Estimating the Cost of Capital - Literature review Example

Critical Analysis Name: University: Date: Critical Analysis Article 1 In their study, Stretcher and Johnson (2011) examined the capital structure’s theoretical foundations by demonstrating a number of issues experienced when the theory is applied to reality. Besides that, the authors recommend a practical managerial decisions’ framework regarding the capital structure. They emphasise that the explanation is particularly valuable in the business’ core curriculum of undergraduates, especially for finance majors where professional management is considered as a profession. As opined by the authors, decisions on capital structure depend on the multifaceted scope of practical considerations as well as theoretical foundations. Clearly, it is unfeasible for decisions made at the managerial level to be rooted purely in theory. Although the best capital structure insight can be developed, Stretcher and Johnson emphasise that the theoretical base practical limitations normally obscure the decision. For decision techniques and policies to be handy to the practising managers they must be resourcefully accomplished and anchored on the existing information. Therefore, Stretcher and Johnson artice offers a practical framework for practical managerial decisions regarding the capital structure. Stretcher and Johnson established that although conventional capital structure theory is often impractically used, the professional managers can utilise a number of tools to make decisions that are informed concerning the capital structure. The authors provide a summary of the remaining concrete concepts as well as present Z-scores, debt servicing multiples and leverage multiples as promising indicators, which could be utilised by the managers to identify risks and benefits of debt use. Furthermore, the authors present estimation process by Brigham and Daves as a suitable means of making capital structure decision and recommend the utilisation of inlevels. The authors have not demonstrated how tradeoff theory can be enriched by the managerial traits by allowing individual attributes to influence the capital structure decisions. As mentioned by Hackbarth (2008), capital structure decisions are normally considered as a tradeoff of different determinants of bankruptcy costs as well as corporate taxes. Clearly, Stretcher and Johnson have failed to provide sufficient quantitative or qualitative guidance about the connections between managerial traits and agency conflicts. As emphasised by Hackbarth (2008), the conflicts between shareholders and managers could come about when latter become reluctant to disburse cash. Therefore, a dynamic model of the capital structure should include disciplining forces for imposing the issuance of debt devoid of possibly reversing leverage choice that was made at the outset. In terms of capital structure decisions, Stretcher and Johnson affirm that the financing decisions of the firm normally lie in the hands of the managers, but they do not indicate that type of manager that can possibly select the levels of disciplinary debt and those inclined to continue using the debt policy within the dynamic setting. Hackbarth (2008) posits that the higher initial debt cost is normally the basis of unproductive investment behaviour after maximisation of the equity value. Hackbarth (2008) agrees with Stretcher and Johnson that indicators like the Z-score, debt-servicing multiples, and leverage multiples are solid information sources that can be utilised by the practitioners. Although the capital structure offered by these indicators is not precisely optimal, they are useful as well as practical for manager’s debt use perceptions. Article 2 Ward (1999) introduces different ways that can be used to estimate the cost of capital. First, the author reviews the capital structure’s main theories briefly before expounding how debt finance (fixed-interest) could influence the cost of capital. The author determines ways through which the cost of capital could be utilised in assessing projects such as those undertaken by the firm as well as how it could be utilised to consider projects that are beyond the firm’s normal business activities range. Even though scores of techniques are normally utilised to review investments or new projects’ values, Ward posits that the most consistent and rigorous method encompass projecting future cash flows and arriving at the current value by discounting the projections at a suitable interest rate. The project’s return rate according to the author must be higher as compared to the cost of capital of the firm in case the project is approved. Still, scores of managers do not understand how to choose a suitable rate of discount. Besides that, even when the cost of capital is calculated properly, the firm could utilise various cost of capital in order to review the new projects. The author stresses that there are conceptual and practical challenges that managers experience when evaluating the capital budgeting decisions. For non-listed companies, the owners do not have any market valuation; therefore, it becomes challenging to evaluate the management decisions’ failure or success. As opined by Ward, non-listed companies should try to measure their cost of capital; specifically, the cost required to be paid by companies listed in the stock market. For that reason, Ward thinks that managers must project the forecasted investment’s cash flows being reviewed and ensure they are valued through discounting at a suitable cost of capital. A positive net result after the adoption of the project could lead to increased share price, but negative net results bring about decreased share price. Even though there exist some disagreements amongst the researchers regarding the level to of tax, effect or bankruptcy since scores of scholars as cited by the author concur on the adjustment of the average cost of capital through debt’s tax-shield effects. That is to say, given that the firms could legally consider payments of interest as the operating cost, the sum of tax due could be decreased after paying more interest. However, the author fails to Cleary mention how the financial markets’ information can be utilised to calculate the cost of capital. As mentioned by Palliam (2005) small companies normally lack the required information about the market; thus, calculating the cost of capital is somewhat challenging. Palliam (2005) provides a multi-criteria paradigm that could be used to calculate an appropriate cost of capital. Clearly, Palliam (2005) and Ward (1999) agree that decision tools together with poor evaluation risk the likelihood of using the scarce resources in areas promoting less return as compared to the cost of capital. Eventually, it leads to the value destruction. Evaluation systems that do not use resources in forecasting a return offering that is greater as compared to the cost of capital could lead to a potential loss of competitive advantage due to the opportunity cost. For that reason, Ward suggested the essence of evaluating the cost of capital of the firm in order to promote good decision-making. Practically, Palliam (2005) thinks that this cost is very challenging to appraise. Article 3 The objective of Hassan and Halbouni (2013) article is to examine the impact of corporate governance mechanisms on the listed firms’ financial performance in UAE. The authors observed that the corporate governance principles that are sourced from the developed economies can also be utilised in other countries. According to the authors, the significance of governance could be reduced in the eyes of shareholders and managers if the corporate governance level of fails to influence the firm’s financial performance. The authors cite a number of empirical studies that have examined the connection between firms’ performance and corporate governance, and they established that most of these studies had inconclusive results. A number of studies according to Hassan and Halbouni offer evidence exhibiting that corporate governance positively influences the performance of the firm, but others demonstrate a negative relationship between firms’ performance and Hassan and Halbouni. This is what the authors describe as inconclusive results, which are attributed to intra-countries institutional differences. Besides that, a number of studies use performance measures that are based on accounting like earning per share, return on equity, return on assets, or asset turnover. Other studies utilised the performance measures based on the market like Tobin’s Q. Hassan and Halbouni study results demonstrated that board size, CEO duality, and voluntary disclosure considerably influenced the UAE firms’ performance measured by return on equity and return on assets, but the firms’ performance measured through Tobin’s Q was not significantly influenced by any governance variables. In addition, the authors observed that the only variable control which considerably influenced the performance of the firm was the firm size. Other variables like listing years, type of audit, board committees, leverage and the industry have less effect on the performance of the firm. Shahwan (2015) also found a positive correlation between effects of the corporate governance and the firm’s financial performance. Shahwan (2015) cite a number od studies that support Hassan and Halbouni’s study findings such as market-to-book value and Tobin’s Q positive correlation with the practices of corporate governance. The study results of both Hassan and Halbouni (2013) and Shahwan (2015) studies demonstrate that there is a positive correlation between firm performance and corporate governance, but Shahwan (2015) insist that this is true where the ownership structure is highly concentrated and safeguards the stakeholders and investors’ interests. Both studies agree that there exists no connection between firm performance and the board composition. Still, Shahwan (2015) maintains that the size of the board positively influences the firm’s performance. Therefore, it has been argued that good corporate governance can positively influence the performance of the firm as measured through economic value added, but using Tobin’s Q and other conventional performance measurements cannot validate this relationship. References Hackbarth, D. (2008). Managerial Traits and Capital Structure Decisions. Journal of Financial and Quantitative Analysis, 43(4), 843–882. Hassan, M. K., & Halbouni, S. S. (2013). Corporate governance, economic turbulence and financial performance of UAE listed firms. Studies in Economics and Finance, 30(2), 118-138. Palliam, R. (2005). Estimating the cost of capital: considerations for small business. The Journal of Risk Finance, 6(4), 335 - 340. Shahwan, T. M. (2015). The Effects of Corporate Governance on Financial Performance and Financial Distress: Evidence from Egypt. The International Journal of Business in Society, 15(5), 1-9. Stretcher, R., & Johnson, S. (2011). Capital structure: professional management guidance. Managerial Finance, 37(8), 788 - 804. Ward, C. (1999). Estimating the cost of capital. Journal of Corporate Real Estate, 1(3), 287 - 293. Read More