Mci Communications Corp

by lorepipsum | studymode.com

It seemed that the board of directors at MCI was divided between two possible solutions.
Should the company finance the repurchase by increasing MCI's debt financing by at least
doubling the current debt-equity ration that stood at 36% at that time (MCI)? Conversely,
would a more conservative approach of using an open-market purchase program,
announcing its intentions to repurchase its stock from "time to time" but only as corporate
funds become available, be more appropriate (MCI)? The answer to this question will help
determine the path that the company will follow in the years to come. It will also either
instill confidence or continue the growing sense of restlessness that is currently being
exhibited by the company's shareholders. Therefore, in an effort to determine the most
advantageous path for MCI, we will focus on answering the following three questions given
in the course module to meet our objectives. 1) What would be the effects of issuing $2
billion of new debt and using the proceeds to repurchase shares of the following: a) the
book value of MCI's equity b) the price per share of MCI's stock; and c) the earnings per
share of MCI's stock. 2) What is the current WACC for MCI and what would it become after
the new debt and repurchase? 3) Would you recommend this new debt and repurchase of
stock alternative to the MCI Board of Directors? Explain your answer. The first questions
asks us what would be the effects of issuing $2 billion of new debt and using the proceeds
to repurchase shares of the book value of MCI's equity, the price per share of MCI's stock,
and the earnings per share of MCI's stock. Referring to the chart below, we realize that by
accruing debt re-capitalization by issuing a $2 billion debt to purchase $2 billion stock will
not affect the firm's cash flow. Based on the assumption of earning before the interest
income remains the same, we have determined that the cost of debt will increased by
$123 millions due to the interest accrued by the new debt. We get EBT by subtract the
interest expenses from EBIT. Then we subtract the tax expenses from EBT will lead us to
the new net income, $498 Million. The $2 billion debt divided by the current market price
per share will result in a shares buy back of 72 million shares. Furthermore, the
outstanding shares should be using the original outstanding shares minus the buy back
shares. New EPS equals the new net income divided by the new shares outstanding. The
new Long-term debt increase from $3,444 million to $5,444 million and therefore, the new
book value of equity is $ 9,602 Million minus $2 billion.

Based on these computations, MCI's new book value is $7,602 million. Equity holders will
receive a higher expected rate of return after the re-capitalization, but will bear a higher
level of risk per dollar invested, for which the higher expected rate of return precisely
compensates them. By increasing debt, decreasing equity for $2 billion, MCI's EPS
decreased 1 cents per share from $0.83 per share to $ 0.82 per share. However, the Price
per share increased to $ 32.31, PE ratio, and ROE are increased as well. (chart) The
second question asks us to compute MCI's current WACC and what would it become after
the new debt and repurchase. The first thing we need to do is determine MCI's existing
WACC. The following formula is used: (formula) Given the following, provided in the case
study, one is left to derive VL and rS: (chart) The CAPM provides the following means to
derive rS: (chart)

Based on these computations, MCI's new book value is $7,602 million. Equity holders will
receive a higher expected rate of return after the re-capitalization, but will bear a higher
level of risk per dollar invested, for which the higher expected rate of return precisely
compensates them. By increasing debt, decreasing equity for $2 billion, MCI's EPS
decreased 1 cents per share from $0.83 per share to $ 0.82 per share. However, the Price
per share increased to $ 32.31, PE ratio, and ROE are increased as well. (chart) The
second question asks us to compute MCI's current WACC and what would it become after
the new debt and repurchase. The first thing we need to do is determine MCI's existing
WACC. The following formula is used: (formula) Given the following, provided in the case
study, one is left to derive VL and rS: (chart) The CAPM provides the following means to
derive rS: (chart)

1) The new beta will be approximated by looking at other firms in the industry. Since we
can estimate a projected debt-equity ratio, we will set our beta equal to that of another
company that currently has our projected debt-equity ratio. In this case, it is Sprint. 2) Cost
of debt will increase with additional debt. Given the current capital market conditions, we
will assume that our rate will go up, but not by too much. In this case, the assumption is
that our interest rate will increase from 6.10% to the rate available to a current AA1 rated
firm, or 6.160%. With these assumptions, and using the same methodology used in the
initial WACC computation, we determine that the new WACC resulting from the additional
debt and new capital structure is .356. In order to go before the Board of Directors of MCI
and make a recommendation on the issuance of new debt to repurchase the company's
stock, we must first do some homework. The Board of Directors were considering this
change to enhance shareholders value as well as sending a strong message to the market
about MCI's bright future. To select the best option for MCI, we first need a clear
separation between MCI's equity and debt.

MCI is a leveraged firm and taxation influences the value of this firm. The last question
asks whether we would recommend this new debt and repurchase of stock alternative to
the MCI Board of Directors. Naturally, we will support our recommendation with data
generated from the first two questions above. We recommend the board at MCI to issue
the additional $2 billion in debt and to apply the capital to repurchase MCI stock based on
MCI's current Weighted Average Cost of Capital (WACC) is 0.362. We realize that by
adding the additional $2 billion in debt, their WACC decreased to 0.356. We realize that
this is not a significant drop in the cost of capital; however, it is a decrease in cost. The
next thing that we need to focus on is how the additional debt and repurchasing of stock
effects the companies stock ratios. Since one of MCI's stated goals is to increase share
holders value, we want to find out if the change in capital structure help the overall stock
value? The answer can be found in question one. According to calculations, we
determined that the PE Ratio increased from 33% to 40%. In addition, the price per share
increased with this additional debt from $27.75 to $32.31.

Lastly the ROE also increased from 5.97% to 6.55%. The only negative change
determined was, the decrease in earning per share from $0.83 to $0.82. Again, we note
the insignificant change with the earnings per share value; however we do keep in mind
that the value did in fact decrease. Overall, the stock ratios that were evaluated with this
additional debt improved. Based on the ratios given, we conclude that change in MCI's
capital structure would add to the shareholder value. Lastly, we examined the effects of
the tax shield that this debt would generate. With our current tax laws, there is a tax
advantage for a company to be leveraged. Our tax structure allows a maximum tax rate in
which at a certain point, the amount of debt generated does not grant additional tax shield.
MCI has yet to hit their maximum tax rate and therefore, can still benefit from the tax
advantages. The present value of the tax shield for MCI was calculated at $776 million
while the interest expense on this new debt is $304 million. These numbers show that
today's tax advantage dollars is more than double the cost of interest on this new debt. All
of this data supports our recommendation to the board of directors that it would be
beneficial for MCI to issue the 2 billion in debt in order to repurchase the company stock.

The issuance of new debt and repurchasing of company owned stock looks to be the
safest hedge against an insecure future/economy and stiffening competition from start ups
and less debt-laden companies. The data, from the stock ratios down through the final
WACC computations tend to quantifiably support our recommendations for the MCI Board.
Couple this with the tax shelter benefits that are still currently below their cap, this growing
telecommunications force should weather the late 90's storm and produce better than
average dividends and earning estimates to maintain its stock prices and therefore its
foothold in this lucrative and burgeoning field.

No.2

Caleb Johnson
Capital Structure Theory Working Capital Management Dr. Woodward
10/14/14
Part a. (Capital Structure)

Capital Structure Theory

Capital structure is very important. Not only does it influence the return a company earns for
its shareholders but can also be a determining factor on whether or not a firm survives a
recession. A company’s capital structure is a mix of their short-term debt, long-term debt, and
equity. A firm’s capital structure is the way the firm finances all of its operations, investments,
and growth. When a firm’s debt- to-equity ratio maximizes its value and minimizes the firm’s
weighted average cost of capital (WACC), it is said to be at the “target” or “optimal capital
structure”. Debt usually offers a lower cost of capital because of the ability to deduct tax from
interest, but the company’s risk increases as debt increases. Part b. (Business Risk)

Business risk refers to the risk brought upon the firm by its operations. This can be influenced
by many factors such as, cost of production, sales volume, unit price, competition, demand,
government regulations, etc. A company with higher business risk should operate with a
capital structure that has a lower debt ration to safeguard its shareholders by guaranteeing
that it can meet all of its financial obligations. A high business risk means a low debt ratio
while a low business risk means that a firm might be able to operate with a high debt ratio.
Part c. (Operation Leverage)

A firm that makes few sales with sales providing a high gross margin is said to have high
operation leverage. Operating leverage is dependent on a firm’s fixed and variable costs. If a
firm has a

high proportion of fixed costs it has high operation leverage as opposed to a firm with low
fixed costs and high variable casts which are considered to have a low operation leverage. A
high-end car dealership has high operating leverage while a grocery store has low operating
leverage. In a high operating leverage firm or industry, forecasting is incredibly important. A
small error in forecasting could greatly damage the firm’s EBIT. The opposite can be said for a
firm with a low operating leverage. A small error in forecasting is accepted and expected. The
error will have little effect on the firms EBIT. A Company with high operation leverage should
finance its operations with a low amount of debt to insure, in the case of a misprediction, to
protect its investors. Business risk and operation leverage often go hand in hand and are used
to calculate the firms total risk on ROE.

Part d. (Trade-Off Theory)

The trade-off theory states that there are benefits to debt within a capital structure up until
the optimal, or target, capital structure. The theory takes into effect the “tax shield” created by
interest payments. Interest payments on debt are tax deductible creating a tax benefit for debt
financing. A firm reaches optimal capital structure when the marginal tax shield equals the
marginal bankruptcy costs. Bankruptcy costs are the increased costs of financing with debt
instead of with equity which result in a higher probability of bankruptcy. Thus, there is a point
where the marginal tax benefits equal the cost of financing with more debt. At this point, we
see the firm’s optimal capital structure.
Part e. (Asymmetric Information and Signaling)

Asymmetric information refers to the realization that managers have more and better
information that outside investors do. Signaling is based upon a firms actions and how it is
preserved by its investors. Optimist asymmetric information could lead to a firm suddenly
taking on more debt or increasing their dividend policy. This would signal that the company is
about to experience growth or is at a mature and stable state. Pessimist asymmetric
information could lead a firm to issue more stock because they recognize an upcoming loss.
By issuing more stock, the loss could be spread over a larger

number of stockholders resulting in a smaller loss per share. Investors know this however
and are wary when a firm issues more stock. Because of signaling, when a firm tries to adjust
their capital structure their investors behave in a way directed by the signal given, whether
that signal is accurate or not.
Part f. (WACC)

WACC or weighted average cost of capital is the firm’s cost of capital with each category of
capital weighted proportionately. The more debt that company uses, the higher the WACC.
The higher the WACC, the higher the company’s risk. When using debt, the WACC begins to
fall, but eventually, the costs of debt and equity will cause WACC to increase which will in turn
cause the value of the company to drop. This brings us back to the optimal or target capital
structure, where the debt to equity ratio maximizes the firm’s value.
Part g. (Reserve Borrowing Capacity)

Firms should however, use a lower debt to equity ratio than optimal capital structure
suggests. The reason being, that an opportunity may arise where more funds are needed. As
previously discussed, the issue of more stock sends a negative signal whether the signal is
accurate or not, but to issue more debt past the optimal capital structure ratio would decrease
the firm’s value which would also send a negative signal. Therefore, a firm should have a
reserve borrowing capacity in the case of such an opportunity.
Part h. (Windows of Opportunity)

A window of opportunity is a time period where a normally unreachable opening exists. An

example is today’s interest rates. The windows of opportunity theory suggest that because
interest rates are so abnormally low, now is a good time for businesses to issue debt. On the
contrary, when stock market prices are exceptionally high, firms should issue more equity.
Part i. (Personal Application)

It is of the utmost importance that managers know and understand their firm’s risk and how it
breaks down into operation leverage and business risk. This might be based solely off their
particular firm or off their industry as a whole. Managers should also consider the benefit of
deducting interest on debt to use as a tax shield. Managers should take the asymmetric
information theory and signaling into consideration. They should be aware of what certain
actions signal and how they can avoid sending the wrong signal and use signaling to their
advantage. The WACC should also be considered when determining the corporation’s debt to
equity ratio. They should know that at a certain point, WACC will begin to increase as at this
point the firm is taking on too much debt. If a corporation wants to take advantage of an
opportunity but does not have the funds necessary, they should issue more debt to take
benefit. For this reason managers should have a reserve borrowing capacity and have a lower
initial debt to equity ratio than the optimal capital structure suggests. Managers should also
be watchful and aware of windows of opportunities in which they can maximize the
corporation’s growth. As one can see, there are many aspects one needs to consider when
determining a firm’s capital structure and this essay only slightly begins to scratch the surface
of capital structure theory.

No.3

capital structure
by heykaka | studymode.com

A review of capital structure theories

1.0 Introduction
One of the most contentious financial issues that have provoked intense academic
research during the last decades is the theory of capital structure. Capital structure can be
defined as a 'Mix of different securities issued by a firm' (Brealey and Myers, 2003). Simply
speaking, capital structure mainly contains two elements, debt and equity. In 1958,
through combining tax and debt factors in a simple model to price the value of a company,
Modigliani and Miller firstly begin to explore a modern capital structure theory, and their
work inspired this area study. However, the MM theory has no practical use because it
lacks of direct guidance for companies to determine capital structure in real life (Baxter,
1967; Sarig and Warga, 1989; Vernimmen et al, 2005). During the past years, researchers
strived to establish a more reasonable capital structure theory that can be put into
practices efficiently, and they attempted to expand debt ratio and tax advantage factors
into a new area. Myers (1984) states that only practical capital structure theories, which
introducing adjustment cost that includes agency cost and information asymmetry
problems, could provide a useful guidance for firms to determine their capital structure.
However, from recent studies, Myers (2001) believes that how information differences and
agency costs influence the capital structure is still an open question. From this
perspective, it is very important to review the development of these two factors which
make theoretical research having a strong relationship with reality. Thus, this project will
summarize the capital structure theories orientated by agency cost and asymmetric
information from extant literature. Also some gaps and conflicts among theories of capital
structure will be found and discussed in order to further improve this area study. The rest
of this project is arranged as follows. Section 2 will present the theories based on agency
costs that causes the conflicts between equity holders and debt holders or managers.
Section 3 will illustrate from two areas, interplay of capital structure and investment,
followed by signal effect of debt ratio, to show the theories based on asymmetric
information. In conclusion, Section 4 will summarize the entire essay and suggest further
research direction of capital structure theory.

2.0 Capital structure theories based on agency costs

Although Berry and Means (1931, cited in Myers, 2001) state an adverse relationship
between the separated ownership and corporate control status, it commonly admits that
Jensen and Meckling (1976) firstly conducted the research in how agency costs determine
capital structure (Harris and Raviv, 1991). Over the past decades, researchers have tried
to add agency costs to capital structure models (Harris and Raviv, 1991). The perfect
alignment between firm investors and firm agencies, such as managers, does not exist
(Myers, 2001). According to Jensen and Meckling (1976), company agents, the managers,
always emphasize on their own interests, such as high salary and reputation. Also these
company agents use 'entrenching investments', which make the asset and capital
structure orientated by the managements knowledge and skills, to increase their
bargaining power with the true company holders (Chen and Kensinger, 1992). However,
Myers (2001) believes that the firm holders can reduce such transferred value through
using different kinds of methods of control and supervising, but he further points out the
weakness that these methods are expensive and reduce returns. As a result, the perfect
monitoring system is out of work, and agency costs are produced from these conflicts.
According to Jensen and Meckling (1976), the conflicts between investors and agencies
are generally divided into two types. The first conflict occurs between debt holders and
equity holders, and the second conflict is from between equity holders and managers.
Consequently, all the capital structure theories based on agency costs can be also
classified based on these two conflicts. In the rest of this section, each individual conflict
will be separately discussed.

2.1 Conflicts between Debt holders and Equity holders

Jensen and Meckling (1976) point out that agency costs problems happen in determining
the structure of a firms' capital when the conflict between debt holders and equity holders
is caused by debt contracts. Similar to Jensen and Meckling's conclusion, Myers (1977)
observes that since equity holders bear the whole cost of the investment and debt holders
get the main part of the profits from the investment, equity holders may have no interest in
investing in value-increasing businesses when companies are likely to face bankruptcy in
the short term future. Thus, if debt occupies a large part of firms' capital, it will lead to the
rejection of investing in more value-increased business projects. However, in 1991, Harris
and Raviv cast a contrasting opinion to adjust the capital structure theory based on this
conflict. They point out that most debt contracts give equity holders a push power to invest
sub-optimally investment project. If the investment fails, due to limited liability, debt holders
bear the consequences of a decline of the debt value, but equity holders get most of yields
if the investment could generate returns above the debt par value. In order to prevent debt
holders from receiving unfair treatment, equity holders normally get less for the debt than
original expectation from debt holders. Thus, the agency costs are created by equity
holders who issue the debt rather than debt holders' reason (Harris and Raviv, 1991).
Tradeoff capital structure theory has a basic and strong relationship with this type of
agency costs. However, different researchers hold various explanations of the relationship.
Myers (1977) points out the debt cost reason, Green (1984) announces that convertible
bonds can reduce the asset substitution problem which comes from the tradeoff theory,
Stulz and Johnson (1985) consider about collateral effect. In the end, only Diamond model
(1989) is widely accepted. If Equity holders do not consider reputational reason, they are
willing to trade relatively safe projects, but this activity will lead to less debt financing
(Diamond, 1989; Mike et al, 1997). Diamond model (1989) assumes two tradeoffs, risky
and risk-free, to show that the debt repayment should consider both possible investment
plans. Furthermore, Mike et al (1997) use empirical evidence to indicate how to use debt
to trade off these two optional investment plans. Moreover, in 1991, Harris and Raviv
expanded Diamond's model to three investment choices. They point out that one choice of
investment can only contain the risk-free project, one option can invest in risk project and
the last option combine both risk-free and risk projects. In fact, since the reputation factor
is vital for a manager, managers are willing to choose risk-free investment projects that
have more possibility of success. Consequently, the amount of debt is often reduced by
managers.
No.4

Capital Structure Theory

by fishersci | studymode.com

Overview
MCI Communications Corp., a long-time client of Lynch Investments is inquiring about
establishing a program to repurchase some of its outstanding common stock. Their stock
has been somewhat "sluggish, in an otherwise buoyant market, and has indications that
stockholders are becoming restless from the corporation's lack of stable growth" (MCI
Communications Corp. Case, 2004). An earlier meeting held by MCI, an idea was
proposed for the company to repurchase some of its outstanding common stock, which
would increase MCI's debt financing and would eventually double the current debt to
equity ratio almost to 80%. To repurchase to stock, MCI would be required to take on an
additional $2 billion in debt. This will "give the perception to the market that the company
was performing well and therefore, increase both interest and sales for their stock." (MCI
Communications Corp. Case, 2004)

Some feel that this approach is too drastic and proposed an open-market purchase
program, that will allow the company to repurchase their own stock but only when
corporate funds would enable them. The upside to this approach is that would not require
such a large increase in debt for MCI. The downside is that it might not give immediate
results in regards to gaining interest in the stock.

1.) What would be the effects of issuing $2 billion of new debt and using the proceeds to
repurchase shares on the following:

·Book value of MCI equity

·Price per share of MCI stock

·Earnings per share of MCI stock

By using the $2 billion in additional long-term debt would increase the debt-equity ratio in
terms of book value from 41.1 % (3,944/9,602) to 51.9 (5,944/7,602). MCI should use the
debt and equity's market value, not book value in order to determine their debt-equity
ratios for better analysis.

We used the EBIT/EPS analysis to determine which position would provide better earnings
per share. The analysts took on the additional $2 billion in debt, which shows the long-term
debt will increase to $5,944. We then calculated the number of shares the additional debt
would buy and then subtracted it from the current outstanding shares to calculate a new
market value.

·Book value of MCI equity

From the income statement, there are 687,000,000 common shares. The book value of the
equity is calculated by dividing the stockholders equity ($9,602,000,000 from the balance
sheet) by the number of shares. This gives a book value per share of $13.98.

stock repurchase $2,000,000,000

stock price $ 27.75

# of shares 72,072,072

ItemSourceCurrentNew

stockholders equitybalance sheet $9,602,000,000 $ 7,602,000,000

common sharesincome statement 687,000,000 614,927,928

book valuecalculated $ 13.98 $ 12.36

·Price per share of MCI stock

The price per share will not change as a result of the increase in debt.

·Earnings per share of MCI stock

EPS will change significantly, as shown in the table below

ItemSourceCurrentNew

earningsincome statement $ 573,000,000 $ 573,000,000

common sharesincome statement 687,000,000 614,927,928

earnings per sharecalculated $ 0.83 $ 0.93

Current LTD$3,444

LTD in 1 year$500

$3,944
Additional Debt$2,000

New LTD$5,944

Additional Debt$2,000,000,000

Share Price27.75

Divided72,072,072

Current Out Shares 681,000,000

Add shares -72,072,072

Remaining shares608,927,928

Share Price X$27.75

New Mkt Value$16,897,750,002.00

New L.T.D$5,444,000,000

New Mkt Val16,897,750,002

New LTD/Equity /0.3221

2.) What is the current WACC for MCI and what would it become after the new debt and
repurchase?

The WACC provides us with the average cost of each dollar and prioritizes which
investments should be made.

Cost of equity

Market risk premiumpage 27%

30 year T-billpage 76.17%

Cost on equity 13.60%

DebtCurrentNew

LT Debt (within 1 year) $ 500,000,000 $ 500,000,000

LT Debt $ 3,444,000,000 $ 5,444,000,000

Total debtcalculated $ 3,944,000,000 $ 5,944,000,000

ItemSourceCurrentNew

Re = return on equity13.60%13.60%

Rd = cost of debtpage 26.10%6.10%

Stock Price $ 27.75 $ 27.75

Shares outstanding (1000s) 687,000 614,928

E = the market value of the firm's equity ($1000s) $ 19,064,250 $ 17,064,250

D = value of the firm's debt ($1000s) $ 3,944,000 $ 5,944,000

V = E + D $ 23,008,250 $ 23,008,250

E/V = percentage of financing that is equity82.9%74.2%

D/V = percentage of financing that is debt17.1%25.8%

Tc = the corporate tax rate40%40%

WACC= (E/V x Re) + [(D/V x Rd) x (1-Tc)]11.90%11.00%

B= BL / (1-(D-E)(1-T))

Bu= 1 / (1-.209(.6))

Bu= 1 / (1-.1254)

Bu = 1.143
BL= Bu / (1-(D/E)(1-T))

BL = 1.143 / (1-.3221)(.6)

BL= 1.143 / .406

BL= 2.815

Proposed

KE = (BL X Mkt Prem)

KE = .05125 + (2.815 X .07)

Ke = 19.70%

WACC = .1970 (16.898 billion / 22.842 billion) + .0626 (5.444 billion / 22.842 billion)

145.736 + .0149 = .1457

Existing

WACC = .1457 (18.898 billion / 22.842) + .0626 (3.444 billion / 22.848 billion)

WACC = .12993

Recommendations

From the above, it can be seen that the WACC decreases with the issue of the new debt
to buy back stock.. This alone highlights this as a good decision, with tangible results.
Unless the cost of borrowing escalates beyond 11.75% (calculated value of cost of debt
that result in an unchanged value of WACC), the WACC remains lower than the unlevered
condition, and so adds value to the company. A second benefit will be the increase in
share price anticipated by this move. It is also unlikely that the stock beta value would
change significantly. MCI has low levels of leverage compared to the industry averages,
and so it would be anticipated that both the required return on stock and the cost of
borrowing would not increase disproportionately. Also, the owners equity decreased by $2
billion with a direct affect on the decreasing number of shares with no change in the price
per share.
The conclusion is that MCI should borrow $2 billion to buy back the stock.
No.5
Teoria de la agencia: gobierno corporativo?a la buena, acciones, la ley, auditores.

Capital Structure and Agency Theory

by yangxiema | studymode.com

1.0 Introduction
The maximization of the company’s value has long been the objective of financial
management. In order to create more value for business organizations, how to
comprehensively make the most effective investment, financing and operating decisions
becomes more crucial. Among these decisions, the optimization of capital structure has a
great influence on the performance of the companies, for a reasonable capital structure
can decrease the financing cost, take advantage of the financial leverage and play an
important role in corporation governance. Given the importance of capital structure, this
essay will firstly discuss the ways that capital structure affects corporation value, then it will
introduce the influencing factors of capital structure and how to effectively manage it. Due
to the conflicts among the debtors, managers and shareholders etc, this essay will also
illustrate the agency problems that are existed in the companies and evaluate the role of
effective financial management in addressing these problems.

2.0 The ways that capital structure affects corporation value The capital structure is
refered to the allocation between the long-term debt and equity, which determines the
solvency and refinancing ability of the company to a large extent. While the optimum
capital structure is the capital structure that can maximize the wealth of shareholders or
bring about the least capital cost. It is necessary to manage the capital structure
effectively, for a reasonable capital structure can maximize the value of a company
through a series of approach. According to a series of capital structure theories, the way
that capital structure affects corporation value can be described from different perspectives
(Margaritis, D. & Psillaki, M. 2010).

2.1 Form the perspective of capital cost

The traditional Net Income Theory holds the view that due to the lower debt cost compared
to the equity cost, the increase of debt ratio in the capital structure can decrease the
weighted average cost of capital (WACC), thus a 100% percent of debt can maximize the
value of the corporation. Although the Net Operating Income Approach suggests that the
financing decision has no relationship with the corporation value, the traditional theory
thinks that although the increase of debt ratio or financial leverage will increase the risk of
the corporation and the equity cost, the increase of equity cost can not offset the
advantage that is brought about by the relatively lower debt cost. When the marginal cost
of debt is equal to the marginal cost of equity, the optimum capital structure with the least
capital cost emerges. Therefore, reasonably arrange the debt ratio in the capital structure
can greatly decrease the WACC, thus increase the value of the corporation.

2.2 From the perspective of the benefit on financial leverage Due to the often costant debt
interest, the fixed interest that is born by every pound profit will decrease correspondingly
when the earnings before tax and interest (EBIT) increase, which will finally increase the
profit after tax (Luoma, G. A. & Spiller, E. A. 2002). Therefore, reasonably make use of the
debt capital within a limit can bring about the function of financial leverage, which will bring
the benefit on financial leverage to the shareholders and increase the corporation value.

2.3 From the perspective of tax shield returns

While the classic MM theory holds the view that capital structure has no relationship with
the corporation value, the tax MM theory lay an emphasis on the tax shield returns form
debt. Due to the debt interest can be paid before tax, the debt can bring about the tax
shield returns. Therefore, in the management of capital structure, a higher debt ratio can
create more value for the corporation.

2.4 From the perspective of the costs that are brought about by debt financing Although
the MM theory had taken account for various benefits that can be brought about by the
debt, it had ignored the costs. The trade-off theory had considerated these defects (Frank,
M. Z. & Goyal, V. K. 2007). The increasing debt ratio in the capital structure brings about
various costs including the financial risks, bankruptcy cost and agency cost etc. Therefore,
the constant increase of debt ratio will not elevate the corporation value all the way. When
the anticipated maiginal benefits of debt is equal to its anticipated marginal costs, the
optimum capital structure emerges.

2.5 From the perspective of corporate governance

In the changing process of the corporation’s capital structure, with the transfer of the
capital, there exists the change of rights and obligations. As the respective stakeholders
are sure to define the use of capital, the allocation of yields, the control and other related
rights and obligations relationships, the choice of capital structure in these processes will
influence the corporate governance from various ways.

First, due to the voting right of ordinary shares instead of the debt, the capital structure will
necessarily affect the allocation of control rights so as to affect the value of the
corporation. The stand out function is the hard constraint of debt financing, which will
improve the governance structure and decrease the agency cost. In addition, it will
contribute to the improvement of corporate performance through the pressure of
repayment of principle and interest as well as going into administration.

Second, a reasonable capital structure and equity structure will encourage the managers
to act for the maximization of shareholders’ interests instead of a series of extravagant and
wastful behaviour. The stock proportion of the first shareholder, ownership restriction
proportion and other factors also exert effects on the internal governance of the
corporation so as to influence the corporation performance. The checks and balances
between the small, middle shareholders and the major shareholders can better the
corporation governance.

In addition, the capital structure can affect the effort level and choice of behavior of the
managers so as to affect the market value of the corporation. The appropriate injection of
the convertible bonds and some other derivatives will optimize the financing varieties,
which indirectly improve the corporation value.

In general, the selection of an optimum capital structure and the effectively management of
it will make a corporation operate more efficient and finally improve the corporation value,
which contribute to the accomplishment of the objective of maximising the wealth of
business organizations.

3.0 The influencing factors of capital structure

First, a Corporation with better stability and higher growth rate can bear more fixed
financial expense. Therefore, it can adopt the capital structure with a higher debt ratio,
which will enhance the EPS.

Second, a corporation with better financial state and higher credit rating is easier to obtain
the debt capital, thus usually possess higher asset-liability ratio.

Third, the different asset structure will influence the selection of capital structure. A
corporation with large amounts of fixed assets mainly raise funds through long-term
liabilities and issuing shares, while the one which possesses large amounts of current
assets often depends on current liabilities to raise funds (Kjellman, A. & Hansen, S. 1995).

Fourth, the attitudes of the shareholders and managers will affect the selection of capital
structure. From the perspective of shareholders, a corporation with the isolated share
structure may raise funds more through equity to distribute the risk, while the one which is
controlled by minority shareholder often avoid raising funds through common stocks for it
will dilute stock. From the perspective of the managers, a moderate manager prefer to
choose the capital structure with a lower debt ratio.

Fifth, the macroeconomic factors, industrial feature and enterprise development cycle also
affect the capital structure. A corporation that belonged to a mature industry can increase
the proportion of debts, while the high and new enterprises should decrease it. The higher
income tax rate will encourage the corporation to make full use of the tax shield returns of
debts to increase the corporation value. In addition, the monetary policy, the inflation rate
and other macroeconomic factors will affect the capital structure.

4.0 The effective management of capital structure to increase corporation value Through
the analysis of the ways that capital structure affects the corporation value and the
influencing factors of capital structure, the optimization of capital structure can be carried
on according to these ideas (Philosophov, L. V. & Philosophov, V. L. 1999).

The macroeconomic approaches contain the optimization of equity structure, the

regulation of dividend distribution system and behavior supervision in the listed
corporations etc. The microeconomic approaches contain the improvement of corporation
governance structure, a better recognition and acknowledgement of macroeconomic
policy, industrial feature (Talmor, E 1984).

In general, the importance of effectively management of capital structure for the

improvement of corporation value is undoubted. A corporation should treat its own capital
structure from a dynamic angle and select the optimum capital structure and financing
decisions to maximize the corporation value.

5.0 The problems of agency theory

The agency theory is the main content of contract theory, which focus on the research of
agent relationship. In the contemporary society, the clients seek for the maximization of
their own wealth, while the agents seek for maximization of payments, luxuries and leisure.
Due to the different utility function between the client and the agent, there inevitably exists
the conflicts between them. Therefore, the problems that are existed in the agency
relationship emerged (Arnold, B. & Lange, P. D. 2004).

5.1 Moral hazard problem

Due to the information asymmetry after the agreement of agency relationship, which
means one side of the relationship is difficult to supervise the behavior and acquire
information of the other side, the information superiority side make use of its advantage to
infringe the interests of the information inferiority side. Therefore, the moral hazard
problem emerged, which includes both the problems of the client and the agent.
The most common moral hazard problem is from the agent, which has the private
information and is more familiar with the projects. While the client can only observe the
results, which is isolated form the behavioral process of the agent and the state of nature
itself. Therefore, the agent can adopt a series of actions to maximize his own benefits
while harm the interests of the client.

While the client can observe the production results and pay the agent according to this,
many agency relations have subjective randomness for the measurement of it. Therefore,
the client sometimes deliberately underestimate the outputs and decrease the payment for
the agent for he can not verify the observed results. The moral hazard problem from the
client emerges.

5.2 Adverse selection problem

While the moral hazard problem lay a more emphasis on the ex ante information
asymmetry, the adverse selection problem focus on the ex post of it. Due to the
maximization of self-interests of the agents, they will harm the interests of the client by
adopting the opportunistic behavior. From the perspective of the client, no matter from the
observation of team outputs or the contribution of each person, the equilibrium is always
the same. Therefore, the unobservability of personal contribution brings about the problem
of “free rider” (Theilen, B. 2003).

The adverse selection of the agents reflects the low efficiency and malfunction of the
market, which will disturb and confuse the selection of the client for it give rise to the
phenomenon of the inferior agents expelling the superior agents.

5.3 The supervision and incentive problems

In fact, under the circumstance of information asymmetry, the acknowledgement extent of
the information of the agents can be selected by the client himself. For an instance,
through employing the supervisor or taking more time and energy, the client can get more
understandings of the information of the agents so as to impove the incentive and
supervison of them. However, the acquirement of information exists costs, thus the client
is faced with the problem of selecting the optimum supervison enforcement.

The above discussed problems which are the results of information asymmetry can all
come down to the agency problem, which is most commonly the infringement of interests
from the agents to the clients. In addition, there also exists the agency problems among
the shareholders, the creditors and other stakeholders. While these problems have
obstructed the function of the agency relationship, the financial management or financial
governance can play an important role in addressing these problems (Johnson, N. B. &
Droege, S. 2004).
6.0 The role of financial management in addressing the agency problems Due to the
agency problems that are existed between the shareholders and the managers as well as
the different layers within the managers, the client should devise a kind of system to
supervise and motivate the agents to work hard so as to fulfil the mission. Therefore, there
should be a management mechanism of mutual constraint and mutual check and balance.
The complete and perfect financial management can bring out this mechanism and better
address the agency relationship and problems, which establish a complete supervison,
incentive and feedback system (Crutchley, C. E. & Jensen, M. R. & Jaherajr, J. S. &
Raymond, J. E. 1999).

6.1 Finanical supervison

A perfect financial supervison system contains the supervison of revenue and expense,
the remuneration and the check and appraisal of financial performance etc, which can be
achieved by the ordinal supervison of general meeting of shareholders, the board of
directors and different layers of managers. In addition, the supervisory role of financial
statements and distribution of dividends can also indirectly address the agency problems
between the shareholders and the creditors.

6.2 Financial incentive and constraint

The substance and rights incentive for the managers and employees can effectively
encourage them to achieve the objective of the corporation, a evident instance is the
incentive from stock option. In addition, stimulating the creditors to participate in
corporation governance can also address the agency problem between them and the
shareholders. On the contrary, the constraint system come from the articles of association,
the supervisory board, the independent directors and the creditors can be combined with
each other to address the moral hazard and adverse selection of the agents.

6.3 Financial feedback

In order to eradicate the adverse influence of information asymmetry, there should be an
Information feedback reporting system which is between the superior managers and the
shareholders. This kind of system can drive the subordinates to accurately and timely
report the financial information, which will also address the agency problems.

In general, keeping a reasonable capital structure and a perfect financial corporation

structure can maintain the normal operation of the corporation and improve the unity of
interests from both the client and the agent.

7.0 Conclusions
In the contemporary financial management, the importance of capital structure for the
corporation wealth is self-evident, it affects the corporation value through various ways
including the capital cost, financial leverage benefits, tax shield returns, bankruptcy and
agency costs and corporation governance etc. Due to a series of microeconomic and
macroeconomic factors that influence the capital structure, how to effectively manage the
capital structure becomes more crucial. In addition, the moral hazard and adverse
selection problems arising from the information asymmetry give rise to the conflicts
between the client and the agent, which can be addressed by an effective and perfect
financial corporation mechanism including the supervison, incentive and constraint, the
feed back system as well as the perfect investment, operating and financing decisions and
management.