Capital Structure final updated file.pdf

  • Published on

  • View

  • Download

Embed Size (px)


  • 8/14/2019 Capital Structure final updated file.pdf


    Application of Capital Structure Theory Presented by Modigliani & Miller

    in the Real W orld: Comparison of Efficient & Inefficient Market.


    Financing through debt or equity remain a challenge for firms operat ing

    in efficient and inefficient markets. Different theorist presented their opinions

    and research to solve this dilemma. MM theory claims to sort this problem out

    under certain assumptions. Literature presents support as well as crit icism of

    the MM theory. To determine the financial health of proposed theory researcherwill conduct a series of empirical analyses in efficient (London Stock Exchange)

    and inefficient (Karachi Stock Exchange). The data collected will be than

    compared to Dubai Stock Exchange that holds all the three assumptions

    suggested MM theory. This will involve qualita tive and quantitative research

    techniques. The study is designed over a period of 3 years


    Key Words: Trade-off theory, MM theory, financial leverage, Operational

    leverage, efficient markets, inefficient markets, Capital Structure, Firm


  • 8/14/2019 Capital Structure final updated file.pdf


  • 8/14/2019 Capital Structure final updated file.pdf


    risk plus financial risk (Janauri, 2005). The underlying study will consider

    capital structure and its determinants with total leverage.

    Neither equi ty nor debts are the best way of determining the capital st ructure of

    a firm. This ironic statement twisted the minds of researchers and financials for

    years and years. As Myers (1984 ) called it capital structure puzzle. Financing

    businesses is a lways a difficult but inevitable task for corporations. Companies

    financing decisions involve a wide range of policy issues (Abor, 2008) . A

    number of internal and external factor determine the capital structure of

    company (Ilyas, n.d.) . In this regard, different types of theories were presented

    on different t imes. These theories are: static trade-off theory by Miller and

    Modigliani (1958) , Pecking order theory by Donaldsons (1961 ) and the markettiming theory (Spremann, Lang, Getzmann, 2010).

    According to the propositions of the MM theory: the value of a firm is

    independent from its corporate financing decisions under certain conditions. In

    fact MM pointed out the direction that capital structure theories must take by

    showing under what conditions capital structure is irrelevant (Harris and Raviv,

    1991). Titman (2001) lists some fundamental conditions that make the MM

    proposit ion hold:

    1. No (distortionary) taxes,

    2. No transaction costs,

    3. No bankruptcy costs,

    4. Perfect contracting assumptions, and

    5. Complete and perfect market assumption.

    Since the publication of MMs irrelevance proposition, hundreds of articles on

    the theory of capital structure have been carried out in order to find out under

    what conditions capital structure does matter. In other words, i t is of great

  • 8/14/2019 Capital Structure final updated file.pdf


    interest to investigate if capital structure choices become relevant once one or

    more of the key conditions are relaxed.

    Capital structure of firms differs from each other as they get affected by an

    array of factors. Some firm have high leverages while other has low. They get

    themselves financed through the issuance of common stock or preferred stock in

    stock market or companies acquire long term debts through institutional

    financing (Brigham, & Houston, 2010). According to Fama, (1970) the primary

    role of capital market is allocation of ownership of economys capital stock. An

    in-depth study of capital market points towards efficient market hypothesis .

    This hypothesis propose existence of three types of markets in economies that

    are strong form market, semi strong form market and weak form market; firsttwo comes under the category of efficient market, while the last is referred as

    inefficient market.

    Turning back to the goal of this study, MM theory holds only in efficient market

    while they do not work in inefficient market. This l i terary argument needs

    empirical justification for the reason this study is being designed for a

    comparison among Karachi stock exchange, London stock exchange and Dubai

    stock exchange.


    What i s the application of Capital Structure Theory presented by M odigli ani and Mil ler in the

    real world; a comparison of eff icient and in eff icient M arkets?

  • 8/14/2019 Capital Structure final updated file.pdf



    To study the capital structure differences in efficient and in efficient market To study the implementation of MM theory in efficient and inefficient market

    To compare the effects of MM theory in different economies (taxable and taxfree)

    To study the asymmetric information effect on capital structure To challenge the assumption taken by MM theory To suggest improvements in financing theories To add value to existing financial knowledge


    The study will be significant for both academicians and practit ioners.

    Academic Significance:

    The study will be significant for academicians in the following ways:

    1. Revisit of theory will test the propositions of MM theory which will provide the

    academicians with the opportunity to make comparisons between efficient and inefficient

    markets of different countries around the world.

    2. It will help the academicians in identifying the gap in literature which exists in MM

    theory in form of no differentiation between financing the business through debt or



    It will establish the comparability between different economies of the world i.e.

    developed and developing. Developing economies like Pakistan are bound with taxes and

    having different arrangements of capital structure as compare to the capital structure

    arrangements of the developed countries.

  • 8/14/2019 Capital Structure final updated file.pdf


    Practit ioner Significance:

    Revisit of theory of finance will be significant for the practit ioners in the

    following ways:

    1. It will help the practit ioners in determining the extent of leverage.

    2. It will be helpful in evaluating the optimal capital structure for the

    smooth running of business.

    3. It will help in determining the proportion of debt and equity in the capital

    structure of the business.

    4. It will help in determining the tradeoff between benefits and costs of

    having debts for a business.

    5. It will be useful for practit ioners as i t will find out that efficient and

    inefficient markets should not be evaluated on the same propositions for

    debt and equity presented in MM theory.

    6. It will help the practit ioners in deciding the best determinants for the

    capital structure.

  • 8/14/2019 Capital Structure final updated file.pdf


    Section I has covered the introduction of the study its aims, objectives and


    Section II will cover the Literature Review surrounding the MM theory.

    Section III will cover the Research Methodology, data collection methods

    and its paradigm.

    Section IV will briefly report the time line of the thesis.

  • 8/14/2019 Capital Structure final updated file.pdf


    Section II:


    In the recent years the concept of optimal capital structure was based on

    asymmetric information (Abor 2008; Myer and Mujalif 1984). This means

    firms prefer to finance internally if the cost of debt along with risk is high in

    the market (Abor, 2008). This concept was replaced by theory presented by

    Modigliani and Miller that provides an opportunity to debt financing as it

    provides tax cover shield. As tax is not implementable on debts hold by

    corporate, so share holders get high returns. But this income on dividing among

    shareholders as profit becomes taxable.

    Modigliani and Miller (1958) claim that under perfect capital market

    conditions, a firms value depends on its operating profitabili ty rather than its

    capital structure. In 1963, Modigliani and Miller (1963) fix the previous paper;

    argue that, when there are corporate taxes then interest payments are tax

    deductible, 100% debt financing is optimal. This means that the firms value

    increases as debts increases.

    The theory of optimal capital structure Modigliani and Miller value

    invariance proposition I states that under certain conditions, the value of the

    firm is independent of i ts capital structure (Firer, Ross, Westerfield and Jordan,

    2008).One of these conditions is absence of tax. However, in the real world

    taxes do exist and specifically interest payments on debt are tax deductible. The

    value of firm will increase as the debt/equity ratio increases. Another way of

    stating M&M proposition I, with taxes is that the value of levered firm is equal

    to the value of firm with no debt plus the present value of the interest tax

    shield. The interest tax shield is the benefit that results from the benefit that

    results from the fact that profits are only taxed after tax payments have been

    deducted. The tax benefits of the debt give a clear reason for the firms to

    borrow rather than issue the equity ( Opler et al. , 1997).

  • 8/14/2019 Capital Structure final updated file.pdf


    Along with high interests on debts here comes two primary issues, one is off

    bankruptcy of a fi rm (Titman, 1984) and the other is of agency cost that arises

    between mangers and shareholders of a fi rm on issuance of more and more

    equity. Debt may be a good option for financing but i t put management under

    stress as i t lowers the stock price (Il lyas, 2008). Damodran (2001) advised

    firms to select their financing plan carefully. Otherwise they can get themselves

    into the troubles.

    According to the theory, the firm borrows up to the point where tax

    benefit from extra rand of debt is exactly equal to the cost that comes from the

    increased probability of the financial distress. The II proposition of the statictrade off theory by MM stated that when proposition I held the cost of equity as

    a linear increasing function of debt/equity ratio. The proposition implied that

    weighted average of these cost of capital to a firm would remain the same no

    matter what combination of financing sources the firm actually chose (Miller,


    Two categories of leverages are in strong connection with financial risks

    and operational risks that cumulate as total risk. According to Titman and

    Wessel (1988) there exist six ways to calculate financial and operational

    leverage. This includes dividing long term, short term, and convertible debt by

    market value and booked value turn by turn.

    Capital structure is actually backed by certain factor these may vary from

    firm to firm and economy to economy. Yet a consensus about certain factor exist

    in li terature these factors are age of the firm, firm size, asset structure,

    profitabil ity, fi rm growth, firm risk, taxation, managerial ownership, type of

    business (Abor, 2008; Il lays, 2008; Song, 2005; Harris & Raviv, 1991;

    Titman & Wessels 1988).

  • 8/14/2019 Capital Structure final updated file.pdf


    This propels the discussion toward efficient market hypothesis; i t

    describes stocks are always in equilibrium and it is impossible for an investor

    to consistently beat the market (Brigham, & Houston, 2010). This had become

    possible with easy availabi lity of information with the help of technology. Now

    the question is about quality and quantity of information about a particular

    market as i t determines the efficiency level of a particular stock market. First

    come weak form that states all information contained in past price movements is

    fully reflected in current market prices ( Fama, 1970) . Second is semi- strong

    form market, here all publically available information is reflected in stock

    prices (Brigham, & Houston, 2010) . Finally strong form market reflects all

    pertinent information weather publically or privately available in stock prices

    ( i b i d . ).Here the reason for discussing these market types was related to the

    intentions of investor to finance capital for a particular firm or not. As their

    intention vary from company to company and industry to industry thus creating

    vast difference in capital structure.

  • 8/14/2019 Capital Structure final updated file.pdf


    Section III:


    S cope of the Study

    The major purpose of this study is to explore and examine the application ofMM theory in Karachi Stock Market (Inefficient Market) that will be then

    compared to application of MM theory in London Stock market (Efficient

    Market). For reliabili ty and validity another market fulfil l ing the assumption set

    by MM theory will be introduced as Control group that will justify the results

    drawn from the above stated two markets.

    Research Methodology:

    The preferred methodology for the study will be

    TRIANGULATION. Triangulation is a powerful technique that facilitates validation of

    data through cross verification from more than two sources. In particular, it refers to the

    application and combination of several research methodologies in the study of the same

    phenomenon .

    It can be employed in both quantitative (validation) and qualitative (inquiry) studies.

    It is a method-appropriate strategy of founding the credibility of qualitative analyses. It becomes an alternative to traditional criteria like reliability and validity.

    It is the preferred line in the social sciences.

    By combining multiple observers, theories, methods, and empirical materials, researchers can

    hope to overcome the weakness or intrinsic biases and the problems that come from single

    method, single-observer and single-theory studies.

  • 8/14/2019 Capital Structure final updated file.pdf


    Data collection Methods:

    Qualitative & Quantitative Techniques:

    Various articles and books written by different scholars helped to gain more

    information about Karachi, London, and Dubai stock markets and practical

    application of MM theory its problems and potential solutions.

    Following qualitative techniques and tools will be used:

    Use of secondary data Informal interviews

    Focus group discussion

    The major focus while collecting data from these resources will be about the

    potential appl ication of MM theory in real world. Beside the above mentioned

    sources, Social Science research Network website, Modigliani and Miller article

    will help in the study.

    Secondary data option is used to carry out the analysis and recommendationabout the application of MM theory in Karachi and London Stock Exchange.

    The quantitative method provides a broad understanding of the concerns and

    potential recommendations and conclusions using various scholarly works on t he

    subject being investigated. The advantages of quantitative research compared to

    qualitative research are given below:

    It is an easy way to investigate breadth specific issues, in contrast to

    qualitative method.

    It is easy to collect quantitative data for inefficient markets rather

    qualitative data.

    The study move according to time se...