FACULTY
:
COMMERCE
DEPARTMENT
:
PROGRAMME
: B COM HONOURS IN ACCOUNTING AND FINANCE
NAME
:
ACCOUNTING AND FINANCE
STANLEY DUBE
STUDENT NUMBER
: L0191881E
MODULE
: CORPORATE FINANCE II
LECTURER
: U SIBANDA
FORMAT/YEAR : BLOCK 2.2 (2023)
DUE DATE
: 17 MARCH 2023
1. (A) Giving examples how would u advise managers starting up a business
on what an optimal capital structure is?
Optimal Capital Structure
The ratio of equity to debt that a business uses to increase its wealth and market value and
reduce its cost of capital is known as its optimal capital structure. It is adjusted to strike a
balance between the company's value and costs. The sources of funding that the company
uses to support its operations—namely, debt and equity—define capital structure. Although
debt financing is often less expensive than equity, it does carry some risk. In order to reduce
the risk of debt defaults, companies would raise enough equity to optimize their capital
structure. The term "optimal capital structure" refers to the best combination of stock and
debt that a business can have while yet maintaining a high market value and low cost of
capital. As two different types of capital, equity and debt should have an optimized balance
between them
Why Optimal Capital Structure
The successful operation of an enterprise depends on having an optimal capital structure. It is
a region where the two main types of financing—debt and equity—work best together. In
order to attain the lowest cost of capital, a company must strive to find the appropriate ratio
of debt to equity. The weighted average cost of capital (WACC) of a corporation is calculated
to determine its optimal capital structure, which maximizes market value while minimizing
WACC.
Determinants of Optimum Capital Structure
Cost of Capital - Every single penny invested in a company is a cost. Therefore, a company
must be able to return the finance provided by suppliers. The return offered to the equity
holders is called the cost of equity and is directly proportional to the degree of risk assumed
by them. In contrast, the interest paid on debts is referred to as the cost of debt. The capital
structure must return the cost of capital to its stakeholders to be called optimal capital
structure.
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Sales Growth, Profitability, and Stability - if the company is earning well in the market, has
a customer base, and has a constant demand for its product and services, its goodwill ensures
a smooth business run. However, low sales and growth can create a vice versa situation with
higher risk and debt issues. Sales and development enable the company to deal with debt and
interest repayments. Hence, it is vital in determining capital structure.
Cash Flow- The ability to generate cash flow plays an essential role in attaining optimal
structure where the predictability and variability of cash flow are crucial determinants of
capital structure.
Company size- In the early business stage, a small company may find it challenging to raise
the required capital. Alternately, a well-established firm can easily obtain any amount of
equity or debt. Therefore, a company’s size or stage has significant consequences on the
capital structure.
Risk - Every business assumes, anticipates, and struggles with risks in operations and
management. When a company designs an optimal capital structure, it usually comes across
two types of risk factors: business risk and financial risk. Business risk is directly related to
the change in the company’s earnings, demand, supply, income, and revenue generation. In
contrast, financial risk refers to the market changes, substitutes available, or entry of new
competition, typically not in control of the company. So, the company’s strength to overcome
all types of risk impacts its overall capital structure.
Inflation - Inflation is a critical factor. A company suffers a hike in raw materials, electricity
or power consumption, transportation, equipment, and machinery costs. A slight rise in the
price of such expenses can negatively impact the budget and production level of the
companies. Thus, it becomes evident that an enterprise must design an optimal capital
structure to take into account inflation uncertainty.
Market Conditions - Market conditions are dynamic, so a firm can never work in an active
market with static and old measures and business ways. The market sometimes faces
recession, and at other times rides high on a massive boom. Hence a company must optimize
its capital structure to remain stable and relevant.
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Examples
1. A small textile company incurred heavy debts due to not analyzing its capital structure.
Everything went well with the orders and demand of their finished goods in the initial phase.
However, due to the unexpected turn of events, it started making losses. Despite losses, it still
had to pay its fixed interest obligation on the debt. As a result, it affected its ability to pay out
dividends. It eventually came to the brink of bankruptcy due to the considerable capital cost
owing to its substantial debts to the market and its suppliers. The company had to incur a high
cost for opting a capital structure with a huge debt.
2. An optimal capital structure is the best mix of debt and equity financing that maximizes a
company's market value while minimizing its cost of capital. Minimizing the weighted
average cost of capital (WACC) is one way to optimize for the lowest cost mix of financing.
Limitations of Optimal Capital Structure.
There is no magic ratio of debt to equity to use as guidance to achieve real – world optimal
capital structure. A healthy blend of equity and debt varies according to industries involved,
business lines and time due to external changes in interest rates and regulatory environment.
(B) Briefly examine any four capital structure theories.
(i) Modigliani Miller Approach
Finance economists were more inclined to study the capital structure when Modigliani and
Miller's (1958) "irrelevance theory of capital structure" was published. Theoretical principles
of business finance in contemporary way begin with the Modigliani and Miller (1958) capital
structure irrelevance scheme. Earlier, theorists have not devised any generally accepted
theory of capital structure. Modigliani and Miller presumed that the firm has a particular set
of expected cash flows. When the firm selects a certain proportion of debt and equity to
finance its assets, it divides the cash flows among investors. Investors and firms are expected
to have equal access to financial markets, which permits for home-based leverage. The
investor can create any leverage that was wanted but not offered, or the investor can get rid of
any leverage that the firm took on but was not wanted. Consequently, the leverage of the firm
has no effect on the market value of the firm. Capital structure irrelevance can be
demonstrated in numerous circumstances. There are two basically different types of capital
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structure irrelevance propositions. The classic arbitrage based irrelevance propositions
provide settings in which arbitrage by investors keeps the value of the firm independent of its
leverage. In addition to the original Modigliani and Miller paper, other theorists that
contributed in this arena are Hirshleifer (1966) and Stiglitz (1969). The second irrelevance
proposition determines that "given a firm's investment policy, the dividend pay-out it chooses
to follow will affect neither the current price of its shares nor the total return to its
shareholders" (Miller and Modigliani, 1961). It can be said that in perfect markets, neither
capital structure choices nor dividend policy decisions matter.
Paper published in 1958 disproved irrelevance as a matter of theory or as an empirical matter.
This research has revealed that the Modigliani-Miller theorem failed to explain theoretical
principles of capital structure under a variety of circumstances. The most commonly used
features include consideration of taxes, transaction costs, bankruptcy costs, agency conflicts,
adverse selection, lack of separability between financing and operations, time-varying
financial market opportunities, and investor clientele effects. Alternative models use differing
elements from this list. Harris and Raviv (1991) provided a survey of the development of this
theory as of 1991.
Basic Propositions of Modigliani-Miller approach:
1. At any degree of leverage, the company's overall cost of capital and the value of the firm
remain constant. This signifies that it is independent of the capital structure. The total
value can be obtained by capitalizing the operating earnings stream that is expected in
future, discounted at an appropriate discount rate suitable for the risk undertaken.
2. The cost of capital equals the capitalization rate of a pure equity stream and a premium for
financial risk.
3. The minimum cut-off rate for the purpose of capital investments is fully independent of the
way in which a project is financed.
Assumptions of Modigliani-Miller approach:
1. Capital markets are flawless.
2. All investors have the same expectancy of the company's net operating income for the
purpose of evaluating the value of the firm.
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3. Within similar operating environments, the business risk is equal among all firms.
4. 100% dividend pay-out ratio.
5. An assumption of "no taxes" was there earlier, which has been removed.
As an experiential proposal, the Modigliani-Miller irrelevance proposition is not easy to test.
With debt and firm value both reasonably endogenous and determined by other factors such
as profits, collateral, and growth opportunities. Researchers cannot establish a structural test
of the theory by regressing value on debt. Advocates of this theory justified that "While the
Modigliani-Miller theorem does not provide a realistic description of how firms finance their
operations, it provides a means of finding reasons why financing may matter." This
explanation provides a sensible interpretation of much of the theory of corporate finance.
Therefore, it influenced the early development of both the trade-off theory and the pecking
order theory.
Restrictions of Modigliani-Miller hypothesis:
1. Investors would find the personal leverage troublesome.
2. The risk perception of corporate and personal leverage may be different.
3. Arbitrage process cannot be smooth due the institutional limitations.
4. Arbitrage process would also be impacted by the transaction costs.
5. The corporate leverage and personal leverage are not perfect alternates.
6. Corporate taxes do exist.
(ii)Pecking Order Theory
Pecking order theory refers to the theory concerning the capital structure of the company
where the managers are required to follow a specified hierarchy while choosing the sources
of finance in the company where according to the hierarchy, first preference is given to the
internal financing, then to external sources when enough funds cannot be raised through
internal financing where debt issue will be considered first to generate funds and lastly the
equity if the funds cannot be raised through the debt as well.
Donaldson first suggested this theory in 1961 and later modified it by Myers and Majluf in
1984. This theory might not always be the optimum way, but it does guide how to start
financing.
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Components of Pecking Order Theory of Capital Structure
Broadly, the method of raising funds for a project or a company is classified into internal and
external funding.
Internal Funding
Internal funding/ financing comes from retained earnings a company has. If the company is
taking up a risky project with low-risk preferences, then internal financing is not the optimum
way to finance the project. The second reason is taxation. By taking debt, the company can
reduce their taxes based on their interest on the debt. Internal Financing has more stringent
regulations on how the funds can be invested without tax.
External Funding
External financing can be of two types. By taking the requisite budget as a loan or selling a
part of the company’s share as equity.
Debt
Debt funding is where the company raises the required amount through a loan – either by
selling bonds if the company wants to raise loans in a tradeable market or by pledging assets
if the company wants to raise loans through the banking system.
Equity
No chief of a company would want to sell a part of their company unless deemed necessary.
However, there are cases where the only way to raise money is by selling the company. Be it
a failure of the company to raise money through debt, or be it the inability of a company to
maintain enough portfolio to raise money through bank loans, the company can always sell a
part of itself to raise money.
One great advantage of equity financing is that it is not risky. It is completely dependent on
the buyer to own a share of the company, and the risk transfer is a hundred percent in this
case. The company has no obligation to pay the shareholder anything. The basic nature of
Pecking Order Theory arises around the information asymmetry – where one party, the
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company, holds better information than the other (in case of external financing). External
financing is generally more expensive than internal financing to compensate for the
information asymmetry and risk transfer. In general, equity holders, who hold the highest
risk, demand more returns than debt holders, though the company has no obligation to hold
those returns.
Pecking Order Theory Examples
1. In pecking order theory, the financial strategy is decided considering the seniority of
claims to assets. Debt-holders enjoy a lower return than equity stockholders because the
former are entitled to a higher asset claim if the company runs into bankruptcy.
Advantages: Where Pecking Order Theory is useful

Pecking Order Theory is valid and useful guidance to verify how information asymmetry
affects the cost of financing.

It provides valuable direction on how to raise funding for a new project.

It can explain how information can change the cost of financing.
Disadvantages: Where does Pecking Order Theory Fail?

The theory is very limited in determining the number of variables that affect the cost of
financing.

It does not provide any quantitative measure of how information flow affects the cost of
financing.
Limitations of Pecking Order Theory

Limited to a theory.

Pecking order theory cannot make practical applications because of its theoretical nature.

Limits the types of funding.

New types of funding cannot be included in the theory.

The very old theory has not been updated with newer financial fundraising methods.

No-Risk vs. Reward measure to include in the cost of financing.
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Conclusion
Pecking Order Theory describes what and how financing should be raised without providing
a quantitative metric to measure how it has to be done. POT can be used as a guide in
selecting financing rounds, but there are a lot of other metrics. Using POT in a mixture of
other metrics will provide a useful way to finance.
(iii) Agency Theory
Agency theory is based on the notion that managers will not always act in the best interest of
the Shareholders. Jensen and Meckling (1976: 305) identifies two main conflicts between
parties to a company, thus its managers versus shareholders or shareholders versus creditors.
Managers per sue firm profits they manage to their own personal gain at the expense of the
shareholders. Also debt provides shareholders with the incentive to invest sub – optimally.
Harris and Raviv (1991) argue that if an investment yields returns higher than the face value
of the debt, the benefits accrue to the shareholders. However if investment fails, the
shareholders enjoy limited liability by exercising their right to walk away, leaving debt
holders with a firm whose market value is less than the face value of the outstanding debt.
Myers (1977) notes that when firms are on the verge of bankruptcy, shareholders have no
incentive to invest more equity capital, even if positive NPV projects are available. This is
because the value from the projects will accrue mainly to the debt holders. Stulz (1990)
argues that debt payments may affect shareholders both positive and negative.
Positively, debt payments force managers to pay out interest thereby reducing the potential
overinvestment problem. Negatively, excessive debt may lead to high interest repayments,
which may lead to the rejection of profitable projects leading to the underinvestment
problem. Vilasuso and Minkler (2001: 65) employ a dynamic model of capital structure,
demonstrating that agency costs are associated with shifts in leverage.
Principal Agency Theory Explained
The agency theory analyses the issues and solutions surrounding task delegation from
principals to agents. The principals appoint the agents to perform specific duties. Agents are
given authority to complete the duties or work assigned. The issues arise because of
conflicting interests and information asymmetry between the principal and agent.
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Types of Agency Theory Relationship
a. Shareholders and Company Executives
In this relationship, the company executives serve as the agents and the shareholders as the
principal. Investors, in this case, are the shareholders who fund the companies run by
company executives. Furthermore, the actions taken by the company’s management will
determine the potential impact on the investment. Therefore, the firm management must
make wise decisions.
b. Board of Directors and CEO
The CEO (agent) serves the board of directors (principal). The board of directors would
support the CEO if he can make profitable decisions. On the other side, the relationship
between the board of directors and the CEO might be problematic if the choice made by the
CEO hurts the company’s financial situation.
Example (i)
Employees are agents, while employers are the principals in agency theory. Employees are
hired in a company to work toward the organization’s goals. However, the increasing number
of corporate scams affects employer and employee relationships. Employees violate the
organization’s ethics, which results in significant financial and reputational damage.
Sometimes the damage done by corrupt employees is irreversible, and an organization
ultimately has to wind up the business.
Example (ii)
The way a country’s government functions is among the most prevalent examples of agency
theory. The people choose political representatives to govern the nation in a way that best
serves their interests. Representatives of various political parties promise voters that they will
bring reforms in line with the interests of the country’s citizens. However, voters feel
deceived when their elected officials do not fulfill guaranteed promises. Here, the electorate
serves as the principal and chooses the public servants as their agents.
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Example (iii)
Agency costs are incurred when the senior management team, when traveling, unnecessarily
books the most expensive hotel or orders unnecessary hotel upgrades. The cost of such
actions increases the operating cost of the company while providing no added benefit or value
to shareholders.
Example (iv)
Agency theory addresses disputes that arise primarily in two key areas: A difference in goals
or a difference in risk aversion. Company executives, with an eye toward short-term
profitability and elevated compensation, may desire to expand a business into new, high-risk
markets.
Example (v)
A popular example is by offering incentives to agents such as corporate managers, to
optimize their relationship with the principal. This exists where shareholders' short or long
term returns determine the compensation of company executives.
Advantages & Disadvantages:
Advantages
It resolves the disputes between the agents and the principals. The incentives motivate the
agents, reducing losses to the firm or the organization. Another strategy to cut agency loss is
compensating agents according to performance. Conflict is less likely to arise if there is
transparency between the principals and the agents.
Disadvantages
Its limited behavioral presumptions and theoretical focus are one of its drawbacks. A larger
spectrum of human motivations is ignored by agency theory since it primarily emphasizes
self-interested and opportunistic human behavior.
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Procedures defending shareholders’ interests may interfere with implementing strategic
choices and limit collective activities. Hence, control mechanisms recommended based on
agency theory are not only expensive but also commercially unsuccessful.
Agency theory importance
It is important because it is used in understanding the interactions between agents and
principals. Agents work on behalf of the principal and are responsible for acting in the
principal’s best interests without considering their self-interest.
Assumptions of agency theory
The two basic assumptions of the agency theory are as follows:
1. People are typically egoists who act on their self-interest. In other words, the agent and the
principal focus on their benefit.
2. Agents often have decision-making capacity and access to more information.
(iv) Capital Structure Theory – Traditional Approach
The conventional capital structure strategy recommends a debt to equity ratio where the total
cost of capital is the lowest and the firm's market value is the highest. Changes in the firm's
financing mix can increase the value of the company on either side of this line. The
conventional strategy, promoted by Ezta Solomon and Fred Weston, is a middle strategy also
referred to as the "intermediate strategy. According to the classic theory of capital structure, a
firm's market value is at its highest point when its equity and debt ratios are just right.
According to this method, debt should only be included in the capital structure up to a certain
amount before any further increases in leverage occur. If the WACC rises above the
threshold, the firm's market value begins to decline. According to the conventional theory of
capital structure, an ideal capital structure is one in which the market value of assets is
maximized while the weighted average cost of capital (WACC) is kept to a minimum.
Utilizing a combination of debt and equity capital is how this is accomplished. The marginal
cost of debt and the marginal cost of equity are equal at this point, and any other combination
of debt and equity financing where the two are not equal presents a chance to boost firm
value by adjusting the firm's leverage.
The conventional theory of capital structure asserts that there exists an ideal blend of debt and
equity financing for any business or venture that reduces the WACC and increases value.
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According to this theory, the ideal capital structure is one in which the marginal cost of
equity equals the marginal cost of debt. This hypothesis is based on presumptions that
suggest that the cost of debt or equity financing varies according to the amount of leverage.
Understanding the Traditional Theory of Capital Structure
According to the conventional capital structure theory, a company's value rises up to a
certain amount of borrowed capital, after which it tends to remain constant and finally starts
to decline if there is too much borrowing. Overleveraging causes the value to decline after
the debt tipping point. Comparatively, a business with no debt will have a WACC equal to
the cost of equity financing and can lower that WACC by taking on more debt up to the
point where the marginal cost of debt equals the marginal cost of equity financing. In
essence, the corporation must choose between the benefits of growing leverage and the
rising costs of debt as rising borrowing costs try to balance the benefits of increased
leverage.
According to the conventional theory of capital structure, purchasing assets with the right
proportion of equity and debt is just as crucial to the creation of wealth as investing in assets
that produce a positive return on investment. When this theory is used, several presumptions
are at play, which taken together imply that the cost of capital depends on the level of
leverage. For instance, the company only has access to debt and equity financing, pays out
all of its profits as dividends, has constant total assets and revenues, constant financing,
rational investors, and no taxes. It also has constant total assets and revenues. Considering
this set of presumptions, it is likely easy to see why there are several critics.
Assumptions under Traditional Approach

The interest rate on the debt remains constant for a certain period, and after that, it
increases with an increase in leverage.

The expected rate by equity shareholders remains constant or increases gradually.
After that, the equity shareholders start perceiving a financial risk, and then from the
optimal point, the expected rate increases speedily.
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
With the increase in the company’s financial leverage, the overall cost of capital
reduces, despite the individual increases in the cost of debt and equity, respectively.
The reason is that debt is a cheaper source of finance.
Example:
There are only debt and equity financing available for the firm, the firm pays all of its
earnings as a dividend, the firm's total assets and revenues are fixed and do not change, the
firm's financing is fixed and does not change, investors behave rationally, and there are no
taxes.
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References
1. Harris, M. and Raviv, A. (1991) Theory of Capital Structure. Journal of
Finance, 46, 297-355.
2. Jensen, M.C. and Meckling, W.H. (1976) Theory of the Firm: Managerial
Behaviour, Agency Costs, and Ownership Structure. Journal of Financial
Economics, 3, 305-360
3. Stulz, R. (1990) Managerial Discretion and Optimal Financing Policies.
Journal of financial Economics, 26, 3-27.
4. Frank, M.Z. &Goyal, V.K (2003) Testing the pecking order theory of capital
structure. Journal of financial economics. 67, 217-248.
5. Myers, S.C. (2002) Financing of Corporations. Handbook of the economics
of finance.
6. Myers, S.C. (1984) The Capital Structure puzzle. The journal of finance, 39,
575 - 589.
7. Brealey, R.A &Myers, S.C. & Allen, F. (2011) Principles Of Corporate
Finance. 10th Edition, McGraw – Hill Irwin.
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