Capital Structure

Modigliani and Miller, 1963 v Trade off model - Kraus & Litzenberger, 1973

I hope you have all had a fun week! This week’s post is going to focus on capital structure, with main references to Modigliani and Miller (1958). How much do you know about company’s capital structure? Probably not much, so read on!

What is the most efficient, effective and relevant way for a company to structure its capital? Does it change between companies? Does it depend on the size of the business? Is that even of relevance to the capital structure?

Businesses have the choice to either be financed by debt or by equity, or by a bit of both. What do you think is the best way to finance a company?

Modigliani and Miller theorem (1958), also known as ‘capital structure irrelevance principle’ highly believed that it did not matter if a company was financed with either debt or equity. They believed that the value of the business depends on its risk.  However this was at first a highly rejected theory. Many limitations were found with this theory in 1958: no taxation mentioned, no perfect information is always available and markets were assumed to have strong form efficiency - the theory was not uniform enough to make complete judgements from. However, they realised this and in 1963 Modigliani and Miller added taxation to their theory to make it a normative and unified. The 1963 theory was way more accepted as it was a ‘real world’ approach.

(Modigliani and Miller theorem, 1963).

Surely this would have swayed people to agree with them? Many did, many didn’t. Modigliani and Miller (1963) assume that it doesn’t matter what the gearing (debt/equity) is, what really matters is the firm’s value which is determined solely by business risk.

Modigliani and Miller advice companies to always finance through debt, is this sustainable? High gearing can negatively impact the economy and businesses.

However the trade-off model (Kraus & Litzenberger, 1973) contrary to Modigliani and Miller, assumes that companies choose the amount of debt and equity finance to use by balancing benefits and costs. Do you think this model is better than Modigliani and Miller? I think so. Having both debt and equity finance allows tax benefits, which increased the gearing to a safe level and having half debt, half equity allows a discount rate for potential projects the company may want to invest in.

The trade-off model assumes that weighted average cost of capital (WACC) will initially fall and at some point will hit rock bottom. Decreased WACC = decreased risk. But we must ALWAYS consider financial distress costs. A high level of debt will equal to a high level of financial distress, is this another factor against Modigliani and Miller? At high levels, financial distress cannot be ignored. Particularly when there is uncertainty in supplier’s minds. High financial distress can lead in bankruptcy costs. 

                                 (Trade off model - Kraus & Litzenberger, 1973)                                                

To me I think that the trade-off model represents a more realistic view of capital structure. Modigliani and Miller seems too good to be true, and does not represent the world that we live in which is definitely not a perfect one. Trade off model takes into account that things can change, and that companies should only borrow as much as they can afford (AKA reasonable level).

What do you think? Which model do you think is more sustainable? Thanks for reading this blog post, and I hope you found it interesting! Please leave your comments and opinions below and let me know what you think. Until next week.

Laura

The Madoff Hustle: Small Investment, 'Low Risk'.

I hope you have all had an exciting week! This blog post is going to focus on international cost of capital, but with ultimate target on the Madoff scandal that happened in 2009 and shocked hundreds of customers, shareholders and even family and friends throughout the world.

How many people trust their grandparents? Because all of the people I know do, so how is it that one man described as a 'caring, friendly family-man who acted like a grandpa' became the limelight of the 'biggest scandal the world has ever seen'?

So ask yourself this, would you have paid into an investment that was low risk, steady return with a promise of 1% return every month each year? Many of you will say no because you know of this scandal, but before the scandal, I know that I would have said yes. A low risk investment with a promised return, why would you say no? 

Bernie Madoff was a highly respected and trusted financier who was also chairman of NASDAQ market, where he had built up contacts, trust and personal friendships with many. This was a huge advantage for Madoff as the more people that invested the more money he was making for himself to fund his four luxurious homes. But unfortunately when the going got tough, all of these people lost thousands and thousands of dollars with many people not receiving even a cent. This makes the extent of losses extremely hard to estimate.

Madoffs main selling point was that he was an ‘exclusive club’. Making people feel lucky if they got into the club making it feel more personal as he got to know his clients. Having personal relationships with his clients worked as a great advantage to him as they committed more and more money with him as trust built with friendships.

Certain returns were promised however in hard times during the credit crunch clients were pressing about getting their money back. But at this point the scheme was getting out of control, too big for him to manage.

However he remained confident, reassured his clients, and promised them their money. But a week later it was revealed - he was a fraud.

A Ponzi scheme is what the scandal entailed. ‘Everyone wants something for nothing, you just having to give someone nothing for something’. Madoff was basically paying clients returns with their own money and saving the rest for himself.

People throughout the world were shocked, out of every one of Wall Street, Madoff was not the man who would ever have even been suspected of such a crime. But Harry Markopolos informed securities in 2005, and again in 2009 where authorities finally investigated the loss of billions of dollars.

The scandal had many consequences for clients, loss of money, homes, and possessions and for one man, (Madoffs brother) even his life.

Bernie Madoff knew his way into the hearts and lives of customers. This retrospectively gained him many clients all of which were affected by the scandal in the U.S. His clients were eager for money and the low-risk investment sounded like the perfect opportunity for them to gain money and not lose any. This was not the case and lives have been turned upside down after the news erupted.

Was it all really Madoffs fault though? Could some of the blame go onto his partners, accountants, financers, family? And even the clients themselves. A good portfolio is a diversified portfolio (Harry Markowitz, 1959) but investors unfortunately did not spread their risk to reduce it. Madoff was convicted and he pleaded guilty, resulting in a 150 year imprisonment.

I think that Madoff deserved his sentence of 150 years imprisonment, he ruined many clients lives, had been unethical in his decisions, manipulated clients, charged for theft, fraud, perjury and money laundering. However, I do not think it is fair that his accountant and lawyer only faced upto 30 years in prison when they were aware of what was happening! Do you think this is justice?  Or at least, fair justice? Madoff cheated clients out of $65 BILLION dollars. But he was not the only person who cheated the system, people knew what was going on. Maybe this requires for higher legislation, more open transparency and a better form of judgement.

I stick to thinking that there was not a sufficient conclusion to this scandal. People are still owed thousands of dollars, trust is lost and may never be returned. Did the convictions make people feel better? Probably. Did convictions make their money appear? No. Let me know what you think of this scandal.

Blog soon. Laura.

Madoff Scandal Explained: http://www.businessinsider.com/how-bernie-madoffs-ponzi-scheme-worked-2014-7?IR=T

Stock Market Efficiency

Does anybody really know the answer to ‘are stock markets efficient’?

After countless hours of research it is safe to say that many authors have so many different views; they believe in efficiency, they do not believe in efficiency, they sometimes believe in efficiency, they can predict the future etc.  So I am going to express my own opinion about stock market efficiency.

In this post I am going to use Volkswagen as a case study example to show my opinion of stock market efficiency. Or lack of it.

Volkswagen are currently at their height of a scandal that has shocked thousands of people in many countries. Their over-polluting cars have been found out after the US Environmental Protection Agency discovered they were emitting up to 40 times, not just 4, FORTY times more toxic fumes than permitted. But could it have been predicted?

New news spreads quicker than wildfire. The graph below shows the share drop the SAME DAY that outrageously high fumes were found in Volkswagen vehicles.

 

This just shows the importance and the magnitude of news and how much news can effect a company’s shares. But does this show an efficient market? In my opinion it does not. To me this graph shows that there is significant inefficiency in the market. It shows that the stock market did not reflect all information before the scandal or else the ‘scandal’ wouldn’t have been so much of a shock to the system. If the stock markets were efficient then the response would not have had as much of an impact to shares, meaning that the line on the graph would stay relatively straight. Is this amount of inefficiency good for markets?

I think that stock markets cannot be predicted; they do not follow patterns and trends within the market. Whatever happens, happens.

Personally, I agree with Kendal (1953) that stock markets follow a ‘random walk’. To me this means that markets can be estimated but they cannot be predicted. Nobody knows what is really going to happen in the future so nobody can say that markets are going to be ‘efficient forever’ or even ‘never efficient’. Stock markets will change when new news enters the market, leaving an element of unpredictability to markets.

Market efficiency can cause many problems for businesses; managers are expected to act in ways which will increase shareholder wealth. Just like Volkswagen tried to do, but their idea failed as they were found out. In fact CEO Martin Winterkorn quit because he couldn’t face his actions!! Headlines in the news found that even the head of Volkswagen, Michael Horn, admitted that he was aware of ‘possible emissions non-compliance’ by the company LAST YEAR! Surely ethics would have been a major impact on this scandal and consequently had an impact on the share price, which altered stock markets.

To conclude this post I am sticking with my opinions on this and I think stock market efficiency will fail to ever be 100% efficient. This is due to the ever changing factors of companies, stocks, shares and news. This is my opinion, what do you think? How efficient do you think stock markets are?

I have included some links below to articles that I think are interesting and relevant to this blog post, check them out if you want to form your opinion on stock market efficiency.

1. http://www.bbc.co.uk/news/business-34324772 
2. http://thismatter.com/money/investments/random-walk-efficient-market-hypotheses.htm
3. http://www.wsj.com/articles/as-volkswagen-takes-heat-car-makers-ads-tout-fuel-efficiency-1443035580

Blog soon. Laura.

Digby Jones - Hereford Furniture

After watching Digby Jones: The New Trouble Shooter at Hereford Furniture I took into account how important it is for businesses to focus on particular areas of the business instead of trying to have it all. For example Mike Muxworthy (the managing director) managed to make a loss of £80,000 in the previous year. According to Digby Jones this was due to having too much of a wide business structure for a medium sized business like Hereford Furniture. Hereford Furniture was in fact three businesses in one; a manufacturing company, an importing company and a retailing company. Not only that they were producing up to 15,000 pieces of furniture a year with thousands of different designs, colours, heights and widths.

The size and scale of the operations could not be handled with 40 employees and lack of expertise in all three areas. This was a main reason in which the business made losses. This emphasizes the importance of a business setting targets, referring to budgets and scaling operations.

During the programme Digby Jones and Mike Muxworthy interviewed employees to find out their opinions to see what they think was going wrong with the business and why they thought that the business was making such a loss. The results found that the communication in the business was poor as was the organisation. Most surprisingly they also mentioned that the relationship with Muxworthy was not sufficient.

This just goes to show that companies are not just product selling and money making organisations. For a successful company internal and external stakeholders and shareholders need to be on the same page. Good communication is key to a successful business as it helps to improve efficiency and effectiveness of the business and its operations. This is shown at the end of the programme as the communication improves so does the business and the businesses success.

Another factor that stood out in the documentary was that the target market for the business was high end. The products they make are high quality, and they sell at a high price. Muxworthy was stuck with the fact that he thought classic looking pieces of furniture were the ones that looked high quality. However Muxworthy was advised to make quirky and clever designs that would reach out to their audience; people will pay more for the right product.

Rebranding is always a huge step for businesses to take, but by taking risks it can pay off. It often gives businesses a new outlook, a modern twist, a new sense of life in the business and a more ‘catchy’ brand. In the Hereford Furniture case they rebranded their company to ‘Hygge’. This is very unique, catchy, and memorable Danish word that means good things with good people. By having a creative, modern and unknown word as a brand name gets a person talking; and to be a successful business this is what needs to happen.

In my opinion this documentary clearly shows the importance of uniqueness, setting targets, stakeholder communication and the importance of focus. In the case of Hereford Furniture, Digby Jones managed to successfully improve the company by giving them little guidance but the big push that they needed. Businesses should sometimes step out of their comfort zones.