Capital Structure

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

Trade-off theory of capital structure - Evidence 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. 2.pdf

Trade-off theory of capital structure - Evidence 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.

Trade-off theory of capital structure - Evidence 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 markets

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[ cm/connect/fonterracom/fonterra.com/our+ business/news/media+releases/fonterra_a nnounces_start_of_capital_structure_cons ultation_programme Fonterra announces start of Capital Structure consultation programme], Media release, Fonterra website, November

Fonterra - Changes to capital structure 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.

Fonterra - Changes to capital structure 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

Fonterra - Changes to capital structure 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.

Fonterra - Changes to capital structure 1 The first two steps of capital structure change received good support from farmer shareholders at Fonterra’s annual meeting in November

Fonterra - Changes to capital structure 1 The third step, titled Trading Among Farmers, involves more far-reaching change to Fonterra's capital structure

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