Capital Structure and Its Determinants

Harris, M. and A. Raviv (1991) in their paper "The Theory of Capital Structure" identified four categories of factors that are responsible for determination of capital structure of a firm. These factors or as they put it "desires" are

• ameliorate conflicts of interest among various groups with claims to  the firm's resources,  including managers (the agency approach), 
• convey private  information  to capital markets or mitigate adverse selection effects  (the asymmetric  information approach), 
• influence  the  nature  of  products  or  competition  in  the  product/input market, or 
• affect the outcome of corporate control contests. 

The theories that it is to "ameliorate conflict of interest" and "affect the outcome of corporate control contests" have nothing to do with the basic purpose of the firm - to create value for stakeholders - and in all probability, these are satanic designs that ruin the firm in the end. If all the stakeholders are working according to the well defined norms of justice and fair play than why there is conflict of interest? The theory of Capital Structure to avoid agency costs that Jensen and Meckling identified lead the managers on the path of destruction since the managers are given incentives such as based on EVA etc. and managers when faced with -ve results try to manipulate the earnings in order to achieve the target and earn incentives, the examples are "Enron", "Worldcom", etc. Debt provides incentive to engage in suboptimal investment because  in debt  contract  there is an implicit provision  that  if  an  investment  yields  large returns, well  above  the face value of the debt, equityholders capture most of the  gain.  If,  however,  the  investment  fails,  because  of  limited  liability, debtholders  bear  the  consequences in case liquidation is insufficient to cover the entire amount of debt. So clever managers who would like to hold on to power would go for the higher debt equity ratio and this is the strategy that comes to mind immediately there is any threat of take over. But that is a dangerous path to move on because debt has to be paid at some fixed time in future and that future is highly uncertain. Uncertainty coupled with fixed nature of debt commitment puts the managers under pressure for results and that is where the best laid out plans fall apart and lead the managers to play games.

The theory that capital structure decison is to convey inside / private information to market means it is used / can be used as a deception. Why can't we convey inside information in a straight forward manner without taking any steps that can lead the firm on the road to destruction? If the answer is no, then something is wrong that is being dragged under the rug. Information asymmetry between insiders and outsiders cause different value for the firms' assets and that may result in financing a new project / investment opportunity by existing owners / managers with debt if internal fund are insufficient - pecking order theory of capital structure. This pecking order begins when outsiders have some serious doubts about the information not available to them and that makes them suspicious. The question is why such asymmetry of information in the first place? Market, it seems always thinks of the information asymmetry that is why  "Noe shows that the average quality of  firms  issuing  debt  is  higher  in  equilibrium  than  that  of  firms  issuing equity.  Therefore,  like Myers-Majluf,  Noe's model  predicts  a  negative  stock market response to an announcement of an equity issue. Noe  also predicts a positive  market  response  to  an  announcement  of  a  debt  issue." There is always mistrust of managers by the market about firm's inside information. Why can't insiders speak the truth? Or why can't market take the words of insiders to be true on its face value unless otherwise proved? Is there lack of trust or lack of reputation? Because of lack of trust and distortion of communication between management and market, the market tends to heavily tilted towards the debt, which promises a fixed return irrespective of any reference to profit / (loss) - a figure that is highly questionable from the point of view of the outsiders for numbers of reasons but mainly on account of asymmetry of information. 

Leverage changes the behavior of the firm and its strategy because a levered firm assumes a sure commitment of periodic fixed payment to debtholders to remain in business. In the face of debt, it is very difficult to sustain high quality. Because quality can only be achieved through truth - speaking truth about its systems, products, people and speaking truth to its suppliers, customers, but when a firm has a debt to pay its ability to speak truth is highly undermined. This is even more true in case of an adverse forecast or less than expected results then the deviations from the straight path take start. All information asymmetries, conflicts of interests, contests for control of firm and competitive strategies move in different directions than the relevant theoretical models predict. 

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.

Halal Phenamenon

Here is an excerpt from an article on "Halal Branding"

THE world is slowly but surely realising the importance of the "halal" branding as major companies around the world move in to capture a global Muslim community, where the "ummah" brings together nearly 1.8 billion people around the world.

The majority of those people are in Asia, particularly South and East Asia. It's also a very young demographic - 52% are under 24. This means a trend-setting, ambitious, and internationally connected market is at hand here.

"Halal" according to Islam is very different than it is being projected as "the authenticity and cleanliness of the product".

"Halal (Arabic:حلال, ḥalāl; means lawful or legal) is a term designating any object or an action which is permissible to use or engage in, according to Islamic law."

We, the Muslims have no concern with anything other than it is permitted by Allah (SWT) or not. There is no such thing as "clean" or "Authentic" in any other sense. Any thing can be clean and authentic but if not permitted by Allah (SWT), it is not Halal.

He hath only forbidden you ...............................and that on which any other name hath been invoked besides that of Allah (Aya 173 of Sura Al-Baqara)

Behavioral Traps

Behavior means actions or reactions of a person or animal in response to external or internal stimuli. It is the mind that sends signal to different parts of the body to act or react to any exteral or internal reason for such an action. Normatively speaking everybody is rational unless otherwise proved. By being rational, we tend to behave rationally, means behaving logically, based on reason. That is where the danger lies.

Our minds set up many traps for us. Unless we're aware of them, these traps can seriously hinder our ability to think rationally, leading us to bad reasoning and making stupid decisions. Features of our minds that are meant to help us may, eventually, get us into trouble.

Here is a list of 10 such traps.

1. The Anchoring Trap: Over-Relying on First Thoughts - Your starting point can heavily bias your thinking: initial impressions, ideas, estimates or data "anchor" subsequent thoughts.
2. The Status Quo Trap: Keeping on Keeping On - We tend to repeat established behaviors, unless we are given the right incentives to entice us to change them. The status quo automatically has an advantage over every other alternative.
3. The Sunk Cost Trap: Protecting Earlier Choices - You pre-ordered a non-refundable ticket to a basketball game. On the night of the game, you're tired and there's a blizzard raging outside. You regret the fact that you bought the ticket because, frankly, you would prefer to stay at home, light up your fireplace and comfortably watch the game on TV. What would you do?

It may be hard to admit, but staying at home is the best choice here. The money for the ticket is already gone regardless of the alternative you choose: it's a sunk cost, and it shouldn't influence your decision.

4. The Confirmation Trap: Seeing What You Want to See - You feel the stock market will be going down and that now may be a good time to sell your stock. Just to be reassured of your hunch, you call a friend that has just sold all her stock to find out her reasons.

Congratulations, you have just fallen into the Confirmation Trap: looking for information that will most likely support your initial point of view - while conveniently avoiding information that challenges it.

This confirmation bias affects not only where you go to collect evidence, but also how you interpret the data: we are much less critical of arguments that support our initial ideas and much more resistant to arguments against them.

No matter how neutral we think we are when first tackling a decision, our brains always decide - intuitively - on an alternative right away, making us subject to this trap virtually at all times.

5. The Incomplete Information Trap: Review Your Assumptions - We keep mental images - simplifications of reality - that make we jump to conclusions before questioning assumptions or checking whether we have enough information.
6. The Conformity Trap: Everybody Else is Doing It - This "herd instinct" exists - to different degrees - in all of us. Even if we hate to admit it, other people's actions do heavily influence ours. We fear looking dumb: failing along with many people is frequently not considered a big deal, but when we fail alone we must take all the heat ourselves. There's always peer pressure to adopt the behaviors of the groups we're in.

7. The Illusion of Control Trap: Shooting in the Dark - Even in situations we clearly can't control, we still tend to irrationally believe that we can somehow influence results. We just love to feel in control.

8. The Coincidence Trap: We Suck at Probabilities - This means that the "miracle" is not only possible but - given enough attempts - its likelihood increases to a point of becoming almost inevitable.

9. The Recall Trap: Not All Memories Are Created Equal - What happens is we analyze information based on experience, on what we can remember from it. Because of that, we're overly influenced by events that stand out from others, such as those with highly dramatic impact or very recent ones. The more "special" an event is, the greater the potential to distort our thinking.

10. The Superiority Trap: The Average is Above Average - With few exceptions, people have much inflated views of themselves. They overestimate their skills and capabilities, leading to many errors in judgment.