Capital Structure .

• Capital Structure

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Capital structure

1 In reality, capital structure may be highly complex and include dozens of sources.


Capital structure

1 This analysis can then be extended to look at whether there is in fact an

optimal capital structure: the one which maximizes the value of the

firm.


Capital structure - Capital structure in a perfect market

1 Their first 'proposition' was that the value of a company is independent of its capital

structure


Capital structure - Capital structure in a perfect market

1 Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax system, the tax deductibility of interest makes debt financing valuable;

that is, the cost of capital decreases as the proportion of debt in the capital

structure increases. The optimal structure, then would be to have virtually

no equity at all, i.e. a capital structure consisting of 99.99% debt.


Capital structure - Capital structure in the real world

1 If capital structure is irrelevant in a perfect market, then imperfections

which exist in the real world must be the cause of its relevance. The

theories below try to address some of these imperfections, by relaxing

assumptions made in the MM model.


Capital structure - Agency Costs

1 There are three types of agency costs which can help explain the relevance of capital

structure.


Capital structure - Other

1 * Market timing hypothesis—capital structure is the outcome of the

historical cumulative timing of the market by managers.


Capital structure - Other

1 * Capital structure substitution theory—managements of public companies manipulate capital

structure such that earnings per share are maximized.


Trade-off theory of capital structure

1 This theory is often set up as a competitor theory to the pecking order theory of capital

structure


Trade-off theory of capital structure - Evidence

1 MyersMyers, S.C., 1984, The Capital Structure Puzzle, The Journal of Finance, Vol



1 Welch has argued that firms do not undo the impact of stock price

shocks as they should under the basic trade-off theory and so the

mechanical change in Asset pricing|asset prices that makes up for most

of the variation in capital structure.http://www.nber.org/papers/

w8782.pdf



1 Despite such criticisms, the trade-off theory remains the dominant theory

of corporate capital structure as taught in the main corporate finance

textbooks. Dynamic version of the model generally seem to offer

enough flexibility in matching the data so, contrary to Miller's verbal

argument, dynamic trade-off models are very hard to reject empirically.



1 Thus, it seems that the optimal capital structure is absent in famous trade off theory


Capital structure substitution theory

1 The theory is used to explain trends in capital structure, valuation

(finance)|stock market valuation, dividend decision|dividend policy, the

monetary policy|monetary transmission mechanism, and

volatility (finance)|stock volatility, and provides an alternative to the Modigliani–Miller theorem that has limited descriptive validity in real

marketshttps://store.theartofservice.com/the-capital-structure-toolkit.html

Capital structure substitution theory - Assumptions

1 * Managements of public companies manipulate capital structure such

that earnings-per-share are maximized.


Capital structure substitution theory - Assumptions

1 * Managements can freely change the capital structure of the company – substituting bonds for stock or vice versa – on a day-to-day basis and in

small denominations.


Fonterra - Changes to capital structure

1 In November 2007, the board of directors announced[http://www.fonterra.com/wps/wcm/connect/fonterracom/fonterra.com/

our+business/news/media+releases/fonterra_announces_start_of_capital_struct

ure_consultation_programme Fonterra announces start of Capital Structure

consultation programme], Media release, Fonterra website, November 2007



1 The board responded in 2008 by shelving the November 2007 proposal and

continuing consultation and discussion with farmer shareholders. In September 2009, the board announced a three-step

process to revamp Fonterra’s capital structure. The new approach abandoned

thoughts of a public listing of Fonterra shares and retained 100% farmer control

and ownership of the co-operative.



1 A key goal of the capital structure changes was to stop large amounts

of money washing in and out of Fonterra’s balance sheet each year

as milk production fluctuates



1 The capital structure changes also sought to provide greater incentives

for farmers to increase their investment in Fonterra shares,

helping ensure Fonterra has sufficient share capital to fund

profitable business opportunities and drive a higher payout to dairy

farmers.



1 The first two steps of capital structure change received good

support from farmer shareholders at Fonterra’s annual meeting in

November 2009



1 The third step, titled Trading Among Farmers, involves more far-reaching

change to Fonterra's capital structure


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