ACC2015M: Financial Manager's Role in Capital Structure Optimization

This essay critically examines capital structure theories, including Modigliani-Miller, traditional approach, and pecking order theory, in the context of real-world observations and empirical evidence. It explores the role of the financial manager in deciding the optimal capital structure of a company, considering factors like the weighted average cost of capital (WACC), de-equitisation trends, and the impact of debt-equity mix. The essay discusses the significance of capital budgeting theories in dynamic environments and the importance of financial managers in maximizing shareholder wealth by carefully selecting a capital structure that aligns with the company's goals. It also highlights the importance of considering the advantages of corporate tax, benefits of the financial advantage as well as the advantages of debt-equity mix.

Running head: ESSAY 0
ACC2015M FINANCIAL MANAGEMENT
JANUARY 3, 2020
STUDENT DETAILS:

ESSAY 1
The Financial Times (29 January 2018) declared certain statistics in relation to the dramatic trend
of de-equitisation in European market as well as the US and emerging markets- ‘De-equitisation,
the shedding by corporate of equity in favour of debt, has been the theme for the past decade as
lower interest rate permitted organisations to borrowing cost were formerly unimaginable.
However, these explanations for de-equitisation are unproductive. This capital structure theory is
known as Modigliani-Miller after the Nobel Prize-winning economists who developed it. As per
this, all things being equal, the organisation’s true value is independent of how this is funded
nevertheless with corporate tax rates in the US and UK cut to levels unimaginable a few decades
ago, the relative benefits of debt issuance are less obvious than they once were.’ In this essay, the
theories of capital structure and connection between theories as well as real-world observations
or empirical evidence is discussed and critically examined. This essay will discuss the role of
financial manager in deciding the optimal capital structure of an organisation.
A capital structure is considered as outstanding equity as well as debt of company. The capital
structure permits the organisation to know what type of financing the organisation utilises for
funding the overall functions along with development. In different terms, the capital structure
states a part of senior as well as subordinated debts, as well as common equity or preferred
equity in a financing. A capital structure is known as the amount of permanent short-term and
long-term debt, common equities, as well as preferred stock used to renders funds for the
company. Therefore, the capital structure is considered as a part of financial structure, which
represent the permanent resources of the financing of organisation. As per the traditional view,
the debt is inexpensive in comparison of the equity. This is main reason that the debt finance is
more preferable over the equity. The investor does not need as high the return (creditor rank

ESSAY 2
ahead of shareholder along with can be offered security). The lower cost of raising debt (bank
arrangement fees or issue costs of a bond) is another reason. The debt can be cheaper for the
reason that the interest is taxation deductible.
Additionally, organisations finance certain functions of business with equity, debt or
combination of both. The weighted average cost of capital is considered as rate that entity is
expected to make payment on the average to every security holder for financing the assets. While
utilising the method of weighted average cost of capital method, cost of good available for sale is
divided by the number of selling units. It produces the weighted average cost per unit. It can say
that the cost of goods available for sale is the sum of net purchase as well as opening stock.
The weighted average cost of capital is normally considered as the cost of capital of entity.
Significantly, it is dictated by the external marketplace and not by administration. The WACC is
considered as the discount rate to calculate NPV of business. The weighted average cost of
capital is utilised to assess the opportunity related to investment, as it is considered to state the
opportunity cost of company. In this way, this is utilised as the hurdle rate by the organisations.
There is significant relationship between capital budgeting theories and real-world observations
or empirical evidence. The organisations operating in the dynamic atmosphere should make
responses to change to beat competitor as well as to withstand, survive along with development
in the marketplaces. The capital budgeting theories are helpful in taking relevant decisions in
relation to the contingency factors. In the present world of social, financial along with geo-
political uncertainty, the strategic financial administration is a procedure of change, in turn
requiring the re-examination of the basic assumption.
As the financial manager has significant role in taking decision of optimal capital structure,
depended on financial proportion, a value of organisation as well as WACC are affected. The

ESSAY 3
four categories of capital structure theories are net income approach, traditional approach, as
well as net operating income and Modigliani and Miller approach. Durand advised the net
income approach. Durand was in favour of the decision of economic advantage. As per the view
of Durand, the changes in financial leverage will make the changes in cost of capital. Therefore,
in a case when ratio of debt in capital structure is enhanced, and weighted average cost of
capital is reduced. In that case, the value of organisation will increase. Next approach is net
operating income approach. Durand also renders net operating income approach. It is not as same
as the net income approach if there is no tax. It is stated by net operating income method that
WACC will be constant. It is also believed that the marketplace assesses the organisation wholly.
In addition, it also discounts at the specific rate that has no relationship to the debt-equity ratio.
In a case when the data related to tax is provided, then it is also recommended that with the rise
in debt financing weighted average cost of capital reduces, as well as values of organisation
would start to increase1.
Furthermore, the traditional approach is not succeed in defining the hard as well as fast fact or
data. As per the traditional approach that the cost of capital is considered as the activity of a
capital structure. The great in relation to the traditional approach is that this approach supports
the optimal capital structure. The optimal capital structure states that at specific proportion of the
equity as well as debt, cost of capital is least and organisation’s value is extreme. On the other
hand, the M&M approach is considered as the capital structure theory named after Franco
Modigliani as well as Merton Miller. The Modigliani and miller approach rendered 2
propositions. The proposition I states that the capital structure is unrelated to the organisation’s
value. The value of 2 recognised organisation will remain similar and value will not influence by
a selection of finance followed for funding the assets. The value of the organisation is relied on
1 Kelvien Brusov Capital Structure: Modigliani–Miller Theory. (Routledge 2018)

ESSAY 4
the expected upcoming earning. It is while there is no tax. On the other hand, the proposition II
states that the financial leverage enhances organisation’s value. It also decreases the weighted
average cost o capital. This is when tax data is available2.
Further, the de-equitisation is considered as the substitution of debt for the equity, particularly at
a stage of marketplaces. At organisational stage, the de-equitisation takes place by the buy-back
shares, acquisition for money, as well as same dealings. Notwithstanding the Modigliani-Miller
approach, the capital structure is significant enough to motivate organisation to adjust in
response to altering situations. The modifications that activate de-equitisation (or alternatively,
re-equitisation) state the modifications in equity as well as cost of debt. A purpose for regulating
the capital structure is normally to lower WACC. This would be assumed by financial manager
that de-equitisation will take place while debt is inexpensive. On the other hand, the re-
equitisation will take place when equity is inexpensive. It can say that as per the issuer, so cheap
is considered as high share price for the equity as well as low yield for debts. The upcoming
trend of the de-equitisation, in which the amount of equity circulating throughout marketplace
shrinks, can be resulted into both bad results as well as good results for investor depending on
the placing in a marketplace. It is evident that the cursory glance at the equity land of United
Kingdom is sufficient to know that there have been the remarked slowdowns in the number of
latest organisations coming to marketplace in the upcoming period3.
It can say that the de-equitisation is great indicator of the relative valuation of equity along with
debt. In general terms, the debt-financed buyback shares are understood as stating that equity is
2 Henry Pathmanandam The weighted average cost of capital. (Oxford University Press 2019)
3 Grand OwenThe M&M approach. (Springer 2019)

ESSAY 5
undervalued. It can implement at both at level of market as well as company. Even though, this
will be more correct to signify that what is stated is an opinion of administration on whether
equity or equity is low-priced. The cost of equity is depended on expected return, as well as in
evaluating the manager can create similar mistake as investor, in spite of having4. One instance
of wide-spread administration mistakes deceits in the volume popularity of buy-back shares
throughout the dotcom boom. The administration as well as shareholders shared over-optimistic
prediction of the development, motivating them to incorrectly evaluate equity as cheap5. Cost of
equity as well as cost of debt is influenced by perception of risks. This is simple to consider that
de-equitisation in 2007 along with 2008 was caused the requirement to reinforce the balance
sheet as investor shied away from debts. When it creates both debt as well as equity less instable,
the larger amount of debts held meant marketplace as the whole was still exposed to similar risk;
a moment contemplation of Modigliani Miller argument will state that it should be so. The less
fundamental cause of modifications in relevant cost equity as well as equity is taxation. It can
evident that the buy back shares are also utilised as the tax-efficient methodology of returning
money to shareholder. Then, it would be paid as dividend. However, it is not required to have
more than the limited effects on de-equitisation. The reason is that it is the source of creating the
payment to shareholder, not the motive for creating large payment to the shareholder6.
Moreover, the financial manager plays the significant part in deciding optimal capital structure.
It is not simple task to ascertain the optimum capital structure of the organisation because
maximisation of the wealth shareholders is depended on certain fundamental choices. In order to
enhance the value of equity stakes, the organisation is required to choose the funding mix-capital
4 Renard John Capital structure theory: An overview. (5th edn Oxford University Press 2018)
5 Emmie Martin Concise Medical Dictionary. (Oxford University Press 2018)
6 Onatca Engin Pecking order theory in determining the capital structure: a panel data analysis of companies in
turkey. ( 8th. edn Oxford university press 2018 )

ESSAY 6
structure that would assist in getting the desired aims as well as targets. In this way, the financial
manager should test the capital from the point of view of the effects toward the value of
organisation. This is unnecessary to state that the organisation should select the financing mix in
the way that it increases the funds of shareholders if the capital structure of an organisation
influences on the total value of enterprises. It can say that it goes by a name of the optimum
capital structure for an organisation7. In this way, there is the clear relation between capital
structure and organisation’s value 8.
A main financial objective is to enhance the wealth of shareholders9. The financial manager
should reduce the WACC. The financial manager may achieve this by getting certain debts in the
capital structure. The debt is comparatively inexpensive than equity, when ignoring extreme of
little gearing (WACC may be reduced furthermore) or too much gearing (an organisation suffers
from bankruptcy cost, tax exhaustion as well as cost of agency). It is essential that the financial
manager should pursue the sensible stages of the gearing. In addition, the financial manager
should be careful about the pecking order theory that considers the completely different
approach, as well as avoids the search for the optimal capital structure. The financial manager
should consider that while the organisation wants to raise funds it does so in a pecking order:
first is retained earning, at that time debt as well as finally equity as the preceding resort10.
To determine amount of optimum capital structure, a financial manager should take certain
considerations, such as the advantages of corporate tax, ignorance of high risk capital structure,
benefits of the financial advantage as well as the advantages of debt-equity Mix. It can see that
the finance manager can consider the benefit of debt-equity mix in a composition of capital
7 John Frieda The relation between capital structure theory and evaluation. (Routledge 2017)
8 Ghosh A Capital structure and firm performance. (7th edn Routledge 2017)
9 Knowles T New meaningful effects in modern capital structure theory. (Routledge 2016
10 Orien Chao The de-equitisation concept. (Springer 2019)

ESSAY 7
structure for ascertaining the optimum capital structure of the organisation. At the time when the
optimum capital structure is received, the finance manager is free from economic risks11. In this
way, the final objective of the finance manager is to consider that an appropriate use of debt-
equity mix has been received. Further, in a case when the return on investment is reasonably
greater than fixed cost of fund, a finance manager can go for increasing finance although there is
the fixed cost of funds, as the equity shareholders would be benefited in a final way. In this way,
finance manager can get the opportunities of using financial leverage throughout corporate tax. It
is a point to consider that the debt funding is less expensive than equity financing due to
allowance agreed by the corporate tax authority. Since the equity financing includes high cost,
the similar may be ignored for increasing funds. The equity shareholder, such as trading on the
equities, would enjoy the final advantages12.
As per the above analysis, it can be concluded that there is significant role of capital structure
and its theories. The optimal capital structure (often also considered or optimal financing mix) is
the fundamental that is needed for the sound business13. It is concluded that there is significant
relation between capital structure theories and real-world observations or empirical evidence.
The optimum capital structure means the manner how the organisation finances the asset, how
much this cost them as well as what they risk with this such as payables financing (supplier),
debts funding (bank) as well as equity funding (shareholder). It is found that the corporate
finance theory states the financing throughout the weighted cost of capital (WACC), signalling a
least stage of return on asset involved for which the financial values of the organisation is not
being demolished. For the optimal capital mix, the WACC is the lower. Additionally, the value
for shareholders is increased. It can say that the de-equitisation states the shrinking of the
11 Tennie Knowles New meaningful effects in modern capital structure theory. (Routledge 2016)
12 Ariena Yapa Accounting and finance research. (Cambridge University press 2014)
13 Andrew Ghosh Capital structure and firm performance. (7th edn Routledge 2017)

ESSAY 8
equity’s amount in issues throughout share buyback shares and merger & acquisition has
arguably been useful to valuation for the numbers of year. The de-equitisation trend has been the
significant element in the post financial disaster bull run. However, it is not actually a good thing
over the long run, the opportunity of investment in public marketplaces disappear.

ESSAY 9
Bibliography
Barr O Oxford Handbook of capital budgeting. (Oxford University Press 2019)
Brusov K Capital Structure: Modigliani–Miller Theory. (Routledge 2018)
Chao O The de-equitisation concept. (Springer 2019)
Engin O Pecking order theory in determining the capital structure: a panel data analysis of
companies in turkey. ( 8th edn Oxford university press 2018 )
Frieda J The relation between capital structure theory and evaluation. (Routledge 2017)
Ghosh A Capital structure and firm performance. (7th edn Routledge 2017)
John R Capital structure theory: An overview. (5th edn Oxford University Press 2018)
Knowles T New meaningful effects in modern capital structure theory. (Routledge 2016)
Martin E Concise Medical Dictionary. (Oxford University Press 2018)
Owen G The M&M approach. (Springer 2019)
Pathmanandam H The weighted average cost of capital. (Oxford University Press 2019)
Yapa A Accounting and finance research. (Cambridge University press 2014)

ESSAY 10