This report are analyse according to few issues which are company has the projects amount to be 250 million pounds that will attract different sources of risk; identify different sources of fund where company can obtain as company is limited by cash; help company making a sensible financing, investing, and dividend decision which compensate everyone that involved.
I hope this report will bring better understanding of the role and importance of capital markets and efficiency market hypothesis (EMH); cost of capital and the different sources of finance available for the company; theories of relevance and irrelevance of dividends and have a better view of how all this factors will bring benefits and affect the company growth.
Capital market is markets where capital funds, debt and equity are traded. For the company that trade in long-term finance with individuals are included ordinary shareholders, preference shareholders, and debt holder which included debentures, unsecure loan, and convertible loans.
Equity Market vs. Debt Market
There are two types of markets which are primary market and secondary market. Primary market is used to describe as a new leading and borrowing where the equity and debt are traded in the first instance. While secondary market is used to represent the subsequent buying and selling of securities that have already been issued.
The stock market is known as shares or equities that are bought by investors who want to earn profits through dividends or the appreciation of the stock's value from the company. However, bonds are form of debt markets. The company, who issues bond to the investors, will pay interest back to them at certain of time in future. Ordinary shareholders are likely to earn more profit but facing higher risks then debt holders, as shareholders are part of the 'owner' of the company assets, they are able to claim on the future earnings of the company, provided the company is making profit. If any thing goes wrong with the company, they are unable to gain back what they have paid for and might sell their stock at loss and sometimes company is less likely to pay compensation back to them. On the other hand, should company run into trouble debt holders are the first to be paid unlike shareholder. However, both of the shareholder play major role in the company buy helping to the raise the funds, their effect on cost of capital and, attract risks to company.
Importance of the Capital Market to the Company
Capital market plays an important role to the company, they helps company to raise money for better use in other investment or projects and meanwhile helping the company to expand its growth or businesses. Besides that, borrowing money from other sources, example from bank could be a good thing as it helps to reduce tax of the company. However, when the company has high level of debt, which means company is highly geared. The company might unable to service its company. Therefore, it is important that company must be wistful when borrowing. Next, they must seek to maximise shareholder wealth and provide sufficient information to shareholders. So, they are aware how the company business current is and will not simply sell off their shares. Company need to be committed to shareholders maybe offer incentive scheme to the investors which allow them to take appropriate actions. If too many people buying the shares, eventually these people will take over the company. Hence, manager needs to be sensible when issuing shares to the investors.
Efficient Market Hypothesis (EMH)
'Efficient market is a market where there are large numbers of investors and companies actively competing, with each trying to predict future market value of individual and company securities, and all relevant information is almost freely available to all participants' Fama(1965).
The purpose of an efficient market is to ensure that prices and shares are fairly priced, to encourage trade in shares, so that company attract investors and experience growth, to help financial managers to make sensible decisions, whose implication signal a rise in share value, and to prevent a poorly run company in a declining sector issuing new shares, and attracting funding which could be better used elsewhere. Therefore, if the market is said to be efficient, the value of the company will be increased and exposed to more projects opportunity.
Basically, there are 3 levels of market efficiency which are known as weak-form, semi-strong form, and strong-form efficiency. The weak form of the efficient markets asserts that the current share prices fully reflect the information contained in past price movement only. There is no predictable trend for weak form efficiency, as it is independent on the previous share prices. Hence, when the market is in weak form, it will not contribute any benefits to the company as the share price is not moving.
Next, semi-strong form efficiency suggests that the current shares price fully incorporates all publicly available information. Public information includes past price movement, company accounts, right issues etc. Investors and companies that rely on this form are not able to make abnormal profits because all publicly available information is already reflected in the share price.
The final level is strong form efficiency, the current share prices reflects all existing information, both public and private. Investors that follow this information could make abnormal profit, by buying before an announcement of good news occurs, or selling before bad news is made to public. There will be numbers of people, insiders which include company managers, advisers, who are able to make abnormal returns.
The managers that understand EMH theory will help the company allocate resources efficiently which requires operating and pricing efficiency. If the company was poorly run but has highly valued shares because the stock market is not pricing correctly then, this company will be able to issue new shares, and thus attract more investor's saving for uses within its business. Somehow, this would be wrong for investors, as the funds will allows company to be better used elsewhere. Besides, EMH give correct signals to the manager. It is important that manager should seek to maximise shareholder wealth and investors their own wealth, good financial, dividend, and investment decision relies on the correct pricing of the company's shares. Manager will need to be assured that the implication of the decision is correctly declared to shareholders and it community through a rise in share prices and get feedback of their decision to enhance shareholder wealth strategies. Also, if the market is efficient, it will encourage investor to buy shares. Investors tend to be more confident to buy the company share if share price is correctly priced. They believe their are able to sell the share at a fair price. Eventually, this will increase company value.
Different Sources of Funds
Normally, company choose to raise funds either through the capital market which are ordinary share holders, preference shareholders (Please refer to Table 1). Also there are others sources which are retained profits, shares, right issues, long term loans, debts, and grants.
In Table 1, as we can see ordinary shareholders has the highest return as they are knows as the 'owner' of the company, so that no wonder why they are likely to exposed to highest level of risk. Ordinary shares have voting rights to control over the company. Also, they will get their dividend only if the company earn profits and vice versa. On the other hand, preference shareholders are commonly issued by the company itself to institutions and it is not easy to obtain by retail investors, however they hold a special privilege which is preference rights that allows them to obtain fixed dividend for the future earning of company. Lastly debt holders are investors that buy company shares but just want to earn the interest, instead of getting dividend.
When issuing shares or letting investors to buy the company shares or borrowing funds from other sources can help company to rise up funds, but there is also few things that company need to consider as these activities will also affect the company cost of capital which are the cost of obtaining the finance, for instance the legal cost involved in issue a share to investors as sometimes it could be very costly. Also, the amount of interest to be paid on borrowed funds or dividends to be paid on shares, the obligations of the company to make regular payments of interest or interest, and the time span if the sources and weather it matches the purpose of funding.
Cost of Capital
'Cost of capital is the expected rate of return that the market participants in order to attract funds to a particular investment' Pratt & Grabowski (2008). It is therefore becomes a guideline for measuring the profitabilities of different investment. Cost of capital is perceived as the opportunity cost of funds by investors, since it represent the opportunity for investing in assets with the same risk as the company. Company must try hard to achieve the return of investors expectation, they will not invest in the company if the company is unable to achieve this expect. Hence, the company value will be decline. That's why, maximise shareholders wealth is very important.
Company can determining the overall cost of capital through calculate base on cost of ordinary, preference, and debt holders using Gordon's growth model which is Ke (cost of equity) = [Do(1+ g)/Pe] + g , where Do is the current dividend, Pe is price of share, and g is the growth of rate. While weighted average cost of capital (WACC) is the cost of the company combination of debt and share in their capital structure. The formula for WACC is a follow:
WACC = [Ke × equity capital/ total capital] + [Kd × loan capital/ total capital] Company can use this formula to determine whether a project is acceptable or not depend on it proposed project return.
Theory of Capital Structure
Capital structure is a mixture of different sources of funds to finance a company investment. A good capital structure is result of low overall cost of capital of the company, which is a discounted value of future cash flows produced by the company, is high. As a result, it increases company value.
One way to making sure the company value is high is to keep the company gearing in optimal level. Gearing level is determined by debts, which is the company borrowing money from other sources. It is a cheap direct cost as debt is less risky to company. Optimal borrowing money is good because it help company to reduce corporation tax, but excesses borrowing can lead to high level of gearing. That company might unable to service the debts. Besides that, high gearing company will not be able to attract investors, as it is too risky for them to buy the company shares. Hence, company shares will fall.
The traditional view of capital structure (WACC) concluded that if a company started to borrow, it helps to reduce corporation tax but excessively will increase gearing which means WACC will increase too. Conversely, Modigliani and Miller (MM) argue that if the market is perfect, all the companies invest in same business risk and same expected annual earnings should produce same total value. The reason is the value of a company should depend on the present value but not in the way it is financed.
Other than that, MM also states that if follows the traditional way, all companies will acquire same profits, value, and WACC. As WACC is rate of return of project that links profits and value. They also believe in borrowing will not increase the value of the company. Whereby, investors and companies can borrow anytime, in order to change its levels of gearing. Thus, for any company, WACC will always be the same at all levels of gearing. In other words, there is no optimal level of gearing.
Somehow, there are two assumptions which have been made because MM's theory has a significant effect on the result; it is assumed if there is not tax. This will become a problem as debt is the tax relief on the interest payments, meaning that company are subjects to pay more tax rather than invest the fund in other better purposes; risk in MM's theory is measured by variability of cash flows. They ignore the possibility of cash flows might stop because of bankruptcy.
The WACC and MM's theory issues can be resolve by addressing all low levels of gearing, lenders tend to be less worried about their risks involved, but eventually the cost of debt will increase. There is an optimal level of gearing where it can help to maximise company's shareholder wealth.
Another capital structure is the 'Pecking Order' Theory (POT) which proposed by Donaldson in 1961. According to this theory, internal resource over any external sources comes first as there is no cost involved and the resources are easily available, while equity will be final choice. Then follow by debt and equity will be the final choice of managers, as it is the most expensive to obtain.
A dividend is refers to the profits of a company which is distribute from the company to its shareholders. It could be in the form of cash, stock, or any other type of property that reward shareholders for investments that make by them in the shares of the company. The dividend decision is normally determines by company's dividend policy. It will decide what proportion of earning should be paid to the shareholders and what proportion are needed to reinvest back in the company investment purposes. Thus, the dividend policy is actually bearing the choice of finance.
Basically, dividends are pay out of available profits after the deduction of corporation tax. This implies that a company's level of gearing has an important impact on the dividend policy. If there is increasing in dividend payout, level of gearing will also increase. This will effect the growth of company, as company might short of funds to reinvest in new opportunities. On the other hands, if paying too less dividend, the market price will be affected, as company did not met investors expectation, Therefore, managers need to balance the growth and the distribution of the shareholders as it will influence the value of the company.
Dividend Relevancy & Irrelevancy (Traditional View vs. Modigliani & Miller (MM)'s Theory)
In the tradition view, dividend are said to be relevant in determine the value of shares. According to the traditional school of thoughts, Lintner (1956) in the imperfect market the payment of a dividend will increase the equity value of the company. Also, the imperfect of the market will affect the company differently as transaction cost is varying from one and another, and the irrational of investor behaviour. Besides that, traditional view believes that investors prefer dividend to capital gain on their shares. That's why, they have higher payout ration because dividends are believe to be less risky than future capital gain.
On the other hand, MM's theory argued that dividends are irrelevant. Reason behinds is in the perfect market when there is no tax, no transactions cost involved, the payment of dividends does not affect the value and shareholders wealth of the company since investment decision is independent of financing decision. Shareholders wealth will be affected if the company fail to invest in the new projects with a positive net present value (NPV). Also, MM's theory believes that investors can create their own risk by creating their own gearing which is to sell their shares. They stated that the shareholders are they one should decide on dividend policy but not the company. Hence, there is no optimal dividend policy for company and company wealth will increase only rely on investment policy.
Somehow, we are not living in the world with perfect market. There are always taxes or transactions costs involved in out daily routine. The MM's theory might be not applicable in the real world. Also, they believe investors can create their own dividends, by selling their shares. Eventually, these people will run out of shares to sell. Thus, company and investors who believe in this theory will not able to gain profits.
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