making capital structure decisions

Question

In a perfect capital market, what advice would you give a corporate financial manager on making capital structure decisions? Justify your advice. How and why would your advice change as real world capital market imperfections are introduced?

The assignment in economics is about capital structure decisions to be taken in a perfect capital market. The solution focuses on the prevailing capital market and the type of capital structure that needs to be maintained by a corporate organization. The cost and availability of debt and equity play a major role in the debt equity ratio of a company. The concept has been explained in detail in the solution. 

Answer 1

As the Enterprise grow they require capital, they can either raise capital for short term from Money Market of for Long Term from Capital Market. Capital Market consists of debt and equity market where companies or governments can raise long-authority.term funds (usually more than a year). Capital Markets can further be classified as Primary and Secondary Markets. Fresh listing of securities is done in Primary Market and resale of securities is done in Secondary Market. There is a government regulation in Capital Market to prevent fraud and to save public money. In Australia, Australian Securities and Investments Commission is the regulatory authority. 

A market free from Arbitrage opportunities is called Perfect Capital Market. In Perfect Capital Market people cannot take benefit of differences in price between two markets, it is assumed that in Perfect Capital Market there is an even same price in all the markets and people cannot buy goods from one market and sell them at higher rate in other market. In Perfect Capital Market any investor should expect profit only at market rate of interest; he should not expect any abnormal return based on technical or fundamental analysis. In Perfect Capital Market investors should not try to exploit differences in price of same financial instruments in different markets. Corporations finances their assets in various ways, usually it is a combination of both equity and debt. The way any corporation raises money and finances its assets is called Capital Structure. Basically the structure of the liabilities is the Capital Structure. For example a firm sells $3 billion in equity and $7 billion in dept then it is said to be 30% equity financed and 70% debt financed. Now consider a Perfect Capital Market where there is no transaction or bankruptcy cost no taxes also. There is a same rate of interest for firms and individuals and most importantly company's value in market is independent of its Capital Structure. The primary role of the financial managers is to increase the enterprise and shareholder's wealth. In Perfect Capital Market (PCM) financial managers can have any Capital Structure for firm, as Capital Structure is irrelevant in deciding the firm's value. So in this kind of scenario financial managers should work to increase the shareholder's wealth by increasing the value of company, they can leave behind the Capital Structure of the company. The firm's investment decisions should be free from its financing decisions and financial manager should not think about financial problems before making investment decisions and policies. Financial Managers can neglect bankruptcy costs and tax codes also.  

However it's only theoretically possible to have Perfect Capital Market. In real world no such market exists consequently it is not possible for financial managers to assume the market to be perfect and they have to think about capital structure before making any investment decisions, in fact one of their job is to design a better capital structure for the firm as capital structure do have an effect on firm's overall reputation in market which in turn affects shareholders. In real scenario financial managers have to think about tax savings also, a firm can save its interest payment if it can include its tax payments. Another thing to look forward by financial managers is that what other firms in same industries are offering and what is their capital structure. It is observed that generally all the firms within same industry have similar capital structure. It is the role of financial managers to understand all the associated risks, understand the capital structure and then make sound investment decisions with which shareholder's wealth can be increased. In real world bankruptcy cost is also included and it is advisable to prefer financing with debt. In real world companies prioritize their sources of financing and firms always prefer internal financing. Then debt is preferred over equity. It is only when it is no more sensible to raise debt firm raises money with equity. 

References 

Bliss, C.J. (1976): “Capital Theory in the Short Run,” pp. 187-205 in Essays in Modern Capital Theory, ed. M. Brown, K. Sato and P. Zarembka. Amsterdam: North-Holland

Dasgupta, P.S. and P.J. Hammond (1980): “Fully Progressive Taxation,” Journal of Public Economics, 13, 141–154.

Hammond, P.J. (1987b): “On the Impossibility of Perfect Capital Markets,” Stanford University Institute of Mathematical Studies in the Social Sciences, Economics Technical 

Report No. 516.

Stigler, G. (1967): “Imperfections in the Capital Market,” Journal of Political Economy, 85, 287–292.