an Islamic state shall not accept any cost as cost of capital and economists are expected to be explicit about the independence of rate of interest from IRR’s so that opportunity cost of capital is justifiable.
6-A distinction has to be made between opportunity cost of capital and cut-off rate. It should be clear by now that although in an Islamic state the opportunity cost of capital is zero, but a lower IRR in array of IRR’s can be used as cut-off rate of the project under consideration. An entrepreneur is expected to be keen about this point. Diversity in capital investments made by an entrepreneur can be taken as obvious explanation that he/she cares and is cautious about the above point. In general, opportunity cost of capital is both cost and cut-off rate but the reverse is not true. It seems that in an almost all occasions we are concerned with cut-off rate and rarely with opportunity cost, despite the common belief. Opportunity cost of capital being nil in an Islamic framework has numerous positive economic implications and consequences; to name a few, among other, cet. par. (1) it raises the profits enjoyed by firms which have signed partnership contract with an Islamic bank which is by itself a powerful stimulant to further investment, (2) if such high profit rates are distributed among depositors ( in an Islamic bank) effective demand will go up, (3) if 1 and 2 are combined it would make possible to expand size of the firm and hire more labor which , makes full employment an accessible goal of the economy, (4) more taxes will be collected and budget deficit, if any, would tend to decrease over time, (5)if part of reduction in production cost is reflected in prices of the commodities produced, the whole community will enjoy lower prices, higher income and boost in aggregate demand.
IRR of various projects are quite useful outcome of a logical analysis which provides a measure to gauge qualification of these projects for selection. However, bringing in another measure exogenous to the system requires careful consideration concerning its relevance and other costs and benefits. Costs and benefits of interest go beyond private frontiers in that they both entail social aspects to be considered, especially the social costs. It is not hard to prove that social costs of interest-based system overshadow the benefits by far.
Prevention of simultaneous coexistence of stable prices and full employment is part of social cost of introducing interest (rate)to the system. Additionally, inflation and unemployment which are both consequences of such introduction hurt the general public at the expense of a very low percentage of the population enjoying the benefits through interest incomes. This simple explanation may be key to the locked-in position which is being able to overcome most of the capitalistic deficiencies.
Islamic banking narrows the gap between the rich and poor in three ways:
First: Stable Prices,
Second: Full Employment, and
Third: Enjoyment of bank depositors from (higher than interest) profit income through PLS. This in turn provides equitable distribution of income; the cornerstone of sustained growth and development.
Capitalistic system has long been unsuccessful to simultaneously attain full employment and stable prices due to existence of interest (rate), development of money market and, consequently, speculation. In other words, in such a system necessary condition to maintain full employment, i.e., the equality of saving with investment is absent. This is because part of saving will go to money whirlpool and hence Say’s law cannot hold. It can be logically demonstrated that the root cause of inflation is saving gap which produces excess demand (via income earned in the money whirlpool which brings about inequitable distribution of income) and excess demand, in turn, brings about inflation.
In brief, Islamic banking (especially through its principal pillar, PLS, its end results of zero opportunity cost of capital, and disappearance of speculation) seems to offer solution to the apparently incompatibility of simultaneous full employment and stable prices, for which Western economists have long strived to find remedies.
The basic aim of optimizing capital structure is to select that proportion of various forms of debts and equities that maximizes the firm’s value while minimizing the average cost of capital. This, however, is easier said than done. Though the topic has been extensively researched, there is no single formula or theory that conclusively provides the optimal capital structure for all firms. Some of these theories are given below.
The Net Income (NI) approach to an optimal capital structure states that the total value of the firm changes with a change in the financial leverage. The NI approach holds true under certain assumptions. For example, the NI approach assumes that the cost of debt is lower than the cost of equity. Therefore, an increase in the proportion of debt in the capital structure would result in a decrease in the firm’s average cost of capital. A lower cost of capital would result in an increase in the value of the firm. The NI approach can be used to determine a firm’s optimum capital structure where the value of the firm is highest and the cost of the capital is lowest.
The Net Operating Income (NOI) approach states that the proportion of debt and equity in the firm’s structure does not have any impact on the firm’s value or its cost of capital. The NOI approach assumes that while the cost of debt is constant for all levels of leverage, the cost of equity increases linearly with financial leverage. This increase is explained by the increase in the financial risk to the firm as it increases the proportion of debt in its capital structure. Cost of equity increases because the shareholders expect a higher rate of return to cover the risk of increase in leverage. Therefore, according to the NOI approach, there cannot be any optimum capital structure for a firm.
The Modigliani and Merton Miller theorem is perhaps the most widely accepted capital structure theory. In 1958, Franco Modigliani and Merton Miller established two propositions for the relation between a firm’s capital structure, its market value and cost of capital. They both won the Nobel Prize for their contribution to corporate finance. The first proposition, also referred to as the debt irrelevance theorem, states that the value of a firm is unaffected by its capital structure. The second proposition states that the required rate of return on equity increases as the firm’s debt equity ratio increases. This exactly offsets the less expensive funds represented by debt.
It should be noted that these capital structuring theories operate under various assumptions, such as no taxes, rational investors, perfect competition etc. However, the actual marketplace is quite different. Besides impacting the financials of the firm, capital structure of a firm also has intangible effects, particularly regarding investors’ perceptions of the firm.
Still, the knowledge of these basic capital structuring concepts will help a manager utilize the market conditions to the firm’s advantage.
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