Financial management Assignment May 2015 (APC 308)

Banking Academy, Vietnam
ASSIGNMENT COVER SHEET
UNIVERSITY OF SUNDERLAND
BA (HONS) BANKING AND FINANCE

Student ID: 149080615/1
Student Name: Tran Quyet Thang
Module Code: APC 308
Module Name / Title: Financial Management
Centre/ /College:
College: Banking
Academy
of Viet
Nam Nam
Centre
Banking
Academy
of Viet

Due Date: 15 May 2015

Hand in Date: 15 May 2015

Assignment Title: Individual assignment

Students Signature: (you must sign this declaring that it is all your own work and all sources
of information have been referenced)

Financial Management (APC 308) – May 2015

Title page

Financial Management
APC 308

Banking Academy, Vietnam
Submitted on 15 May, 2015
Prepared by: Quyet Thang Tran
Student ID: 149080615/1

Financial Management (APC 308) – May 2015

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Table of Contents
Title page ......................................................................................................................................... i
Part A: Academic research has provided mixed and conflicting evidence as to whether an optimal
capital structure exists for individual companies and businesses. Demonstrating knowledge and
understanding of the differing theoretical viewpoints associated with the concept of capital
structure, and drawing upon relevant empirical research within this field, critically analyze and
evaluate whether an optimal capital structure does exist. ............................................................... 1
1. Traditional view ................................................................................................................... 1
2. Miller and Modigliani’s theory (MM) ................................................................................. 2
MM (I): The net income approach .......................................................................................... 2
3. Pecking-order theory............................................................................................................ 4
Part B: The concept of market efficiency can be defined using three differing strengths; weak form,
semi strong form, and strong form. Critically evaluate and analyze the three differing strengths of
market efficiency, ensuring the response draws upon relevant empirical research within this field
of study............................................................................................................................................ 5

1. Weak-form ........................................................................................................................... 6
2. Semi-strong form ................................................................................................................. 7
3. Strong form .......................................................................................................................... 8
References ..................................................................................................................................... 10
Appendixes ................................................................................................................................... 14

Financial Management (APC 308) – May 2015


Part A:

Academic research has provided mixed and conflicting evidence as to whether an

optimal capital structure exists for individual companies and businesses. Demonstrating
knowledge and understanding of the differing theoretical viewpoints associated with the concept
of capital structure, and drawing upon relevant empirical research within this field, critically
analyze and evaluate whether an optimal capital structure does exist.
Capital has an important role for the businesses in investing and operating. Capital refers to the
firm’s sources of long-term financing (Brealey, et al., 2011). An appropriate capital structure is an
important decision for any business by the need to maximize the benefits obtained from individuals
and organizations related to the operations of the business. Moreover, this decision also impacts
to the capability of enterprises in the competitive environment. The capital structure refers to the
way businesses looking for financing decisions through a combination of debt and equity. By
deciding the distribution of different sources of funds, the businesses try to minimize their cost of
capital and maximize the shares’ price to benefit the shareholders’ wealth as much as possible.
This is refer to as optimal capital structure. There are different theoretical viewpoints about the
existence of optimal structure.

1. Traditional view
The traditional view theory will be shown in the figure below:

Figure 1: Traditional view of capital structure

(Watson & Head, 2013)
KE: cost of equity
KD: cost of debt

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It can be seen in Figure 1 that when the level of gearing increases, it also leads the cost of equity
KE to increase while the cost of debt is stable and WACC goes down. It means that by increasing
the ratio of debt, businesses can enjoy cheaper cost of capital. In this figure 1, WACC curve has
U shape. It means that the lowest point (X) indicates the optimal capital structure. However, when
level of debt increases, the shareholders have to face to higher risk of financial, it causes cost of
equity increases. At the point that level of gearing become very high, KE curve rises steeply due
to threat of bankruptcy. This theory is based on some assumptions such as no taxes, no transaction
cost, earnings are paid as dividend (Appendix 1).
Based on the traditional view, there is an optimal capital structure. With high level of debt,
companies may fail to complete the obligations to pay back and then go to bankruptcy. A research
finds that a high-levered firm can engage actions that are harmful to their shareholders and find
difficult to get more external finance and may find it more costly to efficiently carry out its dayby-day business (Rocca, et al., 2008). Moreover, a research paper about impact of capital structure
on Bangladesh firm’s value shows that maximizing the wealth of shareholders requires a perfect
combination of debt and equity, and cost of capital has to be as minimum as possible (Chowdhury
& Chowdhury, 2010). However, the contention of the traditional theory, that moderate amount of
debt in ‘sound’ firms does not really add very much to the ‘riskiness’ of the shares, is not defensible
(Pandey, 2009). Furthermore, Marimuthu (2009) concludes that the traditional view has been
greatly devastated by the ‘modern practitioners’. In addition, in the traditional view, risk pricing

is inefficient; investors do not always have information and/or time needed to closely monitor
changes in the level of debt relative to equity (Grant, 2003).

2. Miller and Modigliani’s theory (MM)
MM (I): The net income approach
By assuming a perfect capital market without taxes, no transaction costs and individual investors
can borrow money at the same rate as companies, Miller and Modigliani argued that the market
value of a company depends on its expected performance and commercial risk: the market value
of a company and its cost of capital are independent of its capital structure (Watson & Head, 2013).
To support the argument, Miller and Modigliani used arbitrage theory. As investors exploit these
arbitrage opportunities, the value of the overpriced shares will fall and that of the underpriced share
will rise, thereby tending to eliminate the discrepancy between the market values of the firms

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(Modigliani & Miller, 1958). Moreover, because the market value of companies and its cost of
capital are independent of its capital structure, there is an equation:
rwacc = We*Ke + Wd*Kd
 rwacc = D/(D+E) * Kd + E/(D+E) * Ke
 Ke = rwacc + D/E (rwacc –Kd)
Because rwacc and Kd are unchanged, Ke will increase if D/E increase. It means that when
companies increase their debt, shareholders will face higher of risk. Therefore, they will require
higher ROE or the cost of equity will go up. The figure below will illustrate this issue.

Figure 2: Miller and Modigliani (I): the net income approach

Through the figure 2, it can be seen that WACC curve is a straight line. It means that based on the

MM (I): the net income approach, there is no optimal capital structure.
MM (II): Corporate tax

Figure 3: Miller and Modigliani (II): corporate tax

(Watson & Head, 2013)

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In the second paper, these two researchers mentioned about the advantages of taxes. By taking
taxes, companies can take debt with cheaper cost because the interest is tax deductible. This is
called tax shield. It means that higher level of debt is, lower WACC is. In the figure 3, WACC
curve is going down with high level of debt. It means that companies should take 100% of debt in
order to minimize WACC as much as possible. This means that according to this theory, the
optimal capital structure does exist.
There are some evidences from researches supporting for this theory. By analyzing the relationship
existing between leverage and corporate performance in Nigerian Petroleum Industry, David and
Olorunfemi (2010) find that an increase in leverage ratio leads to increase in earnings per share
and recommend that managers should do much to improve on the leverage ratio. This finding
follows the conclusion of MM (II). On the other hand, the MM (II): corporate tax suggests that
companies should take 100% of debt to benefit from tax shield, it seems to be unrealistic and not
logical. Miller and Modigliani (1963) also reminded readers that the existence of a tax advantage
for debt financing – event the larger advantage of the corrected version – does not necessarily
mean that corporations should all the times seeking to use maximum possible amount of debt in
their capital structures. Furthermore, there are some researches showing the limitations of these
propositions. These limitations includes: 1) it was based on partial equilibrium rather than general
equilibrium analysis, 2) it was not clear whether the theorem held only for competitive markets,

3) except under special circumstances, it was not clear how possibility of firm bankruptcy affected
by the validity of the theorem (Stiglitz, 1969). Moreover, by applying Parameter- Preference
Theory, Becker shows that the valuation of firm and the cost of capital do not require the usual
risk-class or arbitrage assumptions (Becker, 1978). In addition, some tests indicate that neither the
MM tax nor the no-tax valuation equations are accurate predictors of firm value; specifically, the
value of the unlevered firm accounts for much less of firm value than predicted and the sign of the
coefficient of the interest tax shield variable is negative, instead of positive as MM predict
(Fosberg, 2010).

3. Pecking-order theory
In pecking-order theory, management is assumed to know more about the firm's value than
potential investors (Myers & Majluf, 1984). Because of the asymmetric information, the investors
afraid that the value of shares is higher than their market value. Therefore, to solve this problem,

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the firm prefers debt rather than equity. In conclusion, based on this theory, there is no ratio target
between debt and equity to minimize the cost of capital. It means that the pecking order theory go
against the optimal capital structure. There are some empirical evidences that support the pecking
order theory. By using a sample of 629 UK SMEs over five-year period, two researchers find
evidence consistent with a pecking order (Watson & Wilson, 2002). However, there are a lot of
researchers found that firms do not follow this theory. For example, in Chinese, there is no
evidence that capital structure of 407 listed companies follow a pecking order from retained
earnings and debt to equity (Jinlan & Miaomiao, 2008). Furthermore, another research also shows
that the UK, German and French firms do not closely follow the pecking order theory’s prediction
(Dang, 2013). The reasons for these differences may be by the changes in capital market or
business environment because the pecking-order theory was first suggested by Donaldson in 1961

and modified by by Stewart C. Myers and Nicolas Majluf in 1984.
In conclusion, there are two theories which support the existence of an optimal capital structure
including traditional view and MM (II) corporate tax. However these both theories are based on
several assumptions such as no taxes, no transaction costs and a perfect market. Therefore, in
practice, there is no an optimal capital structure for companies to combine debt and equity. The
financial decisions about capital structure of companies should depend on macroeconomic,
microeconomic, industry in order to achieve objective – maximizing shareholders’ wealth.

Part B:

The concept of market efficiency can be defined using three differing strengths; weak

form, semi strong form, and strong form. Critically evaluate and analyze the three differing
strengths of market efficiency, ensuring the response draws upon relevant empirical research
within this field of study.
The efficiency market hypothesis (EMH) state that financial markets make a best use of all
available information in determining a share’s price (Howells & Bain, 2007). Therefore, investors
cannot beat the markets by using current information or the fluctuation of past share prices.
According to Fama (1970), EMH is divided into three levels:


Weak form: the information set is just historical prices



Semi-strong form: the concern is whether prices efficiently adjust to other information that
is obviously publicly available (e.g., announcement of annual earnings)

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

Strong form: the concern is whether given investors or groups have monopolistic access to
any information relevant for price formation.

1. Weak-form
There are a lot of researches in different stock markets are carried out. On the one hand, by
applying the two-regime TAR approach on monthly data over the period 1990:1 to 2009:1, a
research paper shows that Malaysia and Thailand stock market are characterized by a random walk
process, consistent with EMH (MUNIR, et al., 2012). The studies of Milionis and Moschos (2000)
point out that the FTSE 30 share index follows the weak form market efficiency. The major
findings using daily data and a bias-free statistical technique with a sample spanning from
September 1995 to March 2010 support the belief that these equity markets of Brazil, Russia, India
and China (BRIC) may have been approaching a state of being fairly weak-form efficiency
(Mobarek & Fiorante, 2014). For the Israeli, Jordanian and Lebanese markets, composite stock
price indices follow a random walk and so these markets are weak-from efficient (Smith, 2007).
Furthermore, the study of Yuan and Gupta (2014) documents that timing the Chinese Lunar New
Year effect in markets of Hong Kong and Japan does provide incremental wealth for investors,
even after considering transaction costs.
On the other hand, there are some empirical evidences show that the returns on stock market do
not follow the EMH theory. Robinson’s (2005) results suggest that like a number of other emerging
markets, the hypothesis of randomness in stock returns on the Jamaica Stock Exchange (JSE) is
rejected for at least sixty five (65) percent of the stocks listed on the JSE. Mishra (2013) examined
the random walk behavior and efficiency of the Indian equity market and found that the Indian
equity market does not follow random walk behavior. Another study using daily observation over
the span from 3rd July 2007 to 31st December 2011 in India Stock Market also rejects weak form
efficiency of India stock market (JAYAKUMAR, et al., 2012). Kapusuzoglu’s (2013) findings

show that Istanbul Stock Exchange National 100 market is not an efficient market in weak form
by testing daily closing values of the related index during the period from 1996 to 2012.
In addition, by applying two of the simplest and most popular trading rules—moving averages and
trading-range breaks - by utilizing a very long data series, the Dow Jones Industrial Average index
from 1897 to 1986, Brock, Lakonishok, and LeBaron (1992) suggest that technical analysis is
useful for predictability of equity returns from past returns. Metghalchi et al’s (2012) results point

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out that technical trading rules do have predictive power by examining the profitability for 16
European stock markets over the 1990 to 2006 period. Moreover, technical trading rules are all
successful in forecasting stock price movements in Malaysia, Thailand, Indonesia, and the
Philippines, with the TRB having additional predictive ability in Singapore (Yu, et al., 2013).
In summary, there are many empirical studies that support weak-form market efficiency while
others also provide evidences for not supporting stock markets in weak-form efficiency. The
reasons for these differences may be the methods or models that researches use to test the
efficiency of stock markets.

2. Semi-strong form
To investigate semi-strong form market efficiency, there are a lot of researches using the data from
different stock exchanges in the world. On the one hand, by using data, for 47 firms over 1993 to
2006 from the Athens stock exchange (ASE), the study shows that the ASE does not fully
incorporate publicly available accounting information into stock prices and hence violates the
semi-strong EMH (Alexakis, et al., 2010). In India stock exchange, two researchers concludes that
it is not efficient in the semi-strong form (Mallikarjunappa & Dsouza, 2013). A similar result is
found in Malaysia stock exchange. The empirical results indicate that this stock market has not
reached its full efficiency level in semi-strong form, as the time required for the market to absorb

the information conveyed by the dividend and earnings announcements is extensively long
(Hussin, et al., 2010). Torun and Kurt’s (2007) results suggest that there are some countries in
European monetary union are not in efficient in semi-strong form. In addition, the Nairobi stock
exchange is also not semi-strong form efficient as some investors can earn abnormal returns by
having unequal access to public information (Olweny, 2012).
On the other hand, there are some researches supporting the semi-strong form market efficiency.
Mandal and Rao’s (2010) results indicate that India stock market is efficient enough in its semistrong form to assimilate the new information revealed by dividend initiation and omission
announcements and leave no scope for its investors to earn any abnormal return consistently.
Furthermore, another empirical study of India stock market with regards to buy-back of share
shows very negligible reaction on or before the announcement date and these results are supporting
to the implications of efficient stock market in its semi-strong form (Dua & Mittal, 2010).
Moreover, Chena and Fraser’s (2010) results suggest that the publicly available expected earnings

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series have significant power in driving stock prices in the markets of the US, the UK, Japan, Korea
and Malaysia. It means that fundamentals drive stock prices. In addition, another empirical results
show that the permanent fundamentals are the dominant factors in affecting stock prices (Pan,
2007). Additionally, Velinov and Chen (2015) find a self-correction of stock prices towards their
fundamental values by re-examining the dynamic relations between stock prices and
macroeconomic fundamentals for six major industrialized countries in the wake of the recent
financial crisis. These are empirical evidences that support semi-strong form market efficiency.

3. Strong form
In strong form market efficiency, stock prices reflect all public and private information. Despite
having private information, investors cannot earn abnormal returns. However, if investors have
private information that can affect the stock price, this is will be called insider trading. This activity

is considered as an illegal trading activity in most stock markets in the world. For example, insider
trading was found to have had a significant impact on the price by analyzing trading in corporation
insider and their tippees in Anheuser-Busch’s 1982 tender offer for Campbell Taggart (Cornell &
Sirri, 1992). In addition, using a previously unexplored data source, illegal insider trading detected
and prosecuted by the Securities and Exchange Commission, Meulbroek’s (1992) analysis
suggests that insider trading increases stock price accuracy by moving stock prices significantly
and the abnormal price movement on insider trading days is 40 to 50% of the subsequent price
reaction to the public announcement of the inside information. Furthermore, by examining detailed
records of Boesky’s trade, Chakravarty and McConnell (1997) find a positive and significant
relation between Boesky’s trades and stock price changes (During the three-month period prior to
the acquisition of Carnation by Nestlé in 1984, Ivan Boesky purchased 1.7 million shares of
Carnation’s stock on the basis of illegally obtained inside information.). The significant impact of
insider trading to stock price is considered as a reason why insider trading is illegal.
In conclusion, a problem of EMH is asymmetric information. The managers will know better about
the current activities or business results of firms so it leads to adverse selection for investors when
trading shares. Therefore, the EMH theory may be not right in this situation. Furthermore, the
technologies have changed very much. It means that adjusting price can take shorter time than in
the past due to the development of technologies. As the results, chances for investors to earn
abnormal return are very low. Like in developing and emerging markets, their systems using in

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stock exchanges are still low development compare to developed countries. Therefore, investors
may find higher chance to gain excess returns when investing in developing and emerging markets.
That is why most researches above show that stock markets are not in semi-strong form market
efficiency. For strong-form market efficiency, this involves to inside trading – an illegal trading
activities, so it is very hard for researches to have the data for making tests.

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Appendixes
Appendix 1 – Assumptions of traditional view
There are some assumptions that traditional view theory follow:


No taxes exist, either at personal or corporate level



Companies have two choices of finance: perpetual debt finance and ordinary equity share



Companies can change their capital structure without incurring either issue or redemption
costs



Any increase (decrease) in debt finance is accompanied by simultaneous decrease
(increase) in equity finance of the same amount



Companies pay out all distributable earnings as dividends



The business risk associated with a company is constant over time



Companies’ earnings and hence dividends do not grow over time
(Watson & Head, 2013)

Appendix 2: Miller and Modigliani (I): the net income approach
This argument in Miller and Modigliani (I): the net income approach can be explained with an
example as follows:
Option 1

Option 2
500 shares, each $1

800 shares, each $1

$500 debt, r=8%

$200 debt, r=8%

ROA =12%

ROA = 12%

ROE = 16%

ROE = 13%

WACC = 0.5*16%+0.5*8% = 12%

WACC = 0.8*13%+0.2% = 12%

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