A firm's basic capital resource comes from the stream of cash flow produced by its assets. Once there is a gap between internal equity and the cash that the firm need, the firm must finance this gap by issuing equity, debt or hybrid securities. The term capital structure referss to the mix of different types of securities ( long-term debt, common stock, preferred stock, convertible debt, etc) issued by a company to finance its assets ( Song, 2005). There is always a question: How do firms choose their capital structure? A lot of theories have been developed to answer this puzzling question.
Many factors have been identified as the important determinant of capital structure: leverage increases with fixed assets, non-debt tax shields, investment opportunities and firm size, and decreases with volatility, advertising expenditure, and the probability of bankruptcy, profitability and uniqueness of the product.
The financial literature offers two comppeting models of financial deisions: static trade-off and pecking order theory. In the trade-off model, firm identify their optimal leverage by weighting the costs of financial distress and the tax benefits. At the optimal leverage level, the benefit of the last unit of debt just offsets the cost. In contrast, pecking order theory arises due to the existence of asymmetric information and transaction costs. In this theory, firms raise funds in a particular sequence and follow two rules. Firstly, corporations prefer internal financing than external ones. Secondly, firms always issue the safest securities first.
It seems that one is competing the other one and they seem both reasonable to some extent. Scholars always try to run a between them in order to find the circumstances in which one is superior to another (Fama and French 2002). They find that pecking order works best for large, mature companies that have access to public bond markets. These firms rarely raise equity and they prefer internal financing to external ones, yet turn to debt markets rather than equity when external financing is needed. This is not consistent with smaller, younger, growth firms, which are mmore likely to rely on equity instead of debt. Here, the pecking order theory stumbles(Frank and Goyal 2003). The trade-off theory still retains some explanatory power once pecking order motives are accounted for. The theory is particularly helpful in explaining inter-industry differences and works best for those companies with tangible assets. It suggests that the debt ratio is lower in volatile industries where value depends on intangible assets and growth opportunities.
Nevertheless, it has to be noted that many scholars have proved that there is in fact no conflict between these two theories. Rajan and Zingales (1995) constructed a study of debt versus equity choice by large firms and they find that large firms tend to have higher debt ratios; firms with high propositions of fixed assets to total assets have higher debt ratios; more profitable firms have lower debt ratios and firms with higher ratios of market-to-book value have lower debt levels. These results interpret evidences for both the trade-off and pecking order theories. Fama and Frech (2002) stated that though motivated by different forces, the two models share many predictions about dividends and leverage. Confirmed predictions shared by the trade-off and pecking order models are that more profitable firms and firms with fewer investments have higher dividend pay outs.
To sum up, it is always too simplistic to say one is superior to another. Either one is good at explaining certain issues and has obtained a number of empirical supports. More appropriately speaking, pecking order theory is offered as a complement to rather than a substitution for the traditional trade-off model.
Saturday, 30 March 2013
Saturday, 16 March 2013
Week 8 Credit crunch
Credit crunch refers to the severe shortage of money or credit, which stems from the unusual economic situation in the country during the recent decade. United States had experienced a long period of low nominal short-term interest rates, low inflation and fairly steady growth. Also debt to disposable income ratios were at a high level. Household net saving rates (savings to disposable income) had been falling for a decade and were close to zero in 2006.
Many reasons can lead to credit crunches. Accounting to Owens and Schreft(1995). political or regulatory interference with the credit allocation process causes credit crunches. In addition, securitization of bank loans also has a significant influence. The securitization of consumer credits, mortgages and commercial and industrial loans was growing in 1990s. These assets did not show in the bank's balance sheet and are not considered to be bank loans. In fact, the credit slowdown could be the spurious result of increased securitization processes in banking institutions. Consumer credit securitizations are small compared to the total bank lending and commercial and industrial loans in fact decreased. Overzealous regulation is another factor of credit crunch. That refers to the examination practices that have forced banks to make high capital charges against loan losses and to have a more cautious approach to accepting new credit risk. Bernanke and Lown concluded that the evaluation of the capital charges was difficult to execute and thus did not found it to be an explicit reason for a lending slowdown. A data on allowances for loan losses and charges to capital proved that neither of these experienced a discontinuous jump. Thus Bernanke and Lown saw no clear connection between overzealous regulation and lending slowdown. Although the securitization had an effect to bank lending, the fundamental factor of lending slowdown, was a fall in the bank capital. Accounting to Bernanke and Loan, as a result of regulatory capital standards, banks had to sell assets and reduce lending. This situation was called the capital crunch.
To understand more about the credit crunch in 2007-2008, it is important to comprehend the concepts of market and funding liquidity. The credit crunch in 2007-2008 is a fine example of an event where market illiquidity turns into funding illiquidity. According to Brunnemeier and Pedersen (2008) market liquidity is the ease with which an asset is traded and funding liquidity is the ease with which traders can obtain funding. A trader cannot use the entire value of the security as collateral because she must pay a margin which is financed with the trader's own capital. A margin is a difference between security 's price and collateral.
The rationale of Brunnermeier and Pedersen (2009) is explained that when traders' are having difficulties in acquiring funding, that is , the funding liquidity is tight, the traders' are not willing to invest in high-margin securities which would require a lot of capital. This reduces market liquidity and increases volatility because asset is not traded as smoothly. When the market liquidity is low, it might increase the risk of financing a trade, meaning that higher margins are demanded which worsens traders' funding constraint even more. The phenomenon described above is called a margin spiral. A loss spiral is formed when speculators have a large initial capital position that is negatively correlated with the customer's demand shock. That increases market illiquidity and induce higher speculator losses on their positions. Speculators are finally forced to sell more of their assets which cause a further drop on the price of an asset.
In short, funding problems of investors forces the leveraged investors to reduce their positions, which causes more losses and higher margins, which in turn worsens the funding problems and so on.
Many reasons can lead to credit crunches. Accounting to Owens and Schreft(1995). political or regulatory interference with the credit allocation process causes credit crunches. In addition, securitization of bank loans also has a significant influence. The securitization of consumer credits, mortgages and commercial and industrial loans was growing in 1990s. These assets did not show in the bank's balance sheet and are not considered to be bank loans. In fact, the credit slowdown could be the spurious result of increased securitization processes in banking institutions. Consumer credit securitizations are small compared to the total bank lending and commercial and industrial loans in fact decreased. Overzealous regulation is another factor of credit crunch. That refers to the examination practices that have forced banks to make high capital charges against loan losses and to have a more cautious approach to accepting new credit risk. Bernanke and Lown concluded that the evaluation of the capital charges was difficult to execute and thus did not found it to be an explicit reason for a lending slowdown. A data on allowances for loan losses and charges to capital proved that neither of these experienced a discontinuous jump. Thus Bernanke and Lown saw no clear connection between overzealous regulation and lending slowdown. Although the securitization had an effect to bank lending, the fundamental factor of lending slowdown, was a fall in the bank capital. Accounting to Bernanke and Loan, as a result of regulatory capital standards, banks had to sell assets and reduce lending. This situation was called the capital crunch.
To understand more about the credit crunch in 2007-2008, it is important to comprehend the concepts of market and funding liquidity. The credit crunch in 2007-2008 is a fine example of an event where market illiquidity turns into funding illiquidity. According to Brunnemeier and Pedersen (2008) market liquidity is the ease with which an asset is traded and funding liquidity is the ease with which traders can obtain funding. A trader cannot use the entire value of the security as collateral because she must pay a margin which is financed with the trader's own capital. A margin is a difference between security 's price and collateral.
The rationale of Brunnermeier and Pedersen (2009) is explained that when traders' are having difficulties in acquiring funding, that is , the funding liquidity is tight, the traders' are not willing to invest in high-margin securities which would require a lot of capital. This reduces market liquidity and increases volatility because asset is not traded as smoothly. When the market liquidity is low, it might increase the risk of financing a trade, meaning that higher margins are demanded which worsens traders' funding constraint even more. The phenomenon described above is called a margin spiral. A loss spiral is formed when speculators have a large initial capital position that is negatively correlated with the customer's demand shock. That increases market illiquidity and induce higher speculator losses on their positions. Speculators are finally forced to sell more of their assets which cause a further drop on the price of an asset.
In short, funding problems of investors forces the leveraged investors to reduce their positions, which causes more losses and higher margins, which in turn worsens the funding problems and so on.
Sunday, 10 March 2013
Week 7 --- Mergers and acquisitions
Mergers and acquisitions play signigicant roles for helping companies achieve certain objectives and financial strategies. Even though different companies have diverse reasons for engaging in mergers and acquisitions, the main purpose is to create shareholders' value and competitive advantages. Both the terms merger and acquisition indicate that a corporate combination of two separate companies to form one company and they are often used synonymously in practice, but there are slightly different meanings between them.(Harrison et al, 2001)
In a merger activity, it usually takes place when two separate firms which have similar size agree to form a new single company. Then both companies' stocks will cease to exist and the newly created company's stock will be issued in its place (Harrison, et al,2001). This kind of activity is often referred as a merger of equals. While in the case of an acquisition, one company is purchased by another one and then no new company is formed subsequently. From a legal point of view, the target company ceases to exist, the acquirer occupies the business of the target firm and the acquirer's stock continues to be traded (Sudarsanam, 2003). In addition, the acquiring firm collects all asset and gains of the target company as well as the liability (Sudarsanam, 2003).
The synergy motive is regarded as the most popular motive for M&A. It refers to acquire or to merge with the resources of two separate firms and thus it contributes to the value of the newly combined firm greater than that of two separate unities (Seth et al., 2000). One important source of synergy is from the transfer of some valuable intangible assets, such as know-how, between targets and acquirers (Seth et al., 2000) Evaluating synergy effects from M&A deals has become one of major tasks of managers. From the perspective of the relationship between targets and total gains, they are positively correlated in synergy motivated M&A. This means that the higher the synergy, the higher the target gains as well as the acquiring firm's shareholders' benefits.
The Lightbox Photos app developed by the 500 Startups company automatically created personal photo blogs from a user's uploads. But now it will be shut down, has already been stripped from Google's Play marketplace. One problem with Instagram was that its content was siloed. Users could only engage with its photos through its apps or on other social networks. There was no mobile site or website where you could comment or Like Instagrams. But Lightbox auto-generates full-featured photo blogs with their own vanity URLs from a user's uploads, so your friends and followers could interact with your photos from any interface. This understanding of the need for wide-accessibility will serve Facebook well. While this acquisition should bolster confidence in Facebook's mobile product, it doesn't answer the question of how it going to turn mobile into a massive revenue stream. Those two go together, though. The better the mobile product, the more mobile ads Facebook can get away with.
Similar to Instagram, Lightbox wasn't just a photosharing app, but also a community where people browsed each other's mini-masterpieces. However, Facebook won't be adding that community to its 500+ million mobile population. Just Lightbox's talent is joining the big blue social network.
In a merger activity, it usually takes place when two separate firms which have similar size agree to form a new single company. Then both companies' stocks will cease to exist and the newly created company's stock will be issued in its place (Harrison, et al,2001). This kind of activity is often referred as a merger of equals. While in the case of an acquisition, one company is purchased by another one and then no new company is formed subsequently. From a legal point of view, the target company ceases to exist, the acquirer occupies the business of the target firm and the acquirer's stock continues to be traded (Sudarsanam, 2003). In addition, the acquiring firm collects all asset and gains of the target company as well as the liability (Sudarsanam, 2003).
The synergy motive is regarded as the most popular motive for M&A. It refers to acquire or to merge with the resources of two separate firms and thus it contributes to the value of the newly combined firm greater than that of two separate unities (Seth et al., 2000). One important source of synergy is from the transfer of some valuable intangible assets, such as know-how, between targets and acquirers (Seth et al., 2000) Evaluating synergy effects from M&A deals has become one of major tasks of managers. From the perspective of the relationship between targets and total gains, they are positively correlated in synergy motivated M&A. This means that the higher the synergy, the higher the target gains as well as the acquiring firm's shareholders' benefits.
The Lightbox Photos app developed by the 500 Startups company automatically created personal photo blogs from a user's uploads. But now it will be shut down, has already been stripped from Google's Play marketplace. One problem with Instagram was that its content was siloed. Users could only engage with its photos through its apps or on other social networks. There was no mobile site or website where you could comment or Like Instagrams. But Lightbox auto-generates full-featured photo blogs with their own vanity URLs from a user's uploads, so your friends and followers could interact with your photos from any interface. This understanding of the need for wide-accessibility will serve Facebook well. While this acquisition should bolster confidence in Facebook's mobile product, it doesn't answer the question of how it going to turn mobile into a massive revenue stream. Those two go together, though. The better the mobile product, the more mobile ads Facebook can get away with.
Similar to Instagram, Lightbox wasn't just a photosharing app, but also a community where people browsed each other's mini-masterpieces. However, Facebook won't be adding that community to its 500+ million mobile population. Just Lightbox's talent is joining the big blue social network.
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