Corporate Capital Financing - Assignment Example

Corporate Capital Financing Literature Review Executive Summary The capital flow is vital to any business. Without being able to raise capital it is not possible to even start a trade. The share market and the public investment form the cheief source of capital for corporate entities. The Kenesian model has to be considered in the new light of the appearance of modern financial instruments like mutual funds. Many models like the predictive model and consideration of equity are important. We also have to examine the thinking process of capital creation and optimization of capital structure and use in the light of the basic assumption that the cprporate entity’s primary duty is to increase the net value of its stock and share holders and investors. Litrature Review Peter K. Cornelius & Bruce Kogut (2003) have garnered opinions of international dimensions regarding capital flow in their book. It is in the context of the global international capital flows and good corporate governance. The definitions are in relation to one another and examines cross border operation of economic theories. It is pertinent to note that one has to restore confidence in the market economy and in the efficient allocation of resources internationally for capital funding. In this context improvements are required for efficient corporate governance. This theme also was echoed with the addition of equity for small industries and Roger E. Hamlin (2003) proposed in terms of capital aquisition is measured against the total performance predictions. The capital formation can be viewed only in terms of weighted average cost of capital along with the value-based management and risk management are the most important components of corporate finance according Justin Pettit (2006) While the theories so far saw the process as an economic subject we have Neil Seitz, Mitch Ellison (2004) who emphazized budgeting. Their Capital budgeting theory is elaborate and considers all aspects of the business including marketing. The very basis of the existance of a corporate entity is to see that profits are maximized for the shareholders is the view taken by Chris Agar (2005) Culture of anation and the legal angles also ought to be considered. The essential ingredients of any business activity are land, labour, capital and entrepreneurship. Land and labour are available to the entrepreneur, but capital is an elusive thing. Entrepreneurs and business come up with very innovative ideas, but often these ideas are not pursued because of the lack of capital. One of the pillars of any business activity is capital. The capital that flows into the system comes from many sources, and in modern times, capital flow is a business by itself called venture capital. While the stock and share market is the traditional method of raising capital, today it is volatile on account of the dot com burst, and on account of global scope of the market. Every thing that we find happening in the world today affects the capital market. The capital flow is vital to the creation of infrastructure, which is the base of progress. There is a great cycle between the dependent factors, and this review will analyse the thinking of researchers, economists and the entrepreneurs who have shared their experience and thinking through books and other media. With particular emphasis on the subject of capital financing for corporate entities and optimizing cash flow, we will also consider the very nature of capital and its nature from ancient and modern authors. Karl Marx, considered antagonistic to corporations titled his major work “The Capital” (Das Capital) and although the book is from the view point of the labouring class as he called it, we may understand the power of capital and the need for it to make business in the modern sense possible by comparing the methods employed in the period (1800 s) to generate and maintain an industry to the modern market. We find that from the time when the book was written, much water has flown under the bridge. Today the theories propounded by the economists of those times have no relevance. Even John Maynard Keynes seems to be outdated. Modern theories and litrature Amathya sen has revolutionized the financing sector with the concept of ‘micro finance’. How ever todays corporates cannot accommodate that theory although it is useful to small and medium scale industries done on a co-operative basis. One fact we can learn even then is that the banking sector is the most powerful and feasible source of financing. Powerful because if banking institutions invest in corporates in a clear cut and profit oriented manner, capitalization. Franco Modigiliani & Merton H. Miller (1958) first point out that the economists tend to side step the cost of capital problem by assuming that the cost of capital is the interest on bonds and other instruments floated by the corporation to raise capital. They point out that such theory assumes that the marginal yield of the physical assets will equal marginal interest and that based on this principle, the maximization of profits and asset value is studied. The authors then go on to point out that the assumption of the Kenesian model of interest with no risk is not teneble in the modern times, with attendant risk to investments in instruments like mutual funds. The authors therefore seek to then see if the utility principle, and the theory of marginal utility is better suited. This too, they argue is flawed. The authors then proceed to interpret the phenomena with their own theory, that of market value maximisation. There are assumed to be uncertain streams of invesntments coming over to the corporation which is assumed to own the streams or be able to use it. The theory they postulate says that the two streams could be corporate investments and the hedging of the capital markets and the mutual fund markets in such a way that the company could achieve liquidity and a marginal equilibrium coud be set between the borrowings and capital investment and return of capital. The theories propunded by them however was imperfect insofar as they ignored the tax structure and the effects of taxes on corporate capital building and investment. The theory was framed when mutual funds were just being touted. Economics is based on many assumptions. The world and the markets change so rapidly that we cannot say when a particular principle will be outdated. In this cade too, it was a situation where the predictions were based on variables that was just getting current at the time. We are aware that the principle by itself does not explain the capital market nor does it provide a complete set of cirteria that can have universal application for all corporates. This is so because the nature of a corporate entity and its interatction in the capital market is very complex. Some of the development in the capital markets also require reexamination of theories that were propounded some time., or even a decade ago. “Wall street today is not the same as it was 5 years ago” is the feeling. We now therfore proceed to examine the authors who later examined and modified the theories. Today the scenario requires a deeper understanding of corporate debt and obligations and the nature of the prevelent market. Long after the theory of Franco Modigiliani & Merton H. Miller became current , Paul Marsh (1982) Suggested the predictive model in which the author using earlier findings of Martin and Scott considered the payout effect and proceeds to examine the effect in the light of a model where the hypothesis was that higer risk companies tend to show lower debt ratio and smaller companies relied on long term borrowing and credit. If this hypothesis was tested and a model derived, they argued it was posssible to predict the behaviour of the capital market and the company decisions. Tax was also to be included in the study to prevent the criticism that was the basis of this alternate strategy. They propounded a formula for arriving at the maximum likely hood estimate and tested the theory with select firms. The research concludes with the finding that companies tend to be heavily influenced by market conditions and the fluctuations in the past with regard to the price of securities, equity and debt. Paul Marsh also concludes that these considerations are regardless of a company's financial position or structure and size of the company. The bancuruptcy risk, size of the company and the choice of financial instrument play a role when the choice is made for long term debts and therefore the predictive model is asserted to be the method that can be used to analyse the market, and chose the best options and if necessary predict the future outcomes both for the company and the investor. The major work after marsh was that of Peter L. Bernstein (2005 ) Being the President of a corporate entity, Bernstein tries to analyse the capital formation from the point of view of where the capital is: That is the stock and share markets. He argues that there were brillant writers like Harry Markowitz, and the thory of optimizing the tradeoff between risk and reward, William Sharpe's assertion that the market cannot be beaten, and the financial derivatives which is the brainchild of Fischer Black, Myron Scholes, and Robert Merton which is the chief instrument of capital creation to day, and Franco Modigliani and Merton Miller who explored the theme of arbitrage in determining the value of securities are the fundamental ideas and concepts that have motivated and moved corporate entities, and facilitated capitalization. the book explores the Black-Scholes formula for pricing options in depth. He contends that United States has some peculiarities: " The long run returns of the US market of about 8% annually on a real, after-inflation basis, are unique to the United Sates in the 20th century. No other country has done as consistently well, due to disruptions such as wars, famines, revolutions and the like." he also picks with teh investors index, and predicts that people are averse to change. One aspect he mentions and which this reviewer also agrees, for which we have tried to go afield for this research is : "Financial theorists have been almost exclusively English and American scholars, though that seems to be changing now. And they have been 100% men. Not a woman figures among Bernstein's pantheon. So many theorists were converted engineers, physicists and mathematicians (I think that's where the "improbable origins" subtitle of the book comes from; these guys were just looking for some good problems to work on). It's the ultimate nerd activity." Capital and raising capital is of concern for the shareholder because it will eat into the value of the shareholders assets. Debts are liablities and have to be viewed in that context. Investment and raising capital is always pitted against the concern of the value of the holdings. This is true of the whole economy. The capital and especially debt capital in terms of the global economy was considered in depth by Roger E. Hamlin (2003) Although the author considred the small industries, we can use the contentions for corporates because many small industries are run by corporate netities. Added to that what worksi ni a micro level ought to work in a global macroeconomic level. The author proposes a model for improving capital generation for the small industries which is similar to the ones advied for giant corporations but with a simplified system where the total layout in terms of capital aquisition is measured against the total performance predictions. The author explores why the capital investors seem to shy away from the industries and concludes that expansion of small industries are seen by investors as fraught with risk and therefore financing them is avoided. In the author's model a corporate entity must project its future capital requirements in advance an dproject it with the futuer cost of expansion and the break even point. A model for enhancing small business capital formation in the United States is also elaborated. Many small variations in theory and consideration of many relevant factors caused some economists to give similar but slightly independent observations. Justin Pettit (2006) argues that it is important to consider the weighted average cost of capital along with the value-based management and risk management are the most important components of corporate finance which ought to also be considered in the case of the corporate decisions on mergers and acquisitions. Performance measurement and optimization of the capital structure it is argued are the tools to use in this regard. Neil Seitz, Mitch Ellison (2004) Stress the need for budgeting. According to them the financial acument to budget and forsee needs and long tem requirements in the corporate managers helps them take decisions on capital funding. It is according to them based on each company's financial structure and perception. Capital budgeting is a concept that requires extensive synchronization of all corporate strategies and goals in all aspects of the business including marketing. Capital budgeting is claimed to be the tool that corporates ought to use in dittermining their future capital needs and structure. In contrast to this, Chris Agar (2005) argues that the basic principle for a corporation is to see that shareholders get maximum value. All financial decisions ought to revolve around this principle. Any investment and borrowing should always be assesed to see if it will enhance the share value and thus the wealth of the holders in the long run. This ought to be viewed at all times, and is the core of any financial decision. " The intrinsic value of proposed investments should be assessed before deciding how much capital to allocate; the benefits and risks associated with each available source of finance should be considered when capital is being raised; and capital, and any associated financial risks, should be managed in a way that continues to maximise value." Christos N. Pitelis (1986) is of the opinion that “corporate decisions with regard to retained earnings act as a constraint to the consumption-saving decisions of all shareholders, except those who take the decisions - the controlling group. The latter exhibit a preference for a higher retention ratio than the non-controlling share-holders and tend to realize their "preferences." Given less than perfect substitution between corporate and personal saving, this tends to increase aggregate financial capital accumulation. “ The book Financing Corporate Capital Formation edited by Benjamin M. Fried has major economists writing on aspects of e corporate capital formation in the U.S. economy. The book focuses on debt and equity financing by corporations and the relationship between corporations' real investment decisions and their financial implications. In this book Robert Taggart establishes a relationship between corporate and government debt. While Robert McDonald insists that the volatility of interest rates always causes a demand for higher returns form the investors' side as risk compensation . Viewing it from other angles: Is the corporate policy market driven? What happens in a context where faith and culture operate in such a way that some of the factors that dittermine freeplay is nullified and the assumption of ceteris paribus is no more effective, and we have to include elements which we never considered as economic factors before to be a powerful force in the economy? Today the Middle east is slowly becoming an economic power. It will be interesting to see how capitalization is done in a country where banks are prohibited from giving or taking interest. Infact all the economic formulas we considered hiterto gets nullified. Arguements may be submitted that in such a situation investors may be tardy of investing and will naturally tend to hold gold or precious metal as we know from the economy during the world wars when the banking system failed and even cigarettes were used as money. The arguement that such a system is lieky to fail is disproved by the rapid growtha nd enormous capital that is available for corporate trade and investment in the middle east. Here is a phenomenon that beats explanation in the conventional economic view. Marjorie Kelly (2003 ) Principles of Economic Aristocracy Publisher: Berrett-Koehler Publishers is of the same opinion. In the book the concept is labeled “The principles of economic aristocracy” Which elaborates the need for corporations to exist for the shareholders rather than for the employees or community. The maxim “ paying stockholders is more important than paying employees, the belief that the corporation is a property that can be owned and sold, and the fact that only stockholders can vote to determine the company's future” are part of the argument. It is alos explained that this attitude is the cause of labour unrest, and the author wants corporates to consider the social benefits and employee benefits as a part of the culture. The author borrows and cites various thinkers like. Jefferson, Lincoln, Adam Smith and others to mark her view. Any investment and borrowing should always be assesed to see if it will enhance the share value and thus the wealth of the holders in the long run. This ought to be viewed at all times, and is the core of any financial decision.BBut that can have implication sof a different kind if there is a factor like faith which is not based on economic principles. Based on the laws and working of the countries of the Middle East, A.L.M. Abdul Gafoor (2007) informs us that in the 'Islamic' system, thete cannot be any interest and therefore there is no interest paid on deposits. But the capital invested is guaranteed by the authorities. The author proposes a world wide banking policy based on thsi model. This though is based on the current system prevailing, has a lot of unverified claims by the author. It however shows us an alternate model that is being practiced in other countries, where the principal variables that are touted to be the cause or effect of capital accumulation, and equity and debt, namely Intrest and borrowing are absent, and banking is done as a service based on service charges rater than investing the money for profits. This model however assumes an authoritarian government which can ensure that the system works. In democracies it is highly improbable. The book is targeted at Muslims and nations of that faith. However leaving aside the religious and regional bias, we may show that alternates to the Western system of raising capital and growing is demonstrated to exist. Legal costs and laws affect capital creation: Gerry Nkombo Muuka PhD (1999) Points out that we must not ignore the legal aspects of debt financing. Economic theories do not take into account the legal restraints imposed on a corporate entity. In this book the author has extensively pointed out some of the legal restriants that can upset the economic theories we discussed earlier and also pose a new set of rules under which corporates play. the legal aspects of financing has never been considered while framing economic theories. The author argues that imperfect market conditions, play a vital role in capital formations, and it is additional to the desire of increasing the stock holders wealth. The author points out that costs paid to agencies, liquidity barriers, taxes, and cost of information and advertising (for investment) and other professional costs to getting capiital and the legal rules play a vital role. His research is centred on Zambia which is taken as a state where the legal framework can be studied with this issue. The author concludes that the stock exchange is a very important and powerful institutions whose effect can be seen in a nation that is just developing the economic structure. It is to be assumed that laws and practice in the stock and trade markets in advanced nations will be having a greater impact. In a commercially growing nation, the author argues, the financial laws are the barometer that can be used to dittermine the level of investment, the type and the cost of raising capital in a time and equity analysis. Thus there cannot be an economic analysis in capital markets without considering the legal and operational costs and methods which prompt investment and borrowing. Summary and conclusion The capital flow is vital to the creation of infrastructure, which is the base of progress. There is a great cycle between the dependent factors, and by this review we can see that there are a host of factors that interplay and all the hypothesis forwarded by the authors with particular emphasis on the subject of capital financing for corporate entities and optimizing cash flow,. Tend to see a small part of the whole picture. To sum up we see that the Nobel laureates Franco Modigiliani & Merton H. Miller (1958) first pointed out that the assumption of the Kenesian model of interest with no risk is not teneble in the modern times, with attendant risk to investments in instruments like mutual funds. The Market value theory propounded by them however failed to take in many of the variables like mutual funds, taxes and the corporate behaviour and complexity. The theory they postulated was based on investments and hedging of the capital markets and the mutual fund markets to achieve liquidity and a marginal equilibrium. Paul Marsh (1982) tried to set out the diffrences and anomaly that was found in the market two decades later by suggesting his predictive model which included tax and modern market conditions with new financial instruments and borrowing standards. Equity was juxtaposed with market conditions and the fluctuations in the past with regard to the price of securities, equity and debt. Investors were more keen on minimum risk and for long term debts the model favours trend analysis to choose the best options and if necessary predict the future outcomes both for the company and the investor. Peter K. Cornelius & Bruce Kogut (2003) have garnered opinions of international dimensions regarding capital flow in their book. It is in the context of the global international capital flows and good corporate governance. The definitions are in relation to one another and examines cross border operation of economic theories. It is pertinent to note that one has to restore confidence in the market economy and in the efficient allocation of resources internationally for capital funding. In this context improvements are required for efficient corporate governance. This theme also was echoed with the addition of equity for small industries and Roger E. Hamlin (2003) proposed in terms of capital aquisition is measured against the total performance predictions. The capital formation can be viewed only in terms of weighted average cost of capital along with the value-based management and risk management are the most important components of corporate finance according Justin Pettit (2006) While the theories so far saw the process as an economic subject we have Neil Seitz, Mitch Ellison (2004) who emphazized budgeting. Their Capital budgeting theory is elaborate and considers all aspects of the business including marketing. The very basis of the existance of a corporate entity is to see that profits are maximized for the shareholders is the view taken by Chris Agar (2005) Culture of anation and the legal angles also ought to be considered. Conclusion: It is a complex situation where any number of factors can come into play. We conclude that the most important thing for any corporate entity is to add value to the stock and share holders, and with this view the corporate entity has to choose and pick a relevant model from among the many available sources in such a way thet in the long run capital issue and borrowings do not erode the value of the assets and shares. To do this a holistic approach which choses the aproppriate pardigm from all those considered above ought to be seen in light of the needs and financial health of the inidvidual corporate entity to suit its policies and governance. We have to therefore conclude that while many tools for analysis and methods of dittermination are available in this context we have no tailormade formula to suit all corporate entities, and each will have to frame its financial policies based on the elements considered in the theories and those relevant and appropriate to the individual cases, which ought to also consider grographic, social and legal parameters in operations. Reference Franco Modigiliani & Merton H. Miller (1958) Cost of capital, corporation finance and the theory of investment , American Economic Review (jun 1958) Vol 48 – 3 PP – 261-297 Paul Marsh (1982) The Choice Between Equity and Debt: An Empirical Study The Journal of Finance, Vol. 37, No. 1. (Mar., 1982), pp. 121-144. URL:http://links.jstor.org/sici?sici=0022-1082%28198203%2937%3A1%3C121%3ATCBEAD%3E2.0.CO%3B2-8 Gerry Nkombo Muuka PhD (1999) Legal Aspects of Corporate Capital and Finance, (Washington DC: Penn Press, 1999) Murray State University Volume 6, Number 4 (December 1999) http://www.murdoch.edu.au/elaw/issues/v6n4/muuka64.html A.L.M. Abdul Gafoor (2007) ,Islamic Banking and Finance: Another Approach Publisher: A.S. Noordeen, P.O. Box 10066 50704 Kuala Lumpur, Malaysia. Roger E. Hamlin (2003) Financing Small Business In America: Debt Capital In A Global Economy Published By:Praeger Publishers Published:October 31, 2003 Chris Agar (2005) Capital Investment & Financing Published By:Butterworth-Heinemann Published:June 21, 2005 Justin Pettit (2006) Strategic Corporate Finance Applications in Valuation and Capital Structure Vol. 24, Issue 19 John Wiley & Sons Neil Seitz, Mitch Ellison (2004) Capital Budgeting and Long-Term Financing Decision Published By:Nelson Education Ltd. Published:January 8, 2004 : Peter L. Bernstein (2005 ) Capital Ideas: The Improbable Origins of Modern Wall Street Published By:John Wiley & Sons Published:June 6, 2005 Marjorie Kelly (2003 ) The Divine Right of Capital: Dethroning the Corporate Aristocracy Publisher: Berrett-Koehler Peter K. Cornelius & Bruce Kogut (2003) Edited by Peter K. Cornelius, World Economic Forum, Switzerland , and Bruce Kogut, Wharton School, University of Pennsylvania Christos N. Pitelis (1986) Corporate Control, Social Choice and Capital Accumulation: An Asymmetrical Choice Approach : Review of Radical Political Economics, Vol. 18, No. 3, 85-100 (1986 Read More