Effective Financial Management, Essay Example

As one of the main theories of capital structure, the static theory is pretty straight forward, and could certainly be applicable in the case study of a firm that manufactures tennis racquets that desires to take full advantage of its growth potential. This company wants to determine an ideal mix of stocks and bonds in order to obtain the needed funding for an expansion, which is precisely what the static theory of capital structure can accomplish.

Variables in applying the static theory of capital structure: There are different ways to describe the theory, but in simple terms the static theory of capital structure “asserts that there is an optimum mix of debt and equity that minimizes the firm’s overall costs of capital (Sheehan, 2001.)” The primary variables are the inter-relationship that defines the balance between the costs and benefits of borrowing. Potential tax advantages could be represented as a specific tax credit that would be provided as a result of borrowing. such as that generated by creation of a tax shield. Both are powerful financial tools, and the static theory is based on the assumption that there is a desired balance to strike between the two variables that will produce the greatest success and most leverage for the company and its shareholders. The costs of borrowing would be represented by the expense and negative impact that comes with borrowing, such as large adjustment costs and interest that is applied. The benefits of borrowing would be represented by the upside, where there is potential for profitability as long as the company borrows to an optimum level. Variables considered include value of the firm, total debt of the firm. financial distress costs, and the value of tax shield on the debt. Possible costs include debt to expand, loss of business or possible cost of bankruptcy. Among the primary elements or variable costs that could affect the condition of financial distress include the auditor’s fees, management fees as well as the legal fees that are included in the bonds that businesses are often invested in. Relatively though, there are still other fees that could greatly affect the static condition of finances in the market. In this case, it could be assumed that the emergence of financial distress is still possible even when particular possibilities of bankruptcy have already been avoided.

Steps to determine optimal capital structure: The general steps used to determine the optimal capital structure for our successful tennis racquet manufacturer requires a methodological approach. One article relates this process as one of testing through modeling, where steps are taken within a scenario to compare and contrast the benefits versus the costs of borrowing. The value of borrowing costs is measured, along with the value of borrowing benefits, and a ratio is achieved that would indicate a specific monetary value that results from a combination of these two primary variables. Through the modeling process this procedure is repeated by altering one of the both of the borrowing costs and borrowing benefit variables, and this is accomplished by either swapping debt for equity, equity for debt, or both. This process may continue to be repeated many times, and results are compared between all of the different individual models until one is proven or disproven to be optimal (Myers, 1984). While determining optimum debt ratio, it may also be wise to consider other potential influencers. In terms of basic parameters, initial steps should include comparing the value of the firm to the amount of debt. Comparisons must also be made between the average costs of capital versus the average costs of debt and equity. You must also determine which of three essential cases a specific, given situation entails. In one case, the value of the firm is unaffected by capital structures. In another case, the value of the firm increases while the cost of capital decreases as additional debt increases. In the third case, an optimal amount of value is achieved when debt reaches an optimal level.

An article cites three general factors that influence the optimal capital structure. These influencers are defined as macroeconomic factors, industry factors, and company specific factors. These influencers collectively contribute such considerations as government regulation, corporate culture, and whether or not an industry is growing or contracting (Sheehan, 2001). Understandably, given that the classical tax system principle is followed, the effect of taxes and risky debt on the condition of the investment and capital that a business possesses specifically dictates the capacity of the investment to earn further profit from the market. For instance, the emergence of manager’s fees and legal fees directly affect the capacity of an investment to earn; in contrast to this, the current rate of debt that the business has in its record will intend to balance such equity.

Debt to Equity Ratio: The relationship that will exist at the optimal debt-to-equity ratio for our tennis racquet manufacturing firm can be measured. According to one assessment, most firms work diligently to create a target debt ratio and strive to achieve it, and that these debt targets change over time to adjust to changing industry and market patterns. Industry itself seems to be a major influence on debt ratios, and therefore should be monitored for changes (Sunder and Myers, 1998). Another article describes that optimal debt-to-equity ratio is “determined by a tradeoff of the costs and benefits of borrowing, holding the firm’s assets and investment plans constant (Myers, 1984).” The debt to equity ratio amounts to a financial measurement where liabilities, such as long term debt, is divided into the equity of the company. There are specific costs to borrowing, such as potential for high costs of adjustment, servicing of the company debt, and reputation among other considerations. The benefits of borrowing can be defined through maintaining improved liquidity, the potential for tax advantages and a potential for low costs of adjustment (Myers, 1984). These costs and benefits collectively can be evaluated through methods such as modeling to achieve a ratio of benefits and costs. This will determine the debt-to-equity ratio. It is important to note that costs and benefits of borrowing is based in large part on which of three essential cases the model follows. Either the value of the firm is unaffected by capital structures, the value of the firm increases while the cost of capital decreases as additional debt increases, an optimal amount of value is achieved when debt reaches an optimal level. This will influence the costs and benefits of borrowing in a given situation.

Pertaining to the condition of equity between the cost and benefit between debt and fees when investing, it is evident that the said variables coexist to affect the overall performance of the business and the supporting investment that instantiates its market valuation. For instance, in relation to the raising of capital value, the managerial fees and legal fees may increase as well which initiates a rise on the debt rate of a business or an individual investor. In relation to this, the need to take advantage of over-valuation in the market becomes necessary. In doing so, investors will begin to give lower value to the new equity price of the invested stock that belongs to the organization. Once such approach is applied, balancing the debt with the capital becomes possible hence defining the benefits of the said transactions towards the development of the organization in terms of financial stability.

References

Myers, S. C. (1984). Capital Structure Puzzle. The National Bureau of Economic Research. Retrieved from http://www.nber.org/papers/w1393

Sheehan, R. J. (2001). Capital Structure Choice and the New High-Tech Firm. Proceedings of the Academy of Economics and Finance. Retrieved from http://csb.uncw.edu/people/edgraham/docs/Published%20Files/Investments/FinalProceedingsCopy.pdf

Sunder, L. S. and Myers, S. C. (1998, July 9). Testing static tradeoff against pecking order models of capital structure. Journal of Financial Economics. Retrieved from http://pages.stern.nyu.edu/~eofek/PhD/papers/SM_Testing_JFE.pdf