Since graduation from college, you have worked at Precision Manufacturing Pty Lt
ID: 2817863 • Letter: S
Question
Since graduation from college, you have worked at Precision Manufacturing Pty Ltd, as a financial analyst. You have recently been promoted to the position of senior financial manager, with responsibilities that include capital budgeting decisions and the raising of long-term financing. Therefore, you decide to investigate the various alternatives for raising funds. Your goal is to make sure that the benefits received from undertaking long-term projects are greater than the costs of raising the long-term funds needed to finance those projects. With this goal in mind, you decide to answer the following questions:
1. What returns can investors in the ordinary equity expect on the first day of trading if they commit to purchase shares through the IPO issue? What factors may affect the relative amount of these first-day returns?
2. Discuss the implications of the various capital structure theories for optimal capital structure including Trade-off Theory and Pecking Order Theory
Explanation / Answer
Benefits of IPO are to the investors:
The investors can get the opportunity for picking up the shares at lower price. For example new issues priced at $12 to $15 per share would be priced at a rate of $20 to $25 in the secondary market & when the investors sell the shares in the secondary market, they can get huge profits. Similarly shares issued at par by new companies also get quoted at premiums. This is the reason that IPO’s are more popular as investors can make quick money which few other investments provide.
Following factors can affect the IPO returns:
Implications of capital structure theories:
According to the theory of M&M, the firm’s value is unaffected by the capital structure. even though their theory is valid theoretically, in the world without taxes is not valid in reality. In order to make it more accurate, they incorporated the effect of tax on the cost of capital of the firm. In the presence of corporate tax, the firm value increases with leverage due to tax shield. Interest on debt capital is an acceptable deduction from firm’s income & reduces the net tax payment of the firm.. this can add benefit in using debt capital by lowering the capital cost of the firm.
Trade off theory:
One of the basic theory that have dominated the capital structure theory which recommends that optimal level of the debt is where the marginal benefit of debt finance is equal to its marginal cost. Firm can achieve an optimal capital structure through adjusting the debt and equity level thereby balancing the tax shield and financial distress cost. There is no consensus among researchers on what consist the benefit and costs. Eliminating the constraints of the capital structure irrelevance proposition of MM Myers (1984) use the trade of theory as a theoretical foundation to explain the “Capital Structure Puzzle”. Myers (1977) suggests that the use of debt up to a certain level offset the cost of financial distress and interest tax shield. According to Fama and French (2002) the optimal capital structure can be identified through the benefits of debt tax deductibility of interest and cost of bankruptcy and agency cost.
Pecking order theory:
Based on the pecking order theory Harris and Raviv (1991) claim that capital structure decisions are intended to eliminate the inefficiencies caused by information asymmetry. Information asymmetry between insiders and outsiders and separation of ownership explain why firms avoid capital markets (Myers, 2001). Frydenberg (2004) explains that debt issue of a firm give a signal of confidence to the market that firm is an outstanding firm that their management if not afraid of debt financing. Further Frank and Goyal (2007) show that due to the agency conflict between managers and owners and outside investors pecking order can occur.
Studies on pecking order theory have not been able to show the significance of this theory on determining firms’ capital structure. Fama and French (1998) compared the trade off theory and pecking order theory and shows that certain features of financial data are better described by the pecking order theory. This is confirmed by Shyam-Sunder and Myers (1999) Raj Aggarwal et al (2006) and Karadeniz et al (2009). Shortcomings in this theory pressed the further development of the theories of capital structure to solve the capital structure puzzle.