Research Aims and Objectives
Long-term debt is one of the components of capital structure. The capital structure can be optimized to increase the shareholders’ wealth. The capital cost is also much affected by the capital structure. The capital structure refers to the value of the form and its scale.
Enterprise’s capital structure of the debt and equity is the scale which largely determines the repayment ability and financing. It is an important indicator in a company. The reasonable cost of financing structure reduces the amount of finance used and enables financial leverage adjustment to more enterprises of their own thus leading to profitability.
Aim of the Research
The aim of this dissertation is to study the impact of debt in capital structure. Capital structure is much affected by the debt ratio. The research seeks to find out the percentage of debt in the whole capital that is best for the company.
Research Objectives
- To evaluate advantage and disadvantage of using debt in the firm
- To evaluate impacts and implications of using debt in the firm
- To find out how debt can be used and limited so as to maximize the profitability of a corporation.
- To identify the best structure of debt and equity in a firm
- To identify the differences between an equity company and leverage company
- To find out the impacts and implications of debt in the firm
Rationale
The Background
Rose et al. (2008) states that, “capital structure refers to a source of capital and constitute a long-term scale, specifically, the long-term debt and equity capital funds in scale”(p.1). On the other hand, Baker & Martin (2011) states that, “in 1958, the financial economist France Modigliani and Merton H. Miller created the famous theory of modern capital structure” (p.151).Baker & Martin (2011) further notes that,
“Modigliani and Miler 1958 asserts that under certainty, the two criteria of rational decision making-the maximization of profits and the maximization of market value are equivalent and that using debt instead of equity to finance a given venture may increase the expected return to the owners but only at the cost of increased dispersion of the outcome” (p.153).
These theoretical frameworks form the basis of this study.
Why this Research is Useful
This research can be used as a reference by finance managers who want to know how to maximize the value of a company buy use of capital structure (Bessley, 2007). It also enables us to know the impacts of capital structure of the enterprises on financial leverage (Pettit, 2007). From the research, we get to know how the equity capital cost is changing, from the business of tax to paying profits (Mankiw, 2011).
The capital structure refers to the value of the form and their scale. Our chief research is on a long-term equity capital and the rights of the capital and its scale. So it is important that we should know about corporate performance. This topic is necessary for us who study finance because we get to know the operation and value of companies through the capital structure (Glen et al., 1997). And we can judge what kind of company it is.
Who will Benefits from this Research?
Companies and individual will be beneficiaries of this research. From this research, finance managers will be in a better position to manage their firms. They will know how to maximize the value by use of debt in the corporate finance (Puntaier, 2010).
The manager under the specific company under study will also be in a position to assess his achievement in terms of performance in managing capital structure by using the results of the research. On the other hand, the research will create public awareness about the state of the companies, thus making it easier for individuals to identify companies that they can invest in (Glen et al., 1997).
Theoretical Underpinning
Rose et al. (2008) defines capital structure as, “a source of funding employed by a firm” (p.1). Rose eta al. (2008) explains further that, “these sources include debt, equity and hybrid securities that a firm uses to finance its assets, operations and further growth” (p.1).
Baker & Martin (2011) note that “before the MM seminar article, the conventional finance wisdom was that a moderate amount of debt increases the value of a firm’s common stock because debt is less expensive than equity, which makes the u-shaped capital of leverage” (p. 151).
However, this view changed after the publication of the MM in 1958. According to Baker & Martin (2011) the MM theorem states that, “under perfect capital market and in the absence of taxes, the value of the firm is independent of its capital structure and is given by capitalizing its expected return at the cost of unlevered equity” (p.151).
In no corporation tax situation, MM theory suggest that all the stock holder of the total risk will not change the capital structure for a change to happen in the company (Ross et al., 2008). Therefore whether the company has debt or not the total value of the company will be the same (Petit, 2007).
Theoretically the capital structure influences the value of a firm in three ways (Bierman, 2002). The first way is that by changing the capital structure, the cost of capital and the use of the finance in the firm as planned (Rahul & Hitt, 1998).
The second way is by use debt capital of the tax revenue to consider the effects of the enterprise market value. The last way is by use of capital structure of the selection signals that influence the market for business judgment and influence the market value.
Key Concepts
- Capital structure theory and pie theory
- Financial leverage and company value
- Modigliani and Miller theory (no tax)
- Modigliani and Miller theory (tax)
- Debt cost
- Personal tax
Ross et al. (2008) notes that “In 1958, two professors of the United states by the names Miller and Modigliani (short MM) published an article on capital and finance in the American Review magazine” (p. 50). They presented a theory that described the basic ideas in capital structure (Ross et al., 2008).
The whole idea of the theory was that, without regard to income tax, company and enterprise management and risk, capital structure is not relevant (McDougall, 2009). Or it could say when the company’s debt ratio increased from zero to 100%, the capital costs and value does not change (Ross et al., 2010).
The revised MM theory (tax theory of the capital structure) was done in 1963 (Westerfield & Jordan, 2010). Modgliani & Miller found that, in considering the corporation tax situation, the liability of interest is exempt from tax payments, and it can reduce the cost of capital and increase enterprises (Baker & Martin, 2011).
Therefore, if the company by the financial lever in the interest increases, and the cost of capital reduces with debt, there will be greater leverage (Stevens, 1982).
Baker & Martin (2011) note that, “the MM theorem asserts that under perfect capital market and in the absence of taxes, the value of the firm is independent of its capital structure and is given by capitalizing its expected return at the cost of unlevered equity” (p.151).
Baker & Martin 2011) further note that, “all capital structures are equivalent because the cost of capital in their model remains unchanged regardless of the capital structure”(p.151).
In no corporation tax situation, MM theory suggest that all the stock holder of the total risk will not change the capital structure for a change to happen in the company (Ross et al., 2008). Therefore whether the company has debt or not the total value of the company will be the same (Petit, 2007).
MM proposition value only refers to the value of the debt (Ross et al., 2010). There will be inevitably effect in business enterprise income tax, the value of the phenomenon and the capital structure of the enterprise which will change the value of the enterprise but will not include liability and share (Vernimmenn & Quiry, 2009).
This should also include enterprise income tax, so that the capital structure of the change in business value will not be affected (Ross et al., 2008).
Ross et al. (2008) notes that, “in MM Proposition I (no tax), the value of the levered firm is the same as the value of the unlevered firm while in MM Proposition II (no tax), Rs=R0+B/S (Ro-RB)”(p.78).
M&M theory with corporation tax, borrow the virtues of the interest payment In liability to tax from the financial lever of the corporation tax putting in mind the weighted average capital costs.
Baker & Martin (2011) note that, “ according to MM, instead of equity to finance a given venture may increase the expected return to the owners but only at the cost of increased dispersion of the outcome” (p. 153).
The more the company avoids income tax, the greater the value of the company (Henry, 1998).
Therefore, the origin of M&M models after the adjustment to the corporation tax may conclude that: tax in the capital markets could not be an important expression due to the capital market’s imperfection thus the capital structure change will affect the company’s value and the cost of capital and the company will exceed the leverage value (David et al., 1998).
There are other theories and models that also do address debt as capital structure. Puntaier (2010) notes that “the use of more debt is not only addressed by the Tax-bankruptcy trade-off, but also by agency cost model according to which the discipline provided by debt is more valuable for profitable firms”(p. 70).
Methodology
Approach and strategy
The aim of this research is to unearth the function of debt in capital structure. In this research the focus of study is the M&M theory that was found in 1958 which is an important theory in modern industries.
First this research will define capital structure. We will also discuss the capital structure and the debt in the capital structure. This research will further discuss how to manage the company through the capital structure. It is important for managers to know about the aspect of corporate finance.
This research also aims to create awareness to the public on how to invest in the company’s stocks. We will discuss about equity ratio and debt of the company and how it can reflect on the company’s performance.
This research will take the qualitative approach. Hebert & Irene (1995) defines qualitative research as, “any research acquiring data which is not subject to quantification or quantitative analysis”(p.40).
This method does not make use of numerical data, like quantitative method. It mainly relies on the prediction of rich experience and practice of subjective judgment and analysis, and infers the nature and trend analysis methods of analysis and forecasting a basic approach. In management accounting, the use of such approach is common in the business enterprise and market economy.
A research that is qualitative can collect data in areas requiring exploration like the care given to patients in a certain hospital. The problem with interview method of research is that for the problem with the ‘and for ideas in research, is that participation and talk has been a grievous was very helpful. We used to describe the qualitative analysis and interviews with observers from the interactive, in the course of the data generation.
Qualitative
- Hardware Recorders Pictures
- Analysis Interpretative
- Reporting Respondents’ own words
- Information In depth
- Replication Low
- Generalisation Limited
The research will analyze the MM theory in the modern finance industry. And discuss how to use MM theory to maximize the value of a firm. A company will be selected for a case study. The data will then be collected from the website.
Methods
Case study
Cases study is a method that involves identifying an individual person or company and then using the individual person or company in data collection (Bruner & Eades, 2009). Bruno & Eades (2009) notes that, “the case study method is also called the case history study” (p.12).After identifying the group or individual, one collects data and than writes a report (Bruner & Eades, 2009).
One can also research about a company by collecting information from the annual report which may include: balance sheets and cash flow which can be used to determine equity and debt ratio.
In our case, we will analyse the data collected from the website. From the data, we shall make calculations through the MM proposition so as to know more about the company.
Interview
The interview method of research involves a face-to-face meeting in which a researcher (interviewer) who asks the interviewees a number of questions (Herbert & Irene, 1995). The interview includes questions and answers. A structured interview comprises of set questions that the interviewee is expected to answer.
These questions are normally inflexible and cannot be changed. Here, the interviewee is restricted. An unstructured interview is the opposite of a structured interview. The interviewee is usually unrestricted, thus can express himself or herself informally and freely about their views and opinions (Helbert & Irene, 1995).
A semi-structured interview is one that is in between the structured and the unstructured form of interview. According to Helbert & Irene (1995), this form of interview is often referred to as ‘qualitative research interview’ (p.175). Helbert & Irene defines qualitative interview as
“an adventure in learning about teaching in different countries, their cultural views, their problems and solutions, and how their practices are similar and different than our own. The way we interview depends on what we want to know. It is a process of finding out what others feel and think about their worlds”(P.175).
Since this will be a qualitative study, the form of interview that will be used will be qualitative research interview. A list of questions will be formulated for the interviewees to answer. These questions will be derived from the research question, thus will have a specified theme.
The semi-structured form of interviewing which poses open ended questions will be used to collect the thoughts of interviewees in a similar manner since questions are answered within a similar context. The interviews are to be carried out through the website.
Interview Questions
These are the questions that will be posed to the interviewees. The questions are formulated from the objectives of the research, thus they will be efficient in collecting the required data.
- What is the capital structure of the company?
- Which company do you think is better? (Unlevered or levered company)
- If unlevered is better why?
- If levered is better why?
- What do you think about MM theory?
- In the real world is the MM theory popularly used by the manager of company?
- How should the public choose the company to invest in through the MM theory?
Analysis
Data analysis is a process of analysing the collected data so as to be able to make conclusions. In this research, qualitative data will be collected from the website. Analysis of data involves examining, classifying and listing among other ways.
In this research, data will be collected from the website and analysed in reference to the MM theory. The capital structure of the company will be analysed and then a report will be sent back to the manager of the company on how to improve capital structure in the company.
Limitation
This research is limited to a single case study. Since only one case study was used, the general conclusions that will be made may not be true to other firms. This is because their will be no object of comparison. In other words, because the case study involved the behavior of one company, this can not be used to reflect all other companies.
The research is also limited to company data. Only members of one company were interviewed.
Timetable
Resources
Ethical considerations
Ethical and moral philosophy is a branch of philosophy, that deals with moral concepts such as good or bad, right or wrong, virtue and vice as well as justice, among other concepts. There are four main branches of ethics, namely the meta-ethics, normative ethics, applied ethics and moral psychology.
The research will discuss the capital structure. Data collected in this research will be the property of the researcher and the interviewer. All persons who support this research will be informed. Some of the values that will be observed in this research include: honesty, objectivity, integrity, carefulness and openness,
References
Baker, H.K. & Martin, G. (2011) Capital structure & corporate financing decisions: valuation, strategy and risk analysis for creating long-term shareholder value. New York, John Wiley & Sons.
Besley, S. (2007) Essentials of managerial finance.14th ed. California, South Western College.
Bierman, H. (2002), The Capital Structure Decision. Mexico, Springer.
Bruner, R.F. & Eades, K. (2009) Case Studies in finance: managing for corporate value creation. 6th ed. New York, McGraw-Hill Higher Education.
Davis, H. A., Murton, C. & Bruno, P.(1998) Building Value with Capital-Structure Strategies. Chicago, Morristown.
Glen, A. (2008) Corporate financial management: financial times. 4th ed. New Jersey, Prentice Hall.
Herbert, R. & Irene, R. (1995) Qualitative interviewing: The art of hearing data. Thousand Oaks, Sage.
Mankiw, N. (2011) Principles of economics. 6th ed. South-Western, Division of Thomson Learning.
McDougall, A. (2009) Capital structure and leverage. New York, John Wiley & Sons.
Pettit, J. (2007) Strategic Corporate Finance. New York, John Wiley & Sons.
Puntaier, E. (2010) Capital Structure and Profitability. New York, Diplomica Verlag.
Rahul, K. & Hitt, M.A. (1998) Linking corporate strategy to capital structure. Strategic Management Journal, 2(12), 13-28.
Ross, Westerfield, Jaffe & Jordan (2008) Modern financial management. 8th ed. New York, McGraw-Hill.
Ross, Westerfield, Jaffe& Jordan (2010) Corporate Finance. New York, McGraw-Hill Higher Education.
Stevens, M. (1982) Leveraged finance paper. New York, Simon & Schuster.
Vernimmen, P. & Quiry, P. (2009) Corporate Finance: theory and practice. 2nd ed. New York, John Wiley & Sons.