Capital Structure Decision and Firm Value

According to famous MM proposition I, value of the firm is independent of its capital structure - firm value is invariant to its financial structure. They proved this proposition mathematically. Intuitively this proposition hold value. Valuation of a firm is a function of its expected earnings over time capitalized at an appropriate rate for its given risk class. Critics, however, are ready to point out that value of the firm can be increased by taking tax advantage of debt, which has been rejected by the MM by going over the investors' side and taking help from personal Income Tax. The value maximization criticism can't be overruled as a firm's net after tax cash inflow to firm increase with the addition of debt in the capital structure. 

Inherent in the discussion on capital structure decision is that EBIT of a firm is independent of its financing structure. Expected earnings are a function of assets' earning capacity and its productivity and this has nothing to do with how the assets are financed. But "DEBT is as powerful a drug as alcohol and nicotine. In boom times Western consumers used it to enhance their lifestyles,companies borrowed to expand their businesses and investors employed debt to enhance their returns." Can we say that inclusion of debt in capital structure is synonymous to introduction to a healthy person "drug and alcohol"? In the words of Hyman Minsky, an American economist "these debt crises were both inherent in the capitalist system and cyclical. Prosperous times encourage individuals and companies to take on more risk, meaning more debt. Initially such speculation is successful and encourages others to follow suit; eventually credit is extended to those who will be able to repay the debt only if asset prices keep rising (a succinct description of the subprime-lending boom). In the end the pyramid collapses." 

The problem with debt is that it needs to repay it. That is where the problem starts. The need to repay something in future and future is a t the very best is a mere guess - uncertain. This compulsory payment in future coupled with uncertainty about future is the root cause of the problem that needs to be probed into and analysed thoroughly. A firm which has future obligations for payment must meet the minimum necessary to honor its commitments. In the words of Merton H. Miller "The firm pays  its debts not just  because the  law says it must, but because the value of  the stock to  its shareholders is  greater  to  them  if  the  firm  pays  the  debts  than  if  it  doesn't." So  to remain on the same level of value before inclusion of debt in the capital structure, a firm has to honor its commitment to pay the debt obligation and has to earn a minimum to honor that commitment. This compulsory or mandatory nature of target puts some kind of an extra pressure on the levered firm as compared to unlevered firm. Because of that extra pressure, the EBIT of a levered firm may be different than an unlevered firm keeping everything else same.

Too Big To Fail is a New Way to Fraud

Here is a reproduction of a blog entry that shows the ugly face of capitalism.

As prospects before BP get darker by the day, and the likelihood of bankruptcy grows, the TBTF propaganda begins. Evidence A - Bloomberg headline: "BP Demise Would Threaten U.S. Energy Security, Industry." Just as the failure of bankrupt banks was supposed to lead to the destruction of capitalism, so the bankruptcy of BP plc is now supposed to lead to the degeneration of US energy independence. And who in their mind would force the Chapter 11 of a systemically important company? Once again, free market capitalism is about to walk out through the back door...

So now that we know BP is the new AIG, and the new media campaign is to paint it as this year's TBTF, the only question we need to ask is how many billions in CDS has Goldman sold that reference the BP, and/or how many billions in counterparty risk the firm has outstanding with BP? Surely the answer is "lots", and a simple and elegant solution that would prevent the domino effect that bring take down Goldman and its peers, is the taxpayer funded bailout of the energy giant, which has quietly morphed into another too big to fail company. The opportunity cost, of course, is a ten million march of all soon to be terminally unemployed, and very agnry, gulf workers headed toward D.C. and 200 West.

Deficit Terrorists

The financial sector, which controls the money supply and can easily capture the media, cajoles the populace into compliance by selling its agenda as a “balanced budget,” “fiscal responsibility,” and saving future generations from a massive debt burden by suffering austerity measures now. Bill Mitchell, Professor of Economics at the University of New Castle in Australia, calls this “deficit terrorism.” Bank-created debt becomes more important than schools, medical care or infrastructure. Rather than “providing for the general welfare,” the purpose of government becomes to maintain the value of the investments of the government’s creditors.

England’s new coalition government has just bought into this agenda, imposing on itself the sort of fiscal austerity that the International Monetary Fund (IMF) has long imposed on Third World countries, and has more recently imposed on European countries, including Latvia, Iceland, Ireland and Greece. Where those countries were forced into compliance by their creditors, however, England has tightened the screws voluntarily, having succumbed to the argument that it must pay down its debts to maintain the market for its bonds.

Deficit hawks point ominously to Greece, which has been virtually squeezed out of the private bond market because nobody wants its bonds. Greece has been forced to borrow from the IMF and the European Monetary Union (EMU), which have imposed draconian austerity measures as conditions for the loans.

DEFICIT TERRORISTS STRIKE IN THE UK - USA NEXT?

Balancing Task-Focus with Goal-Focus

"So establish weight with justice and fall not short in the balance." Aya 9 of Sura Ar-Rahman


Recent psychological research suggests one of the keys to getting big projects done is balancing up individual tasks against the grand vision. It's all about knowing when to flip the frame of reference from looking closely at the details of individual components of a project, and when to look up and see the project's grand sweep.


How we react to failure along the way is a clear predictor of ultimate success (or otherwise). That's why Houser-Marko & Sheldon (2008) set up an experiment to see how people reacted to failure depending on whether they were thinking about the individual task or their overall goal.


What they found was that being told they were doing badly made participants feel bad and lowered their motivation. No surprise there. But what they were really interested in was whether their level of focus - either on the individual task or the overall goal - affected their motivation. They found that it did: those told they were doing badly but only on the specific task didn't feel as bad, and didn't expect to do so badly in the future, as those who were focusing on their primary goal. So it seems that when doing badly on a task it's better to keep focusing on the individual task rather than start contemplating the ultimate goal.

Here's what the research means in practical terms:

• To stick to a task, while carrying it out, keep the ultimate goal in mind. Self-control is increased by global processing, abstract thinking and high-level categorisation. Taking the first step on the long road to your goal may require a greater focus on the destination.
• When evaluating progress on hard tasks when the chance of failure is high, stay task-focused. At the start of your journey, when evaluating progress, it's often better to focus on the individual steps. Comparing recent failure with the ultimate goal destroys motivation - instead narrow focus to succeeding on the individual task.
• Once tasks are easier or the end is in sight, a goal focus is once again the psychological approach to choose. It increases positive emotion, decreases negative emotion and increases perceived performance.

Think of it like a 100 hundred metres runner. Moments before the race they look off into the distance, in the general direction of the finish line. Moments after the starting gun fires they stare down at the ground and their feet. Smoothly the head comes up, then, towards the end of the race, they have just one focus: the line.

Only most projects take a little longer than 9.69 seconds.