Financial Management

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Financial Management

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Financial Management
(APC308)
-Individual assignment (Issues in Determination of Capital Structure for Maximizing the Firm??™s value)

Content
1.0 Introduction 3
2.0 Capital Structure 4
2.1 Restraints of Capital Structure 4
2.2 Analysis of Restraints on the Comparative Study of Corporate Value 6
2.3 Evaluation of the Application on organisation??™s wealth 7
3.0 Agency Theory 9
4.0 Role of Financial management 11
4.1 Objective of financial management 11
4.2 Addressing problems of agency theory 11
Conclusion 13
References 14

1.0 Introduction
Economic development makes new requirements to enterprise financial management system improvement and development of proposed. How to set scientifically optimal objective of financial management, financial management theory for the study to determine the optimal capital structure, effectively guide the financial management practices has a certain practical significance. This paper from financial management to determine the optimal objective, analysis of financial enterprises and maximize the value of the relationship between capital structure and capital structure using the measurement of indicators, the liabilities of companies operating conditions were analyzed.

2.0 Capital Structure
Capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities, and it is something that every corporation would encounter. Moreover, capital structure is of great significance to economic efficiency of enterprises, and it also serves as a core issue in financing decision of enterprises. An appropriate capital structure contributes to lowering the enterprises??™ capital cost through selecting sources and proportion of capital. As financial leverage has its own functions, its benefit maximizes when debt ratio is acceptable. Consequently, proper control of debt ratio in capital sources, balance between risk and cost, reduction of financial risks together with the positive effect of financial leverage contribute more to value accumulation. In addition, an appropriate capital structure is conducive to better corporate image and borrowing capacity in a bid to meet the needs of business management and operation (Feng, B. 2005).

2.1 Restraints of Capital Structure
In business management and operation, capital structure can be influenced by many factors which are generally divided into two sections, namely macroscopic factors and microcosmic factors.
Macroscopic Factors (Hu, G.L. 2004)
Industries. As different industries and different corporations in the same industry usually adopt quite different strategies and policies on financial leverage, there are great and obvious differences of capital structure in various industries.
Interest Rate. Financial leverage can bring about more profits to corporations by debt financing, which is benefit on financial leverage. However, if improperly applied, it brings about financial risks too.

Income Tax Rate. Interest on debt is paid before tax while dividend is required to pay after tax, so from the perspective of cutting capital cost, debt financing, when compared with equity financing, contributes to tax-saving, which attracts corporations to choose debt financing under given conditions.
Inflation. In the case of inflation, corporation financial leverage is profitable when return on assets outweighs interest rate, because currency has time value, what corporations pay for is much cheaper one.
Microcosmic Factors
(http://wenku.baidu.com/view/feee367931b765ce04081405.html, 2011)
Enterprise Scale. Generally speaking, large-scale enterprises have better business credit and anti-risk capability than small enterprises, so debt ratio of the former truly exceeds that of the latter.
Profit Level of Enterprise. Only when return on assets outweighs interest rate will enterprises invest by debt financing to achieve tax-saving profits and benefits on financial leverage, or it doesn??™t deserve investment. Thereby, profit level of enterprises directly impacts the decision of capital structure.
Decision Makers??™ Attitude on Risk Investment. In regard to the same project, decision makers who are fond of taking risks would increase debt financing to achieve more profits while those who dislike running risks would avoid it and then make safe and conservative decisions to reduce the proportion of debt financing.
Development Stage of Enterprise. In burgeoning stage, enterprises usually need more capital, which drives them to seek liability capital. At this time debt ratio undoubtedly is relatively high. When enterprises grow much stronger, they have accumulated much fund and do not need much debt financing, which results in the decline of debt ratio.

2.2 Analysis of Restraints on the Comparative Study of Corporate Value
Although comparative study of corporate value has its advantages, it has limited field of application due to the following factors:
Different corporations have different risks, which results in uncertain discount rate. Corporations in different industries have various operational risk and financial risk, so do corporations in the same industry. All these result in the difficulty of identifying capital cost when adopting the Capital Asset Pricing Model (CAPM) (Kurschner, M. 2008).
Madura, J. (2008) pointed that Corporations have to pay for various taxes instead of income tax alone. Taking all the effects of tax revenue into consideration, we may make mistakes when adopting the above-mentioned formula. Especially when the comprehensive effects on corporate value from other tax categories outweigh that if income tax, a converse outcome may emerge, which leads to unfavorable decision of capital structure.
As corporation??™s growth rate ceases to stop increasing, it is rather difficult to confirm capital structure by comparative study of corporate value in the case of ever-growing corporations. The requisite of comparative study of corporate value lies in assuming the corporation cash flow is perpetual annuity. However, it is rather difficult to achieve in reality, because the grow rate of a corporation can be positive or negative. Such fluctuations result to the uncertainty of capital structure which requires calculating dynamically.
2.3 Evaluation of the Application on organisation??™s wealth
Optimum capital structure refers to the capital structure which maximizes the corporate value in a given period. It can achieve optimal balance among financial leverage, financial risk, capital cost and corporate value (Herbst, F.A. 2002). Theoretically, such capital structure might exist and could be served as the target capital structure of a corporation, but in reality many insurmountable difficulties have blocked our way, and even the relatively full-fledged comparative study of corporate value fails to solve this problem.
First of all, different countries have different assessment systems. Assuming that risk level is fixed, there should be an optimal capital structure. Assuming that transaction cost is zero, then the corporate financial structure is unrelated to corporate value. Assuming the corporate risk is low, and then liabilities should increase. For example, in Chinese state-owned enterprises, when vicious price competition occurs, the state-owned enterprise which raises a loan has competitive edge. That??™s to say, corporations can take more risks and produce more items with higher debt level, because corporate risks under such circumstances actually lower. Corporations are willing to borrow more money, which is the reason of why Chinese state-owned enterprises are inclined to raise debt financing and debt ratio keeps rising. However in America most corporations have relatively low debt and equity ratio.
Secondly, the same corporation has different optimal debt ratio in different period and operating performance. To some state-owned enterprises which have sound operating performance or in the period of sound performance, financial leverage has positive effect on economic growth, and general meeting of shareholders or the board of directors would stimulate business manager to raise more debts through incentive mechanism. However, to some state-owned enterprises which have unfavorable operating performance or in the period of unfavorable performance, financial leverage has negative effect on economic growth, and corporations should cut down debts. So the debt ratio of state-owned enterprises is a dynamical number. In a given period, each corporation should have an optimal debt ratio (capital structure). The optimization of capital structure should have a dynamic target, and its rationality is evaluated by whether marginal return on total assets surpasses marginal capital cost (http://www.bylw8.com/, 2011).
Thirdly, given the effects of tax revenue and financial risks, we can draw a restrictive conclusion in regard to optimal capital structure. Benefit of tax revenue brought about by leverage is only important to those corporations having to pay for tax. Corporations which have actual aggregated loss can benefit from tax evasion of interest and depreciation, etc, but they benefit less from leverage. Similarly, different corporations have different tax rates, and the higher tax rate is, the greater debt risk is. As to financial risk, corporations having higher financial risk borrow less money than those having lower financial risk (Chen, H.F. 2005).
In short, when identifying the corporate capital structure with the comparative study of corporate value, we should avoid simple calculation. What we should fully concern is the realistic conditions in realizing the capital structure and optimizing capital structure to maximize corporate value.

3.0 Agency Theory
Agency theory suggests that the firm can be viewed as a nexus of contracts between resource holders. An agency relationship means the principal individuals hire others as agents to perform service or functions (Charles W. L, 2007).
In a seminal paper Jensen and Meckling (1976) suggested that we should think of the firm as consisting of groups of security holders with differing interests rather than as a single agent as traditional theory had done. They emphasized two conflicts. The first is between shareholders or entrepreneurs and bondholders. The second is between shareholders and managers. These conflicts lead to two agency problems.
To illustrate the first agency problem consider the shareholder-bondholder conflict. Given that shareholders obtain any payoff in excess of the debt repayment they (or managers acting in their interest) have an incentive to take risks so that the average payment they receive is increased. They showed that firms acting in the interest of shareholders may be willing to accept negative net present value projects if the shareholders average payment is increased at the expense of the bondholders. This is the risk shifting (also sometimes called asset substitution) problem. The problem is not restricted to the shareholder-bondholder conflict. It can also arise in the context of the shareholder-manager problem.
The second agency problem that Jensen and Meckling (1976) stressed was the effort problem. This can be illustrated in the context of the between shareholder-manager problem but also arises in the bondholder-entrepreneur problem. If managers have a disutility of effort and are paid a wage then they will have an incentive to shirk rather than act in shareholders interests. It is therefore important that managers incentives are aligned with those of shareholders.
Myers (1977) pointed to another crucial agency problem, debt overhang. If a firm has a large amount of debt outstanding then the proceeds to any new safe project that it undertakes will flow to the existing bondholders. As a result if the firm acts in the interests of shareholders it will be unwilling to accept even safe projects even if they have a positive net present value.
The papers by Jensen and Meckling (1976) and Myers (1977) had a huge impact. At one point the Jensen and Meckling paper was the most cited paper in Economics. A large literature focused on the conflict between shareholders and managers. Grossman and Hart (1982) pointed to the incentive effects of debt. If a firm takes on a lot of debt the managers will be forced to work hard. Jensen (1986) also emphasized the incentive aspects of debt in his famous “free cash flow” theory. If managers have access to large amounts of funds, ie free cash flow, they may use it to pursue their own interests rather than the shareholders. One way the shareholders can prevent this is for the firm to take on a lot of debt. Easterbrook (1984) pointed to the incentive effects of dividends. If managers pay out a large amount in dividends they will be unable to waste the funds pursuing their own interests. The Jensen and Meckling article also lead to a consideration of how the managers incentives could be aligned with those of the shareholders through executive compensation. There is a large literature on executive compensation which is summarized in Murphy (1998).
Finally, there is also a large literature justifying debt as an optimal con-tract which uses an agency approach.

4.0 Role of Financial management
4.1 Objective of financial management
Brigham, F.E. (2008) stated that financial management as part of the management of an important component of its meaning lies in the realization of business objectives. Enterprises manage their own business and independent commodity producers and operators, not only to the extent possible, to maximize profits, but also to ensure the steady development, and enhance the mobility of enterprises and avoid the risk. Therefore, the financial management function is to focus on profit maximization and risk minimization targets of this operation.
4.2 Addressing problems of agency theory
Financial management should through capital structure optimized to reduce agency costs, or reduce agency costs through optimization of capital structure, the two are interacting in order to achieve the maximization of corporate value.
Agency conflicts must be resolved in some way. The stakeholders can sign an agreement to resolve these conflicts. For example, they can through restrictive agreements to avoid potential conflicts. When an agreement can not be resolved through a conflict, the investors will be in their own way to solve the problem. They wish to pay by lowering their prices to avoid future debt the risk of loss of wealth. When the company issued the securities, the securities agency costs are all special agreements (such as bonds of restrictive agreements, extremely high cost of such an agreement, because they limit the companys choice.) Costs of, and together with other potential conflicts due to price reduced.
Capital structure will also affect the companys corporate agency costs related to labor agreements. The bankruptcy of a companys employees in order to find a new job are more likely to find costs and these costs each company is different. The expected cost of employee job depends on whether the companys products and services specialization. Employees working on the implementation of mass-specific work with respect to employees engaged in the former expected to find lower cost. Human capital reflects this difference. Therefore, when other conditions being equal, and human-related costs for the agency to provide specialized products and services relative to the companies higher. Due to higher leverage ratio will result in higher agency costs, so this probably means the special products and services will affect the degree of capital structure choice.
Debt financing may also reduce the companys agency costs, such as the cost of shareholders and creditors to monitor the managers cost of shareholder oversight. As long as the company issued new debt, the creditor will carefully analyze the potential situation of the company to determine the fair price of the debt. So every time a new issue of debt, existing creditors and shareholders are free access to a companys external audit. This reduces the external audit due diligence to ensure that an agent spent in supervision costs.

Another approach is the use of sinking fund through the terms. Through the sinking fund, the company can meet each other than interest payments than the need. If difficult to establish a sinking fund, it may be an earlier sign that the company may be in a financial predicament. If you can not create a sinking fund is required means that the company may be unable to pay due. Obviously, this monitoring function is benefit for creditors, but also conducive to the shareholders of the company manager for further supervision.

Conclusion
Solve the agency problems so as to optimize the capital structure, inevitably involves the supervision of financial supervision and accounting, and other monitoring tools. In fact, many factors in the financial environment can be used as monitoring tools, in the normal operating procedures, people, and seek information publicly available, they also transmit information through its own to act, the Government will be disclosed when the implementation of laws and regulations, information, and even the companys reputation and structure will also impart information. A good performance of capital structure management will maximise the wealth of organisations.

References
Feng, B. (2005), Optimization of Capital Structure and Governance, China Legal Publishing House, p.30

Hu, G.L. (2004), Capital Decision Making, Corporate Financial Strategy and Financial Control, Tsinghua University Press

Kurschner, M. (2008), Limitations of the Capital Asset Pricing Model (CAPM): Criticism and New Developments, GRIN Verlag

Madura, J. (2008), International Financial Management, 9th edition, Cengage Learning

Herbst, F.A. (2002), Capital asset investment: strategy, tactics & tools, 3rd edition, John Wiley and Sons, pp.36-37

Chen, H.F. (2005), Corporate Finance Studies, Tsinghua University Press, pp.172-181

Charles W. L, (2007), Strategic management: an integrated approach, 8th edition, Cengage Learning, pp.372-375

Brigham, F.E. (2008), Fundamentals of financial management, 6th edition, Cengage Learning

Jensen, Michael and William Meckling (1976), ???Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,??? Journal of Financial Economics 3, 305-60.

Myers, S. (1977). ???Determinants of Corporate Borrowing,??? Journal of Financial Economics 5, pp.147-75

Easterbrook, F. (1984). ???Two Agency-Cost Explanations of Dividends,??? American Economic Review 74, pp.650-659

Murphy, Kevin J. (1999). ???Executive Compensation,??? in O. Ashenfelter and D. Card (eds.), Handbook of Labor Economics, Volume 3B, New York and Oxford: Elsevier Science, North-Holland, pp.2485-2563.

http://wenku.baidu.com/view/feee367931b765ce04081405.html, (Accessed 5th 2011)
http://www.bylw8.com/, (Accessed 7th 2011)