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.

Change is about changing behaviors

Rosabeth Moss Kanter rightly says " culture is the hardest thing to change, whether ethics in the financial system or the eating habits of individuals. That's because change is not a decision like appointing a new CEO, nor is it an event like winning an election. Change is an ongoing campaign." She argued for five elements than can bring change but the last one is relevant to our subject i-e bringing a change in behaviors.

It is " like marketing campaigns that require point of sale support, successful behavior change campaigns need to place reminders at the point of action - the moment of truth when behavior is set in motion." This constant reminder theory is also mentioned by Richard H. Thaler and Cass R. Sunstein

The Wall Street Journal reports on another study showing that reminding (some call it nagging) has its virtues - this time for exercising. As part of the study, one group of people received a weekly phone call from a human asking them how much exercise they'd gotten that week and congratulating them if they had met a personal goal. Another group got a similar call from an automated system. A third group got no call.

After 12 months, participants receiving calls from a live person were exercising, as a mean, about 178 minutes a week, above government recommendations for 150 minutes a week. That represented a 78% jump from about 100 minutes a week at the start of the study. Exercise levels for the group receiving computerized calls doubled to 157 minutes a week. A control group of participants, who received no phone calls, exercised 118 minutes a week, up 28% from the study's start. "When you knew you were going to have to report back on what you had done, it motivated you," says Ms. Lowe.