CAPITAL STRUCTURE

Modigliani and Miller

Modigliani and Miller stated that in a perfect capital market with no taxes, a
companys capital structure would have no effect on its WACC.
As the level of gearing increases, the cost of equity rises at a rate that exactly
cancels out the effect of cheaper debt. This combines to keep the WACC constant.
The effect of Tax
Modigliani and Miller modified their assumption of no tax and admitted that tax
relief on interest payment does lower the WACC. The tax savings arising are the tax
shield and this enables the WACC to fall up to a gearing of 100%. This suggests that
companies should have a capital structure made up entirely of debt. This does not
happen in practice due to the existence of market imperfections such as bankruptcy
risk and agency costs, which undermine the tax advantages at high levels of
gearing.
Pecking order theory
Pecking order theory has been developed as an alternative to traditional theory. It
states that firms will prefer retained earnings to any other sources of finance, and
then will chose debt and last of all equity.
Companies may therefore choose not to seek to minimize their WACC.
GOAL CONGRUENCE
Managerial reward schemes (performance related pay & share option scheme)
Problem: difficult to find an aspect of corporate performance which is not influenced
by action of director, leading the director to manipulate the result for their own
benefits. E.g. focus short term
Problem: General decrease in SP lead director reward for poor performance, vice
versa
Regulatory requirements (Corporate governance)
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Corporate governance codes of best practice and stock market listing

regulations
Seek to reduce corporate risk and increase corporate accountability
Responsibility is placed on directors to identify, assess and manage risk
within an organization
Non-executive directors to BOD, remuneration committees and audit
committees.

MARKET EFFICIENCY
Weak form
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Share prices fully and fairly reflect past information

Investor cannot generate abnormal returns by analyzing past information,

such as share price movements in previous time periods, in such a market,
since research shows that there is no correlation between share price
movements in successive periods of time. Share price appear to follow
random walk by responding to new information as it becomes available

Semi-strong form
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Share price fully and fairly reflect public information as well as pat
information
Investors cannot generate abnormal returns by analyzing either public
information, such as published company reports, or past information, since
research shows that share prices respond quickly and accurately to new
information as it becomes publicly available

Strong form
-

Share prices fully and fairly reflect not only public information and past
information, but private information as well
Even investors with access to insider information cannot generate abnormal
returns in such a market
Testing for strong form efficiency is indirect in nature, examining for example
the performance of expert analysts such as fund managers. Stock markets
are not held to be strong form efficient.

RISK & UNCERTAINTY

Risk
Probabilities can be assigned to a range of expected outcomes arising from an
investment project and the likelihood of each outcome occurring can therefore be
quantified.
Probability analysis refers to the assessment of the separate probabilities of several
specified outcomes of an investment project.
For example, outcomes from a range of expected market condition can be
formulated and the probability of each market condition arising in the future can be
assessed. The net present values arising from combinations of future economic
conditions can then be assessed and linked to the joint probabilities of those
combination.
The expected net present value can be calculated, together with the probability of
the worst-case scenario and the probability of a negative net present value. In this
way, the downside risk of the investment can be determined and incorporated into
the investment decisions
Uncertainty

Refer to the situation where probabilities cannot be assigned to expected outcomes.

Sensitivity analysis assesses how the net present value of an investment project is
affected by changes in project variables. Considering each project variable in turn,
the change in the variable required to make the net present value zero is
determined.