Case Study: Financial Performance Measurement
Category : Case Studies Samples, Cost of Capital Examples, Debt, Debt Financing, Positive Accounting Theory
Consistency of Other Corporate Objectives to Primary Financial Goal of Maximizing Shareholder’s Wealth
Major user groups of financial statements (FS) include investors/ shareholders, employees, lenders, suppliers, customers, government and the public. Basically, investors and shareholders are concerned on income (from dividends) and gain (from stocks price), employees on wage, salary and employment opportunities, lenders on the resources of the firm (both cash and non-cash), suppliers on financial stability of cash flow, customers on ability to supply quality goods, government on performance for the purposes of taxation and the public on employment, environmental and other social responsibility disclosures (2006). In general, firms must comply with the FS needs of these stakeholders to concede their legitimacy to exist in the society (1996). Otherwise, the latter can implore aggressive or indirect actions (strikes, pull-out of investments, litigation, etc.) that can ultimately lead to corporate demise.
Listed or public companies are, more than anybody else, responsible to these stakeholders and impart in protecting its legitimacy. This is because they come full contact with the public, therefore, exposed their companies to several and trickle-down effects on the public at large. As a result, other than maximization of shareholder’s wealth, corporate finance is also intended to aim objectives for other stakeholders. But the question is how they are consistent with shareholder’s primary aim?
Poor accounting feeds speculative beliefs which can lead to stock market bubbles and inefficient markets that ultimately direct to damage economies ( 2003). This is because even if entrepreneurs with poor business models can easily obtain cash through hot IPO markets which in turn affect the chance of more productive firms to ensure capital for more positive community impact. Further, the primary reason of poor accounting is non-compliance with sound accounting practice (2003) which can stem from management and accountants’ inability to separate facts from forecasts (2005). This temptation is fueled with the need to sustain shareholder confidence to the company as well as attract another set of investors.
Such method will hardly be prioritized and isolated by international standards (e.g. International Financial Reporting Standards) because it is bias to capital-providers and undermine the need of other stakeholders for efficient allocation of resources. In effect, this lead to a conclusion that companies, to be able to continue operations, should be initially compliant to the requirements of its legal owners (e.g. shareholders) before it can serve other stakeholders. Leniency of IFRS is necessary for companies to obtain flexibility; otherwise, it would not be able to continue operations due to shareholder dismay and may as well be unable to serve larger part of the community.
Investor focus, however, is not always the case. For example, employees and managers are considered as internal stakeholders. Listed companies are bound to provide them with equitable compensation and maintain their motivation during growth or recession. Such objective should not be ignored due to the fact that human resources and capital is the most important asset of the firm ( 2003). Consistency on the primary objective is observed when internal stakeholders are strictly recruited, trained and continuously motivated through certain reward systems. This would make the labor force more productive and loyal that can reflect the long-term achievement of the investor’s objective. However, the experience of General Motors wherein its financial difficulty arose from implementation of retirement plans for its employees showed the conflict between labor force and investor needs.
In what case it may be, public communication through social responsibility disclosure is necessary (2006). Even if the society as well as the legitimacy pressures maintains a certain status quo for the whole year, organizations should comply with social disclosures because this type of disclosure is never neutral but the by-product of an “entity and society relationship”. In addition, legitimacy theory is derived from system-based theories which mean that a firm can affects its environment on top of the societal changes and its impacts to the firm. In effect, activities that is thought to have, having or previously had impacted the society and environment in both positive and negative manner should be properly cited. Political economy framework also related the economic activities of a firm to political, social and institutional environments stating that economic issues are not are discernable (or profitable and strategic for that matter) if these factors are undermined in corporate operations ( 2006).
Social disclosure is a set of information firms used to comply with one of its functions which is “to account for certain corporate actions” (2006). As reporting is driven by responsibility rather than societal demand, the indirect stakeholders also find their worth in social disclosures even if their expectations are largely implicit. The managerial side of stakeholder theory provides the identity and ultimately the strengths and weakness of annual reports. Aside from the fact that ethical nature of stakeholder theory is non-testable (therefore, no strict standards can be imposed to firms), listed companies are responsible in emphasizing the social responsibilities of their organizations. In effect, companies accomplish disclosures an integrated and sufficient social responsibility reports as it reflect the managerial capabilities and ethical considerations.
Gearing Management as WACC Minimization Strategy
A firm’s capital structure (CS) is usually a mix of financing alternatives (19992). To understand the concept of CS, three basic financing terms should be considered. According to (2006), debt financing is the act of providing capital by selling bonds, bills or notes to individuals or institutions while common/ preferred stock is sold through equity financing. Taken in simpler terms, the former refers to long-term borrowings while the latter refers to long-term funds (). Lastly, debt/ equity ratio is equal to their quotient whose answer is used as a measure of company’s financial leverage or gearing (2006). Optimal CS is achieved when the firm’s cost of capital is minimized and its market value is maximized (). However, this statement is approached conflictingly by two main views.
In traditional model, capital structure is related to the value of the company and it assumes that the weighted average cost of capital (WACC) can be minimized (Mcmenamin 1999). When WACC is minimized and the value of the firm is maximized, it is said that optimal capital structure is available to the firm. Figure 1 is a graph that shows the relation of gearing and cost of capital. The optimal capital structure is at point m where the value of the firm is at its highest level and financial risks are in its lowest level. When gearing, debt is continuously injected in the capital structure of the firm where initially it remains stable. However, as injection persists, at certain point, cost of debt increases gradually. As debt increases, the financial risks of the firm also increases as lenders demand higher returns caused by high gearing that the company implements. These lenders see that the firm may have limited paying capacity due to the bottleneck of debt.
Figure 1: The Relationship of Cost of Capital and Gearing in Traditional View
Also in figure 1, the cost of equity increases as financial gearing increases. This direction relationship is caused by the traditional view that equity holders are also exposed to financial risks because lenders have bigger priority over them in case of business difficulties. Overall, the graph shows that WACC initially falls due to introduction of lower cost debt but eventually begins to increase after reaching a minimum point wherein the cost of equity and debt begin to increase. These situations seemed to be possible due to the following assumptions; namely, all earnings are distributed as dividends, earnings are expected to remain constant indefinitely, all investors have identical expectations about future earnings, taxation is ignored, business risk remains constant and capital structure can be altered immediately by exchanging debt for equity or equity to debt and transaction are free of cost.
On a different view, Modigliani and Miller argued that cost of capital is not related to capital structure or alternatively capital structure is independent of the firm’s value (1999). Proposition 1 is explained using the pie model. The pie model explains that two companies may have different capitals structure, say; each has 75:25 and vice versa as their equity-to-debt ratio but the size of the pie for each company remains the same at 100% level. The proposition only merits earnings before interest and taxes (EBIT) and volatility of the EBIT as reflection of the firm’s value. On the other hand, WACC is merely used to capitalize the future earnings of the firm. However, proposition 1 assumes the absence of arbitrage where traditional view’s assumption would take place. The former assumes perfect markets and that pricing anomalies will not operate. Thus, when gearing-up, proposition 1 is insensitive to the effects of traditional view and the firm would be in the same footing or value geared or un-geared.
Proposition 2 assumes that the expected yield on a share of stock is equal to capitalization rate for purely equity stream and a premium that results in the difference of financial risks of debt and equity (1999). Simply put, proposition 2 observes financial risk premium or compensation for companies that are highly geared. Figure 2 shows that cost of equity capital is a linear function of its capital structure. The figure shows that when gearing is increased, it also tends to increase the cost of equity or the required rate of return of shareholders. However, even with this consequence, WACC remained unchanged as the trade-off between debt and equity financing exist. For example, the advantages of gearing-up are cheaper debt accessibility but this advantage is cancelled by increasing cost of equity.
Figure 2: The Relationship of Cost of Capital and Gearing in Modigliani and Miller
When rates are regulated, CS receives countervailing incentives based on a primary guide in gearing, that is, “a firm wishes to signal high value to capital markets to boost its market value while also signaling high cost to regulators to induce rate increases” (Spiegel 1997 p. 1). When both high- and low-cost firms are confronted with a large investment project, countervailing incentives lead them to implement a financing strategy that hinders their CS from private information. This situation makes their CS similar. On the other hand, when investment is relatively small, high-cost firms prefer equity issues while low-cost firms prefer debt issues.
There exists financing strategies available to the regulated firms in support of the traditional model to gearing. Such strategies, however, relies on two situations. First, the regulated firm must exploit the incentive to be highly geared because regulators are deterred from lowering the rates (therefore, minimizing the motivation of creditors to take its bonds) as it may lead to bankruptcy of these firms (1997). Second, there should be asymmetrical information that exists between the regulators, creditors and the regulated firm about the firm’s costs which would alter the incentive to leverage. In effect, as regulators are rate-setter, the strategies of the regulated firms are within a game of regulatory commitment under asymmetric information.
The regulated firm is said to maximize two incentives in the game. One is to signal low expected costs and high profits to the capital market to boost the market value of its securities (1997). Another is that to convince regulators that its expected costs are high to manipulate rates according to cost effect (e.g. high costs = high rates). As observed, the regulated firm is capable and would likely implement two-conflicting tactics to achieve its maximization goal even though the means is to hide information between the capital market and regulators. However, this tendency is limited only to big investment projects because regulated firms cannot issue debt when engaged in smaller projects. In effect, they cannot tap positive leverage effect. For example, those low cost firms issue relatively little equity while high-cost firms have little to gain in imitating the former. Alternatively, high-cost firms that issue high equity are mimicked by low-cost firms giving the high-cost firms equity-under pricing effect.
Further, if the project is large, the tendency of both low- and high-cost firms is to finance it with wholly debt to exploit the leverage effect coupled with the admission that they are low-cost firms to boost market value of their securities (1997). However, the incentives (therefore, the traditional view) are diluted in the long-run because the capital market cannot determine who really are low-cost firms because everybody is claiming. Traditional view is applicable when regulated firms act in certain manners. For example, they initially issue debt up to a specific target, and then they mix equity in the CS. This strategy is regarded as an alternative in asymmetric information failure or emergence of market efficiency where regulated firms cannot validate their respective incentives.
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