The paper "Sources, Availability and Cost of Financial Support" is a great example of finance and accounting coursework. A company can seek external financial support either through debt or equity. While debt is in the form of borrowing from banks, financial institutions or any other source, equity finance is provided on the basis of ownership of the company. The ratio between debt and equity is called leverage and the extent of leverage depends on the company’ s ability to sustain debt servicing through interest payments. The capital structure is the composition of the company’ s finances through debt and equity. The main aim of the company is to maximize shareholders’ value.
The debate on the corporate structure began with Modigliani and Miller (1958), who thought that the shareholders’ value remains unchanged with the capital structure of the firm. As a corollary, shareholders’ value is also unchanged with dividend retention by the company, which increases internal funds and the need for external financing through debt (Modigliani and Miller, 1961). This theory, however, is based on assumptions of perfect capital markets in which there are no transaction costs, rational behavior of economic units, perfect knowledge about firms’ investment policies and cash flows and managers acting on behalf of the firm’ s shareholders (Holder et al, 1998).
The independence of shareholders’ wealth from the capital structure and dividend policy will not hold true in the absence of any of these assumptions. For example, Titman (1984) shows that stakeholders other than equity holders have incentives to maximize shareholders’ wealth in order to reduce transaction costs, e.g that of job searches by employees or maintenance costs by customers (Holder et al, 1998). While debt is typically less costly than equity since lenders demand less as interest than investors ask for a return on equity (Cbdd).
Debts are less risky since these usually impose annual claims that are built in the balance sheet of the company. Besides, most of the debt is provided on the basis of security collateral. For a running company, debt can also be offset against tax liabilities. However, firms still limit debt and raise equity finance in order to hedge on risks since the company will be liable to pay interest on debt even when it is running in losses.
The relationship between leverage (or gearing) to earnings per share (EPS) is shown in the diagram below. With the increase in the level of gearing, both risks and returns of the company tend to rise. In the real world, shareholders expect higher dividends. In most cases, announcements of dividends are usually followed by favorable sentiments in the share market indicating that shareholders’ are positively affected by higher dividend payouts, irrespective of Modigliani-Miller’ s dividend irrelevance theory. This is perhaps because of the simplifying assumptions of the theory that is typically not adhered to.
For example, investors do not usually have perfect information about the firm’ s intrinsic values. The asymmetry of information exists between the firm’ s managers and investors and the release of certain information immediately affects the firm’ s share value. Dividend payouts have a signalling effect on the firm’ s value in that it indicates that the firm will continue to pay out higher dividends in the future and also will be committed to higher earnings to sustain the dividend payouts. Also, higher dividend also indicates lower free cash flows of the firms, a phenomenon that is favorably accepted by investors in the face of a conflict of interest between managers and investors of firms.
Free cash flow usually affects the firm’ s value negatively since investors perceive it as an indication of financial slack on the part of the managers. In both cases, higher dividend payouts increase the share value and higher shareholder value of the firm (Natti, 2006).
Miller, M.H. and F. Modigliani, 1961, "Dividend Policy, Growth, and the Valuation of Shares," Journal of Business (October), 411-433.
Titman, S., 1984, "The Effect of Capital Structure on a Firm's Liquidation Decision," Journal of Financial Economics (March), 137-151.
Natti, Keisuke, 2006, Does Dividend Policy Enhance Shareholders’ Value, http://www.nli-research.co.jp/eng/resea/econo/eco060309.pdf
Holder, Mark E., et al., 1998, Dividend policy determinants: an investigation of the influences of stakeholder theory - Special Issue: Dividends, Financial Management, Autumn, http://www.findarticles.com/p/articles/mi_m4130/is_3_27/ai_53649447
Modigliani, F and Miller, M (1958) The cost of capital, corporation finance and the theory of investment, American Economic Review, 48, 261-297
Myers, S.C (1977), Determinants of Corporate Borrowing, Journal of Financial Economics, 5, 147-175
Myers, S.C and Majluf, N (1984), Corporate Financing and Investment Decisions when firms have information that investors do not have, Journal of Financial Economics, 13, 187-221
Chirinko, R S and A R Singha (2000) Testing Static Trade Off against Pecking Order models of capital structure: A critical comment, Journal of Financial Economics, http://jfe.rochester.edu/99377.pdf
Keyhan, A and T Sheridan (2003) Firms’ History and their Capital Structure, October 7, http://www.stern.nyu.edu/fin/pdfs/seminars/003w-titman1.pdf
The Smart Economist, The Debt-Equity Choice, Report 137 March 2006, http://www.smarteconomist.com/insight/137
Network for Capacity Building and Knowledge Exchange in ICT Policy: Regulations and Applications, Introductions to Capital Structure, http://cbdd.wsu.edu/kewlcontent/cdoutput/tr505r/page22.htm
Organization for Economic Cooperation and Development (OECD), The SME Financing Gap, Presented at the OECD Global Conference on "Better Financing for Entrepreneurship & SME Growth", held in Brasilia, Brazil in March 2006
Luecke, Richard (2004) Entrepreneur’s Toolkit: Tools and Techniques to Launch and Grow your Business, Harvard Business School Press