The Determination of Financial Structure Case Solution And Analysis, HBR Case Study Solution & Analysis of Harvard Case Studies

THE INCENTIVE – SIGNALLING APPROACH BY ‘STEPHEN ROSS’

INTRODUCTION:

Mr. Ross was able to create a system which indicates the capital structure of an organization. It can be determined by setting appropriate incentive scheme for the managers who in turn provide signals; which refer to the facts that lead to determine the capital base of an organization. Mr. Ross used the Modigliani-Miller theorem as a base for his approach.

THE MODIGLIANI-MILLER THEOREM

This theorem is based on the assumption that the firm operates in a competitive equilibrium The market holds complete information on all the activities of the firms and the managers hold complete internal information but are not allowed to trade in the instrument of their own firm; then the selected managerial incentive schedule will signal the market and the information drawn from the signals will be considered to be justified legally as it is a competitive equilibrium. One verifiable fact of this theory is that values of firms will rise with the amount of leverage a firm takes; since an increase in leverage indicates to the market that there is high value.

MODIGLIANI-MILLER IRRELEVANCY PROPOTIATIONS

The following quotations describe their Irrelevancy Propitiations,

. . . The market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate Pk appropriate to its class (Modigliani and

Miller, 1958);

and

. . .the current valuation is unaffected by differences in dividend payments in any

future period and thus . . . dividend policy is irrelevant for the determination of market

prices, given investment policy (Miller and Modigliani, 1961).

M&M are trying to say if value of the firm will decrease due to changes in the capital structure then one can buy the proportion of the company and sell it in the market. This can be done to make a gain out of it but since these profits are not consistent with equilibrium this means value of the firm has not changed and is constant across all financial packages.

M&M has been considering theories for determining the financial structure as non value adding and no longer useful. This prospect of the theory has to be modified to include the structural features; this leads to the traditional view of corporate finance.

While calculating corporate income tax, finance cost is deducted from the company’s income that gives the firm additional tax saving which raises the thought of making the company completely debt financed; but the flaw of such a concept is that the firm may get bankrupt. The optimum ratio of debt and equity can bring tax benefits but this benefit is traded off due the increased debt which to high cost of increased probability of bankruptcy.

Stephen agrees to the fact if changes in financial structure affect the operations of the firm (affecting consumption and investment opportunity making them open to economic factors) then; the strategy of maximization of wealth by arbitrage has to be rejected.

Since pricing is complete and value maximization is the goal, hence we will have to look elsewhere for a theory of the financial structure.

The market knows how the returns of the firm are generated and values them in order to set value for the firm, the change in capital structure changes the return generated by the firm which in fact changes the market perception regarding the value of the firm as the market perceives the risk class has changed but in actual it remains unchanged.

The relationships between signaling and the managerial incentive structure in the financial market:

The perfect market assumption still continuous,

Assumption 0: Financial markets are competitive and perfect with no transaction costs or tax effects.

For additional simplicity is can be assumed that the market is risk neutral.

Considering there are two companies A and B having returns a and b; whereas the return of company A is greater than of company B.

If there is no uncertainty in the market then firms A and B can be identified by the investors. At that point, the return generated by the firm for the senior claimant which is debt financier and its junior claimant, the equity financier will be same as of its respective value at time 0.

In simple words it can be expressed that the M&M theory gives the same concept of the Fisher's separation theorem.

Now if we consider that investors cannot distinguish between firms A and B, and if q is the proportion of Firm A, then any firm can become Firm A and there is a q chance of it happening. With the current considerations, the result of all the firms will have the same value which follows the M&M proposition; that mode of financing has no effect on the valuation of the firm.

It will be inefficient for Firm A to inform or signal the market that they are of type A as on the other side Firm B will be doing the same thing (Moral Hazard), which leaves investors with no clear indications by keeping the balance where firms cannot be determined.

For example, if Company A uses finance package X, then it will generate the value Xa; now assume that we are in equilibrium if Company B uses the same finance package then they will have the same value, but now Company B uses a different finance package Xb which makes its.........................

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