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(^292) Financial Management
Compute the equilibrium value for Firms A and B in accordance with the M-M thesis.
Asume that (i) taxes do not exist and (ii) the equilibrium value of k 0 is 9.09 per cent.
Solution
The equilibrium values are shown below:
for Firms A and B in accordance with the M-M thesis. Assume that (i) taxes do not
exist and (ii) the equilibrium value of k 0 is 0.09 per cent.
A A
Rs Rs
Expected net operating income,
X
5,000 5,000
Total cost of debt, INT = kdD 0 1,800
Net income,
X
-kdD 5,000 3,200
Average cost of capital, k 0 0.909 0.909
Total value of firm, V =
X
/k 0 55,000 55,000
Market value of debt, D 0 30,000
Market value of shares, S = V- D 55,000 25,000
Cost of equity, ke = (
X
X-kd D)/S 0.909 0.128
Asymmetric Information Theory
Also called the pecking order theory, this theory is based on the assumption that managers
have better information than investors, postulates that there is a preferred "pecking
order" of financing: first use retained earnings (and depreciation), then debt, and, finally,
as a last resort only, issue new common stock. This theory leads to the conclusion that
firms should maintain a borrowing capacity reserve so that they can always issue debt
on reasonable terms rather than have to issue new stock at the wrong time.
Another important point that needs to be remembered is that the optimal capital structure
is structured by the managers in terms of book value rather than market value terms.
As book values reflect the historical costs of the assets, these have little to do with the
ability to produce cash flows and debt servicing capability. As the main focus of analysing
capital structure is to find a structure which maximises the firm's market value, and
hence its stock prices, so it can only be analysed by an analysis of the market values.
But the problem with using the market values is that they are unpredictable, so managers
tend to use book values which are far easier to predict.
Another point that is not considered is of the growth of the firm. Growth rates have
implications on the marketing approach, investments, organisation size, structure and
capital requirements. When the projected growth is rapid, the capital structure has to
be flexible enough to vary within a certain range of debt and equity ratio to accommodate
funds requirements for the future growth of the firm. A contracting market for the
company's products may indicate a need to move away from debt. This is because in
case of reduced sales and hence lower profits, the risk of the firm defaulting on debt