Financial management Assignment May 2015 (APC 308)

Academic research has provided mixed and conflicting evidence as to whether an optimal capital structure exists for individual companies and businesses. Demonstrating knowledge and understanding of the differing theoretical viewpoints associated with the concept of capital structure, and drawing upon relevant empirical research within this field, critically analyze and evaluate whether an optimal capital structure does exist.The concept of market efficiency can be defined using three differing strengths; weak form, semi strong form, and strong form. Critically evaluate and analyze the three differing strengths of market efficiency, ensuring the response draws upon relevant empirical research within this field of study.

ASSIGNMENT COVER SHEET UNIVERSITY OF SUNDERLAND

BA (HONS) BANKING AND FINANCE

Student ID: 149080615/1

Student Name: Tran Quyet Thang

Module Code: APC 308

Module Name / Title: Financial Management

Centre / College: Banking Academy of Viet Nam

Centre / College: Banking Academy of Viet Nam

Assignment Title: Individual assignment

Students Signature: (you must sign this declaring that it is all your own work and all sources

of information have been referenced)

Title page

Financial Management

APC 308

Banking Academy, Vietnam Submitted on 15 May, 2015 Prepared by: Quyet Thang Tran Student ID: 149080615/1

Table of Contents

Title page i

Part A: Academic research has provided mixed and conflicting evidence as to whether an optimal capital structure exists for individual companies and businesses Demonstrating knowledge and understanding of the differing theoretical viewpoints associated with the concept of capital structure, and drawing upon relevant empirical research within this field, critically analyze and evaluate whether an optimal capital structure does exist 1

1 Traditional view 1

2 Miller and Modigliani’s theory (MM) 2

MM (I): The net income approach 2

3 Pecking-order theory 4

Part B: The concept of market efficiency can be defined using three differing strengths; weak form, semi strong form, and strong form Critically evaluate and analyze the three differing strengths of market efficiency, ensuring the response draws upon relevant empirical research within this field of study 5

1 Weak-form 6

2 Semi-strong form 7

3 Strong form 8

References 10

Appendixes 14

Part A: Academic research has provided mixed and conflicting evidence as to whether an optimal capital structure exists for individual companies and businesses Demonstrating knowledge and understanding of the differing theoretical viewpoints associated with the concept

of capital structure, and drawing upon relevant empirical research within this field, critically analyze and evaluate whether an optimal capital structure does exist

Capital has an important role for the businesses in investing and operating Capital refers to the firm’s sources of long-term financing (Brealey, et al., 2011) An appropriate capital structure is an important decision for any business by the need to maximize the benefits obtained from individuals and organizations related to the operations of the business Moreover, this decision also impacts

to the capability of enterprises in the competitive environment The capital structure refers to the way businesses looking for financing decisions through a combination of debt and equity By deciding the distribution of different sources of funds, the businesses try to minimize their cost of capital and maximize the shares’ price to benefit the shareholders’ wealth as much as possible This is refer to as optimal capital structure There are different theoretical viewpoints about the existence of optimal structure

1 Traditional view

The traditional view theory will be shown in the figure below:

(Watson & Head, 2013)

KE: cost of equity

KD: cost of debt

Figure 1: Traditional view of capital structure

It can be seen in Figure 1 that when the level of gearing increases, it also leads the cost of equity

KE to increase while the cost of debt is stable and WACC goes down It means that by increasing the ratio of debt, businesses can enjoy cheaper cost of capital In this figure 1, WACC curve has

U shape It means that the lowest point (X) indicates the optimal capital structure However, when level of debt increases, the shareholders have to face to higher risk of financial, it causes cost of equity increases At the point that level of gearing become very high, KE curve rises steeply due

to threat of bankruptcy This theory is based on some assumptions such as no taxes, no transaction cost, earnings are paid as dividend (Appendix 1)

Based on the traditional view, there is an optimal capital structure With high level of debt, companies may fail to complete the obligations to pay back and then go to bankruptcy A research finds that a high-levered firm can engage actions that are harmful to their shareholders and find difficult to get more external finance and may find it more costly to efficiently carry out its day-by-day business (Rocca, et al., 2008) Moreover, a research paper about impact of capital structure

on Bangladesh firm’s value shows that maximizing the wealth of shareholders requires a perfect combination of debt and equity, and cost of capital has to be as minimum as possible (Chowdhury

& Chowdhury, 2010) However, the contention of the traditional theory, that moderate amount of debt in ‘sound’ firms does not really add very much to the ‘riskiness’ of the shares, is not defensible (Pandey, 2009) Furthermore, Marimuthu (2009) concludes that the traditional view has been greatly devastated by the ‘modern practitioners’ In addition, in the traditional view, risk pricing

is inefficient; investors do not always have information and/or time needed to closely monitor changes in the level of debt relative to equity (Grant, 2003)

2 Miller and Modigliani’s theory (MM)

MM (I): The net income approach

By assuming a perfect capital market without taxes, no transaction costs and individual investors can borrow money at the same rate as companies, Miller and Modigliani argued that the market value of a company depends on its expected performance and commercial risk: the market value

of a company and its cost of capital are independent of its capital structure (Watson & Head, 2013)

To support the argument, Miller and Modigliani used arbitrage theory As investors exploit these arbitrage opportunities, the value of the overpriced shares will fall and that of the underpriced share will rise, thereby tending to eliminate the discrepancy between the market values of the firms

(Modigliani & Miller, 1958) Moreover, because the market value of companies and its cost of capital are independent of its capital structure, there is an equation:

rwacc = We*Ke + Wd*Kd

 rwacc = D/(D+E) * Kd + E/(D+E) * Ke

 Ke = rwacc + D/E (rwacc –Kd) Because rwacc and Kd are unchanged, Ke will increase if D/E increase It means that when companies increase their debt, shareholders will face higher of risk Therefore, they will require higher ROE or the cost of equity will go up The figure below will illustrate this issue

Through the figure 2, it can be seen that WACC curve is a straight line It means that based on the

MM (I): the net income approach, there is no optimal capital structure

MM (II): Corporate tax

(Watson & Head, 2013)

Figure 2: Miller and Modigliani (I): the net income approach

Figure 3: Miller and Modigliani (II): corporate tax

In the second paper, these two researchers mentioned about the advantages of taxes By taking taxes, companies can take debt with cheaper cost because the interest is tax deductible This is called tax shield It means that higher level of debt is, lower WACC is In the figure 3, WACC curve is going down with high level of debt It means that companies should take 100% of debt in order to minimize WACC as much as possible This means that according to this theory, the optimal capital structure does exist

There are some evidences from researches supporting for this theory By analyzing the relationship existing between leverage and corporate performance in Nigerian Petroleum Industry, David and Olorunfemi (2010) find that an increase in leverage ratio leads to increase in earnings per share and recommend that managers should do much to improve on the leverage ratio This finding follows the conclusion of MM (II) On the other hand, the MM (II): corporate tax suggests that companies should take 100% of debt to benefit from tax shield, it seems to be unrealistic and not logical Miller and Modigliani (1963) also reminded readers that the existence of a tax advantage for debt financing – event the larger advantage of the corrected version – does not necessarily mean that corporations should all the times seeking to use maximum possible amount of debt in their capital structures Furthermore, there are some researches showing the limitations of these propositions These limitations includes: 1) it was based on partial equilibrium rather than general equilibrium analysis, 2) it was not clear whether the theorem held only for competitive markets, 3) except under special circumstances, it was not clear how possibility of firm bankruptcy affected

by the validity of the theorem (Stiglitz, 1969) Moreover, by applying Parameter- Preference Theory, Becker shows that the valuation of firm and the cost of capital do not require the usual risk-class or arbitrage assumptions (Becker, 1978) In addition, some tests indicate that neither the

MM tax nor the no-tax valuation equations are accurate predictors of firm value; specifically, the value of the unlevered firm accounts for much less of firm value than predicted and the sign of the coefficient of the interest tax shield variable is negative, instead of positive as MM predict (Fosberg, 2010)

3 Pecking-order theory

In pecking-order theory, management is assumed to know more about the firm's value than potential investors (Myers & Majluf, 1984) Because of the asymmetric information, the investors afraid that the value of shares is higher than their market value Therefore, to solve this problem,

the firm prefers debt rather than equity In conclusion, based on this theory, there is no ratio target between debt and equity to minimize the cost of capital It means that the pecking order theory go against the optimal capital structure There are some empirical evidences that support the pecking order theory By using a sample of 629 UK SMEs over five-year period, two researchers find evidence consistent with a pecking order (Watson & Wilson, 2002) However, there are a lot of researchers found that firms do not follow this theory For example, in Chinese, there is no evidence that capital structure of 407 listed companies follow a pecking order from retained earnings and debt to equity (Jinlan & Miaomiao, 2008) Furthermore, another research also shows that the UK, German and French firms do not closely follow the pecking order theory’s prediction (Dang, 2013) The reasons for these differences may be by the changes in capital market or business environment because the pecking-order theory was first suggested by Donaldson in 1961 and modified by by Stewart C Myers and Nicolas Majluf in 1984

In conclusion, there are two theories which support the existence of an optimal capital structure including traditional view and MM (II) corporate tax However these both theories are based on several assumptions such as no taxes, no transaction costs and a perfect market Therefore, in practice, there is no an optimal capital structure for companies to combine debt and equity The financial decisions about capital structure of companies should depend on macroeconomic, microeconomic, industry in order to achieve objective – maximizing shareholders’ wealth Part B: The concept of market efficiency can be defined using three differing strengths; weak form, semi strong form, and strong form Critically evaluate and analyze the three differing strengths of market efficiency, ensuring the response draws upon relevant empirical research within this field of study

The efficiency market hypothesis (EMH) state that financial markets make a best use of all available information in determining a share’s price (Howells & Bain, 2007) Therefore, investors cannot beat the markets by using current information or the fluctuation of past share prices According to Fama (1970), EMH is divided into three levels:

 Weak form: the information set is just historical prices

 Semi-strong form: the concern is whether prices efficiently adjust to other information that

is obviously publicly available (e.g., announcement of annual earnings)

 Strong form: the concern is whether given investors or groups have monopolistic access to any information relevant for price formation

1 Weak-form

There are a lot of researches in different stock markets are carried out On the one hand, by applying the two-regime TAR approach on monthly data over the period 1990:1 to 2009:1, a research paper shows that Malaysia and Thailand stock market are characterized by a random walk process, consistent with EMH (MUNIR, et al., 2012) The studies of Milionis and Moschos (2000) point out that the FTSE 30 share index follows the weak form market efficiency The major findings using daily data and a bias-free statistical technique with a sample spanning from September 1995 to March 2010 support the belief that these equity markets of Brazil, Russia, India and China (BRIC) may have been approaching a state of being fairly weak-form efficiency (Mobarek & Fiorante, 2014) For the Israeli, Jordanian and Lebanese markets, composite stock price indices follow a random walk and so these markets are weak-from efficient (Smith, 2007) Furthermore, the study of Yuan and Gupta (2014) documents that timing the Chinese Lunar New Year effect in markets of Hong Kong and Japan does provide incremental wealth for investors, even after considering transaction costs

On the other hand, there are some empirical evidences show that the returns on stock market do not follow the EMH theory Robinson’s (2005) results suggest that like a number of other emerging markets, the hypothesis of randomness in stock returns on the Jamaica Stock Exchange (JSE) is rejected for at least sixty five (65) percent of the stocks listed on the JSE Mishra (2013) examined the random walk behavior and efficiency of the Indian equity market and found that the Indian equity market does not follow random walk behavior Another study using daily observation over the span from 3rd July 2007 to 31st December 2011 in India Stock Market also rejects weak form efficiency of India stock market (JAYAKUMAR, et al., 2012) Kapusuzoglu’s (2013) findings show that Istanbul Stock Exchange National 100 market is not an efficient market in weak form

by testing daily closing values of the related index during the period from 1996 to 2012

In addition, by applying two of the simplest and most popular trading rules—moving averages and trading-range breaks - by utilizing a very long data series, the Dow Jones Industrial Average index from 1897 to 1986, Brock, Lakonishok, and LeBaron (1992) suggest that technical analysis is useful for predictability of equity returns from past returns Metghalchi et al’s (2012) results point

out that technical trading rules do have predictive power by examining the profitability for 16 European stock markets over the 1990 to 2006 period Moreover, technical trading rules are all successful in forecasting stock price movements in Malaysia, Thailand, Indonesia, and the Philippines, with the TRB having additional predictive ability in Singapore (Yu, et al., 2013)

In summary, there are many empirical studies that support weak-form market efficiency while others also provide evidences for not supporting stock markets in weak-form efficiency The reasons for these differences may be the methods or models that researches use to test the efficiency of stock markets

2 Semi-strong form

To investigate semi-strong form market efficiency, there are a lot of researches using the data from different stock exchanges in the world On the one hand, by using data, for 47 firms over 1993 to

2006 from the Athens stock exchange (ASE), the study shows that the ASE does not fully incorporate publicly available accounting information into stock prices and hence violates the semi-strong EMH (Alexakis, et al., 2010) In India stock exchange, two researchers concludes that

it is not efficient in the semi-strong form (Mallikarjunappa & Dsouza, 2013) A similar result is found in Malaysia stock exchange The empirical results indicate that this stock market has not reached its full efficiency level in semi-strong form, as the time required for the market to absorb the information conveyed by the dividend and earnings announcements is extensively long (Hussin, et al., 2010) Torun and Kurt’s (2007) results suggest that there are some countries in European monetary union are not in efficient in semi-strong form In addition, the Nairobi stock exchange is also not semi-strong form efficient as some investors can earn abnormal returns by having unequal access to public information (Olweny, 2012)

On the other hand, there are some researches supporting the semi-strong form market efficiency Mandal and Rao’s (2010) results indicate that India stock market is efficient enough in its semi-strong form to assimilate the new information revealed by dividend initiation and omission announcements and leave no scope for its investors to earn any abnormal return consistently Furthermore, another empirical study of India stock market with regards to buy-back of share shows very negligible reaction on or before the announcement date and these results are supporting

to the implications of efficient stock market in its semi-strong form (Dua & Mittal, 2010) Moreover, Chena and Fraser’s (2010) results suggest that the publicly available expected earnings