Showing papers on "Capital structure published in 1975"

Determinants of the Firm's Capital Structure

Abstract: THIS paper is an empirical study attempting to ascertain those factors that influence the firm's choice of a debt-equity ratio. Baxter and Cragg (1970), have published an empirical study that is similar in nature to this one. However, this paper differs from theirs in several important respects. First, we deal explicitly with the relationship between the overall debtequity ratio of the firm and the firm's choice of new financing. Secondly, we include the notion that the risk premiums required on bonds issued may differ among firms or between years. Finally, we include as a variable the corporate tax rate for each year. In section I we present the statistical model. A description of the independent variables used in the empirical study is presented in section II. Section III contains the results of our study plus implications and conclusions.

Effects of uncertain inflation on the investment and financing decisions of a firm

Abstract: IN THEIR CLASSIC PAPER, Modigliani and Miller 120], assuming the presence of risk classes of firms, first brought out the relationship between the value of shares and the firm's financial decisions without explicitly specifying an equilibrium market valuation model. By use of an arbitrage argument, they derived their three well-known propositions in the financial theory of the firm. Indeed, if value-maximization is an appropriate goal of the firm, the development of any normative theories of the firm's financial policies requires a theoretically sound model of market share valuation. Fortunately, the capital asset pricing models of Sharpe [30], Lintner [13], and Mossin [22] have provided us with theoretically sound valuation equations for risky assets in an equilibrium capital market. The SLM capital asset pricing model has been applied to the problems of capital budgeting and capital structure decisions, and several significant implications for corporate financial decisions have been derived.1 In particular, the cost of capital for an investment project has been shown to depend on its relevant risk and not on the particular firm which undertakes the project. With respect to the problem of a firm's capital structure, it has been demonstrated that the value of a firm is invariant with capital structure if corporate income taxes are not considered. The traditional capital asset pricing models are derived without an explicit consideration of uncertain inflation. Thus, the effects of uncertain inflation upon the firm's investment and financing decisions have not been analyzed within the context of equilibrium market valuation models. The purpose of this paper is to investigate how the presence of uncertain inflation might affect a firm's investment and financing decisions. In Section II, assuming a specific preference structure for investors, we will derive and discuss an equilibrium capital asset pricing model under the condition of uncertain inflation. Based upon the derived model, the

The cost of capital as a weighted average

Abstract: IN RESEARCH, teaching, and application we have found it convenient for some time now to compute the cost of capital as a weighted average of the costs of the various sources of capital. This entire notion, though, that the true cost of capital can be computed as a weighted average of the component costs has recently been questioned. Reilly and Wecker [9] show us that the conditions under which Solomon [10] first formally developed the weighted-average approach to the cost of capital are rather restrictive. Linke and Kim [6] and Ezzell and Porter [2] argue that these restrictions as to cash-flow patterns are not necessary and that a weighting approach to computing the cost of capital is valid as long as the firm's leverage position is maintained. In addition to these discussions on the general validity of the weighting procedure as a computational device, other arguments have focused on the validity of the particular formulations utilized. Specifically, three interrelated issues have been raised. First, Haley and Schall [3, pp. 298-304] imply and Arditti [1] states flatly that the traditional method of weighting in an after-tax cost of debt is incorrect. Secondly, these same authors feel that once the cost of debt is correctly specified on a beforetax basis, the resultant weighted-average cost of capital, as a function of the firm's capital structure, is not minimized at the point of value maximization. Finally, Ezzell and Porter [2], Arditti [1, p. 1004, footnote 4], and Haley and Schall [3, pp. 304-313] imply that the weighted-average figure utilizing the so-called correctly specified (before-tax) cost of debt may not be usable as a cutoff rate in making investment decisions. It is the contention of this paper that the arguments offered in support of these criticisms are misleading. Most of the confusion generated by this literature results from the failure to recognize that even with a generally accepted definition of the true cost of capital, innumerable specifications of this definition, all equally valid, are possible. Two such specifications of the true cost of capital definition are developed in Section II. For each specification, two corresponding weighted-average costs of capital are formulated. One is less general than the other in the sense that it requires conditions necessary for Modigliani and Miller's [7] capital structure propositions.1 An important conclusion of this section is that as weighted-average formulations of a single definition, there is no basis upon which to identify any

Firm valuation, corporate taxes, and default risk

Abstract: SINCE MODIGLIANI AND MILLER [10] demonstrated that the values of firms in the same risk class are equal and are independent of the capital structure of the firm if the probability of default is zero and there are no taxes, a number of extensions of these results to the case of default risk have been given by Stiglitz [16], Smith [15], Baron [2, 3], and Hagen [5]. Conditions under which the values of firms in a risk class will be equal when there is default risk are given in [2]. While the relative values of firms in a risk class are equal, that common value of the firms is not independent of its financing, in general. If changes in the capital structure do not alter the available returns in the capital market, the capital market is complete and the value of the firm will be independent of its capital structure as indicated in [3]. This will be true if investors are able to create homemade leverage as considered by Stiglitz and Baron and thus duplicate any pattern of returns the firm can create by issuing bonds. The value of a firm is also independent of its capital structure in meanvariance models (for example [9, 12, 14]) and in an Arrow-Debreu model (see [8, 16]). Smith has considered the important issue of an investor's preferences for the financing of a firm with a variable scale in the presence of default risk and has demonstrated that investors are not in general indifferent to the financing of a firm with a variable scale in the presence of default risk when the capital market is incomplete. A synthesis of the results regarding the effects of capital structure is given in [3]. A corporate profits tax causes the value of a firm to depend on its debt-equity ratio even with a complete capital market. In the absence of default risk, Modigliani and Miller [11] determined that the value of a levered firm exceeds the value of an unlevered firm in the same risk class by the present value of the tax savings created by the debt in the capital structure. Kraus and Litzenberger [8] have obtained the same result in a contingent claims model. The objective of this paper is to explore the effect of corporate income taxes in the presence of default risk on the value of firms in the same risk class when the financing of the firm does not alter the available returns in the capital market. The analysis is in the spirit of the original works of Modigliani and Miller in the sense that the results are obtained from a partial equilibrium analysis. The analysis is based on a model that makes few restrictive assumptions regarding the probability distribution of earnings of firms or the preferences of inves

Ruin Considerations: Optimal Working Capital and Capital Structure

Abstract: At any point in time a firm must decide both the level of working capital consistent with its productive assets and how to finance these assets. Academic theorists in business administration have traditionally approached decision making of the firm on a segmented rather than on a global basis and have been satisfied with developing suboptimizing decision rules. Thus there has been concern about managing working capital and concern about choosing the optimum capital structure, but traditionally the two decisions have not been made jointly. And even if they were made jointly, decisions would still remain in the working capital area involving inventories, credit granting, and marketable securities. This article is an attempt to interrelate working capital and capital structure decisions with working capital used not only as a buffer to avoid ruin but also to affect sales via changing inventory levels and credit policies. The possibility of ruin introduces a discontinuity that precludes perfect elimination of leverage effects via a market. In this article the acquired working capital serves as a buffer against ruin, as well as a means of increasing earnings, while the debt used to finance the working capital increases the size of the fixed payment obligations, and the cost of debt tends to reduce the total earnings of stockholders.

The weighted average cost of capital: some questions on its definition, interpretation, and use: comment*

Abstract: maximization of the total market value of the firm. The primary purpose of this comment is to reconcile the generally accepted definition of the after-tax weighted average cost of capital (wacc) with the definition proposed by Arditti. In accomplishing this objective we will derive three definitions of the wacc, and will show that the capital structure that minimizes two of the three definitions (within Arditti's framework) is an optimal one. The traditional wacc is derived from the relationship between the market value of a levered firm, VL, and its unlevered counterpart, Vu, both of which are expected to earn the perpetual cash flow X before interest and taxes.' Specifically,

Growth stocks and corporate capital structure theory

Abstract: MORE THAN A DECADE AGO, with respect to the validity of Modigliani and Miller's homemade leverage thesis-namely, their Propositions I and II (see [24, 25])-under growth, Durand [6] expressed pointed skepticism by arguing that the said thesis is valid only under perfect markets where the market value of stock equals its book value.' Since then many others have questioned the validity-and consistency-of the propositions under growth, resting their theoretical as well as empirical analysis on the traditional valuation model,2 eminently set forth by Williams [34]. On the other hand, MM [25, 29, 30] have not only reaffirmed their original conclusions under growth but also have provided extensive tests of their statistical model [29, p. 348], which, in view of the foregoing, is not unequivocal.3 The purpose of this paper is to examine some of the theoretical issues bearing on the specification of empirically testable models concerning the effect of capital structure on the firm valuation. The motivation for doing so stems in particular from Durand's arguments and in general from the controversial nature of the subject. Insofar as the validity of the capital structure "irrelevance" proposition is in the final analysis an empirical issue, this paper takes the consistency of the MM Propositions I and II as a useful guide in generating several hypotheses that could be imbedded in the structural form of econometric models. Section I provides a brief introduction to the relevant literature. In Section II, some earlier results (contained in [15, 16, 12]) are succinctly

Optimal Capital Structure and towel Cost of Capital-Towards an Operational Approach in the Indian Context

Abstract: of Capital Towards an Operational Approach in the Indian Context S K Chakraborty Abhijit Sen Knowledge of the cost of capital helps in planning the optimal capital structure for the firm.

Abstract–Capital Structure and the Value of the Firm

Abstract: In their 1958 article Modigliani and Miller showed that if two firms are in the same risk class and in an economy with a perfect capital market having no transaction costs, taxes, or no bankruptcy costs, then their relative market values are independent of their capital structures.

On the Weighted Average Cost of Capital: Reply

Abstract: The comment by Linke and Kim correctly observes that the assumption regarding the maintenance of constant proportional use of capital sources is not appropriate for our argument and should be deleted. As our analysis did not make use of this assumption, the two conclusions hold.1. The weighted average cost of capital calculated with the usual weights (original capital structure proportions) is not in general equal to the discount rate which equates the current value of the firm to the present value of future cash flows.2. The above conclusion holds for any weights which can be constructed from the cash flows.