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Theories of Capital Structure

The main purpose of this essay is to identify, analyse and evaluate the arguments made in favor and against the feasibility of Optimal Capital Structure and the relevance of dividend policy adopted by the entities. This paper links the implications of the capital structure and the dividend policy with the valuation of the business. There are several theories in the field of capital structure and the dividend policy. However, there exists different views on each of the theories which makes it difficult for the businesses to decide as to which theory is appropriate. The capital structure of the company generally refers to the combination of debt and equity that are used to finance the purchase of assets and carry out the daily operations of the business. from the corporate point of view, the equity capital is more expensive and the source of capital having greater flexibility. In the financial management, the capital structure theory refers to the use of combination of equities and liabilities for financing the activities of the business (Alipour, Mohammadi and Derakhshan 2015).

The dividend policy of the organization refers to the dividend payout structure to the shareholders adopted by the company. Some of the scholars suggested that the dividend policy theory is not relevant in the real world as the investors can sell a portion of their shareholdings if they are in need of funds. There are different types of dividend policy that are used for distributing dividends to the shareholders. There is an implication that the dividend policy can be used to determine the value of the business. The business valuation refers to the process of determining the economic value of the firm (Mercer and Harms 2020). There are several methods for calculating the value of the firm. The main purpose of the valuation of business may be to sell, establish partner ownership or for taxation purposes.

There are several theories in relation with the capital structure such as Modigliani and Miller approach, traditional approach, net operating income approach and operating income approach. The capital structure theory suggests the concept of optimal capital structure. It generally refers to the mix of borrowings and equity that minimizes WACC and thereby increases shareholders wealth (Mu, Wang and Yang 2017). By doing so, the organization can minimize for the lowest cost of financing the activities of the business. The optimal capital structure is the blend of equity and debt that maximizes the firm’s value and minimizes the cost of capital.

Capital Structure and Business Valuation

Hirdinis, (2019) revealed that the profitability is unable to conciliate the effect of capital structure on the valuation of business. The study also states that the capital structure has a significant favorable impact on the firm’s size but also have a significant unfavorable impact on the firms value. The article published by Modigliani and Miller in the 1950s states that the capital structure of the company is not a factor for assessing the value of the firm. The theorem states that the market value of the firm is determined through the present value of the future cash flows. However, this theorem often assumes that no time gaps and no floatation costs are required in raising the new equity capital. In the real world, any organization cannot float without incurring the floatation costs and fulfilling the legal formalities. This theory indicates that the firm’s capital structure has no effect on the overall value of the firm. Hirdinis (2019) has identified that when the capital structure of the company is above the optimal capital structure target, the additional leverage or debt will increase the cost of capital and reduce the value of the firm.

The traditional theory of capital structure states that the optimal structure can be achieved when the market value of assets is maximized and the WACC is minimized. The company’s wealth can be assessed by calculating the present value of the future cash flows. The trade-off theory of leverage states that the optimal capital structure is identified by balancing the advantages of debt financing with the bankruptcy and the higher interest rates. The debt-to-equity ratio indicates the amount of funds borrowed by the company in comparison with the ownership’s equity.

The research conducted by Hossain and Hossain, 2015, identifies the factors affecting the capital structure of the listed manufacturing companies. The paper states that the trade-off theory and the trade-off theory are the two most dominants theory in the field of capital structure. The author concluded that the financial managers should consider major determinants while taking any leverage decisions so that it could maximize the shareholder’s value. The author suggests that the optimal capital structure helps in accelerating the financial performance of the company and ensure the sustainability position, which eventually leads to the achievement of organization goals. There are several theories for determining the optimal capital structure of the firm such as Signaling Theory, Agency theory, Static Trade-off theory and Free Cash Flow theory (Chadha and Sharma 2015). However, none of these theories are recognized as universal theory of capital structure, which makes the topic open to research.

Dividend Policy and Business Valuation

The agency theories suggest that the optimal capital structure can be achieved through minimization of agency cost by increasing the ownership of the firm’s manager. The theory argues that the conflicts of interests can be reconciled if more ownership is given to the managers or capital suppliers (Tripathi 2019). The key factors that influence the capital structure decisions include firm size, profitability, leverage, asset tangibility, growth opportunities, expected inflation, asset tangibility, and the stock market return.

The Free cash flow theory of capital structure states that the firms value can be increased by increasing the value of debt fund largely, despite the threat of financial distress (Bluus 2015). The change in capital structure affects the risk and the future cash flows of the firm. Previous researches shows that the capital structure has a positive impact on the corporate value. In addition, the revenue growth rate, variable firm size, capitalization of equity also has a positive impact on the firm’s value. The capital structure of the firm has an implication on the value of the firm as it is basically the sum of the claims from its shareholders and the creditors. The firm’s value can be calculated by adding the market value of debt, equity and the minority interest of the firm.

Another factors affecting the decision making of the investors is the firm’s dividend policy. The arguments made in favor of dividend policy for valuation of a firm states that it is suitable for the investors who are looking forward to earn dividend through investment. In addition, the dividend valuation is not based on the reported financial figures of the company (Husain and Sunardi 2020).

There are several arguments that are made against the valuation of a firm using the dividend method. Firstly, the dividend valuation ignores the actual earnings of the firm and relies only on the amount of dividend declared by the firm. Secondly, it may be possible that the shareholders of the firm will be interested in capital appreciation. Thirdly, the dividend policies vary from industry to industry and listed to unlisted entities. Lastly, the valuation of business using the dividend policy attracts taxation issues for the firm. The share value of the firm using the expected future dividend is calculated by dividing the next year’s dividend by the difference between the required return and the growth return. The valuation of business using the expectation of future dividend method is shown in the example below:

Arguments For and Against Dividend Policy

ABC limited

Next Year Dividend (D1) = £0.25

Required Return (r) = 0.14

Growth Rate (g) = 0.12

Calculation: £0.25 / (0.14 - 0.12)

Value of the share = £12.50

There are several arguments made in favor as well as against the dividend policy for determining the valuation of the firm. Dividend usually refers to the cash payment in the form of distribution of profits to the shareholders. The company’s dividend policy is often used by the investors to make various investment and the financing decision in relation with the company. Baker and Weigand (2015) provides an overview of the dividend policy, facts and the practical implications. The paper argues that the optimal dividend policy depends on the firms stage in the life cycle. It also states that the dividend policy is important for the security analyst and the investors of the firm.

The Gordon theory states that the dividend policy has an impact on the value of the firm. The main argument in favor of the above statement is that the shareholders prefer dividend rather than capital gain. The main reason for such preference is that the uncertainty of capital gain with respect to dividend. Therefore, the dividend policy affects the value of the firm. the above theory assumes that the investors are risk averse and make their decision on the basis of expected dividend that will be paid by the company. The authors and researchers who are against the dividend valuation argues that in perfect capital market, the company’s policy with respect to dividend does not have a substantial effect on the firms’ value. The assumptions made in this theory states that there is no tax effect on capital gain and dividend, no transaction cost and all the investors are behaving rationally.

Some of the arguments in favor of dividend valuation are discussed. Abdulkadir, Abdullah and Wong, 2016, mentions that the cash dividend payment made by the company provide favorable information to the investors. The research reveals that higher cash dividend implies that the company’s financial condition is sound. Another argument is that the dividend rate policy also helps in reducing the conflicts of interest among the shareholders and the management. With the increased ownership of the management in the company, the managers would focus on improving the personal wealth through the wealth of the company, which will eventually help the shareholders (Budagaga 2017).

In addition to the above benefits of higher dividends on the shareholders wealth, the higher cash dividend reduces the uncertainty of income to the shareholders. Hooi, Albaity and Ibrahimy, (2015), identifies that the share price of the company is affected by the amount of dividend declared by the firm. The dividend declared by the company have a substantial impact on the price of the company’s share.

The research conducted by Mui and Mustapha (2016) revealed that the dividend policy of the firm has a direct impact on the liquidity position as the dividend is usually paid in cash. It is argued that the higher dividend would might lead to liquidity problems for the firm. The amount that are used to pay the cash dividend could have been used to invest in profitable projects which may fuel the share prices in future. Therefore, the current distribution of dividend in cash may have a negative affect on the value of the firm in future.

Ozuomba Anichebe and Okoye (2016) has conducted research on the effect of dividend policies on the maximization of wealth. The research indicated that the dividend policies are irrelevant in determining the wealth of the company. In a similar manner, Chenchehene and Mensah, 2015, shows that the factors such as current dividend payout, firm size and current investment does not have significant effect on the wealth of the shareholders. In addition, the authors identifie that variables such as profitability, earnings, investments, leverage, and share price have an impact on the shareholders wealth.

The business valuation using dividend ignores the profitability aspects of the business. The business valuation refers to the process of setting procedures and techniques to estimate the economic value of the company. There are various methods used for estimating the value of business which include future maintainable earnings valuation, historical earnings valuation, discounted cash flow valuation, and asset valuation.

The dividend valuation model is also known as dividend discount model. This method of valuation makes use of future dividends for forecasting the current value of shares. It is based on the concept that the investors invest in a particular company to earn dividend. The arguments in favor of using the dividend valuation model include: a) This method of valuation is considered to be very conservative as it does not require growth assumptions for creating value of the firm; b) it also provides the option of increasing portfolio to the investors; c) it is very easy to understand as it is based on simple formula; d) the subjectivity involved in this model is less in comparison with other model. The arguments against the use of dividend valuation model include: a) it is overly simplistic which is not applicable in the real world. This method of valuation assumes that the future dividends of the company will increase at a constant rate, which is not the situation in many cases. Some of the companies tend to increase their dividend while other may reduce their dividends; b) this business valuation model only supports those stocks which declares the dividend on a regular basis. Usually, the smaller companies do not declare dividend on a regular basis, in such cases, it won’t be possible to determine the value of the firm using this model; c) this method of valuation ignores the non-dividend factors such as the ownership of intangible assets which may add wealth to the shareholder’s capital, customer retention and brand loyalty; d) this method of valuation is highly sensitive to the quality of information used for determining the value of the firm. The actual value of the firm may be different than the determined value if the information used is inaccurate; e) for determining the value of the firm using this model, the investors use personal observations and experience which is prone to bias; f) it is often assumed that higher dividend means that the company is in a very strong position. However, in some cases, the company use to borrow fund in the form of debt to maintain the dividend payout pattern of the company. In such cases, the firm value under this model will not give the correct information about the firm’s position in the market.

Dang et al. (2021), examines the impact of dividend policy on the corporate value. The research analyses the listed companies in Vietnamese stock market for the period of ten years from 2007 to 2021. The study reveals that the company which adopts higher dividend payout policy has experienced a significant impact on the corporate value whereas the entities that do not pay dividends is not affected by the dividend policy.

Another method that is widely used for determining the value of the firm is discounted cash flow model. This method of valuation is based on the expected future cash flows of the firm. In this method, the weighted average cost of capital is used as a hurdle rate. It implies that the company’s earnings should be more than the cost of capital of the firm. The capital structure of the firm has a greater impact on the company’s value under this method. It is because the weighted cost of capital is calculated using the market value of debt and equity. The WACC calculated is used to discount the expected future cash flows of the company to arrive at the firm’s value. This model of valuation is often used to assess the stocks for long-term investment opportunities.

Conclusion

From the above discussion, it becomes clear that the capital structure is the combination of debt and equity finance used by the company to finance its activities. The optimal capital structure is said to be the one that reduces the cost of capital and maximizes the shareholder’s wealth. The business valuation using the discounted cash flow method utilizes the weighted average cost of capital as a hurdle rate for determining the present value of the firm. An increase in the leverage would reduce the weighted average cost of capital as the debt financing is considered to be cheaper than the equity financing. The factors that have an influence on the capital structure include asset tangibility, growth opportunities, leverage, profitability, expected inflation, firm size and the stock market return.

The business valuation is usually done using the capital structure or the dividend policy. Several authors argue that the dividend policy does not have an impact on the value of the firm as it ignores the profitability and other factors while determining the value of the firm.

References

Abdulkadir, R.I., Abdullah, N.A.H. and Wong, W.C., 2016. Dividend payment behaviour and its determinants: The Nigerian evidence. African Development Review, 28(1), pp.53-63.

Alipour, M., Mohammadi, M.F.S. and Derakhshan, H., 2015. Determinants of capital structure: an empirical study of firms in Iran. International Journal of Law and Management.

Baker, H.K. and Weigand, R., 2015. Corporate dividend policy revisited. Managerial Finance.

Budagaga, A., 2017. Dividend payment and its impact on the value of firms listed on Istanbul stock exchange: A residual income approach. International Journal of Economics and Financial Issues, 7(2), pp.370-376.

Buus, T., 2015. A general free cash flow theory of capital structure. Journal of Business Economics and Management, 16(3), pp.675-695.

Chadha, S. and Sharma, A.K., 2015. Determinants of capital structure: an empirical evaluation from India. Journal of Advances in Management Research.

Chenchehene, J. and Mensah, K., 2015. Dividend policy and its effects on shareholders wealth: Evidence from UK retail industry. International Journal of Liberal Arts and Social Science, 3(2), pp.52-64.

Dang, H.N., Vu, V.T.T., Ngo, X.T. and Hoang, H.T.V., 2021. Impact of dividend policy on corporate value: Experiment in Vietnam. International Journal of Finance & Economics, 26(4), pp.5815-5825.

Hirdinis, M., 2019. Capital structure and firm size on firm value moderated by profitability.

Hossain, I. and Hossain, M.A., 2015. Determinants of capital structure and testing of theories: A study on the listed manufacturing companies in Bangladesh. International Journal of Economics and Finance, 7(4), pp.176-190.

Husain, T. and Sunardi, N., 2020. Firm's Value Prediction Based on Profitability Ratios and Dividend Policy. Finance & Economics Review, 2(2), pp.13-26.

Mercer, Z.C. and Harms, T.W., 2020. Business valuation: an integrated theory. John Wiley & Sons.

Mu, C., Wang, A. and Yang, J., 2017. Optimal capital structure with moral hazard. International review of economics & finance, 48, pp.326-338.

Mui, Y.T. and Mustapha, M., 2016. Determinants of dividend payout ratio: evidence from Malaysian public listed firms. Journal of Applied Environmental and Biological Sciences, 6(1), pp.48-54.

Ozuomba, C.N., Anichebe, A.S. and Okoye, P.V.C., 2016. The effect of dividend policies on wealth maximization–a study of some selected plcs. Cogent Business & Management, 3(1), p.1226457.

Tripathi, V., 2019. Agency theory, ownership structure and capital structure: an empirical investigation in the Indian automobile industry. Asia-Pacific Management Accounting Journal, 14(2), pp.1-22.

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