Application of Capital Structure Theory Presented by Modigliani & Miller in the Real World: Comparison of Efficient & Inefficient

Market.

ABSTRACT: Financing through debt or equity remain a challenge for firms operating in efficient and inefficient markets. Different theorist presented their opinions and research to solve this dilemma. M M theory claims to sort this problem out under certain assumptions. Literature presents support as well as criticism of the MM theory. To determine the fina ncial health of proposed theory researcher will conduct a series of empirical analyses in efficient (London Stock Exchange) and inefficient (Karachi Stock Exchange). The data collected will be than compared to Dubai Stock Exchange that holds all the three assu mptions suggested MM theory. This will involve qualitative and quantitative research techniques. The study is designed over a period of 3 years . Key Words: Trade-off theory, MM theory, financial leverage, Operational leverage, efficient markets, inefficient markets, Capital Structure , Firm characteristics.

Section I: INTRODUCTION:

The underl ying concept of this study is to revisit the theory of finance presented by Modigliani and Miller in order to suggest the optimal capital structure for the firm.

Capital structure decisions are crucial for the financial wellbeing of the firm. Financial distress, liquidation and bankruptcy are the ultimate consequences lay ahead if any major misjudgme nt occurred following any financing decision of the firms activit y. Thus, firm with high leverage need to allocate an efficient mixture of capital that will finall y reduce its cost. Many theories and empirical evidence in providing optimal capital structu re exists in the real world. Yet, there is still cloudy area and with no specific guidelines to assist financial officers in attaining efficient mixture of debt and equit y. Thus, onl y clues and calculated judgment plus some understanding of financial theor y are possible tool to be applied in facilitating of how the financing mix does affect the firms value and its stock price (Kila & Mahmood, 2008)

The term capital structure refers to the mix of different types of securities (long-term debt, common stock, preferred stock) issued by a company to finance its assets. A company is said to be unlevered as long as it has no debt, while a firm with debt in its capital structure is said to be leveraged. There exist two major leverage terms: operational leverage and financial leverage. While operational leverage is related to a companys fixed operating costs, financial leverage is related to fixed debt costs. Loosel y speaking, operating leverage increases the business (or the operating) risk, while financial levera ge increases the financial risk. Total leverage is then given by a firms use of both fixed operating costs and debt costs, impl ying that a firms total risk equals busi ness

risk plus financial risk (Janauri, 2005). The underl ying study will consider capital structure and its determinants with total leverage.

Neither equit y nor debts are the best way of determining the capital structure of a firm. This ironic statement twisted the minds of researchers and financials for years and years. As Myers (1984 ) called it capital structure puzzle. Financing businesses is always a difficult but inevitable task for corporations. Companies financing decisions involve a wide range of policy issues (Abor, 2008) . A number of internal and external factor determine the capital structure of company (Ilyas, n.d.) . In this regard, different t ypes of theories were presented on different times. These theories are : static trade-off theory by Miller and Modigliani (1958) , Pecking order theory by Donaldsons (1961 ) and the market timing theory (Spremann, Lang, Getzmann, 2010) .

According to the propositions of the MM theory: the value of a firm is independent from its corporate financing decisions under certain conditions. In fact MM pointed out the direction that capital structure theories must take b y showing under what conditions capital structure is irrelevant (Harris and Raviv, 1991). Titman (2001) lists some fundamental conditions that make the MM proposition hold:

1. No (distortionary) taxes, 2. No transaction costs, 3. No bankruptcy costs, 4. Perfect contracting assumptions, and 5. Complete and perfect market assumption. Since the publication of MMs irrelevance proposition, hundreds of articles on the theory of capital structure have been carried out in or der to find out under what conditions capital structure does matter. In other words, it is of great

interest to investigate if capital structure choices become relevant once one or more of the key conditions are relaxed.

Capital structure of firms differs from each other as they get affected by an array of factors. Some firm have high leverages while other has low. They get themselves financed through the issuance of common stock or preferred stock in stock market or companies acquire long term debts through institutional financing (Brigham, & Houston, 2010) . According to Fama, (1970) the primary role of capital market is allocation of ownership of econom ys capital stock. An in-depth study of capital market points towards efficient market hypothesis . This hypothesis propose existence of three t ypes of markets in economies that are strong form market, semi strong form market and weak form market; first two comes under the category of efficient market, while the la st is referred as inefficient market .

Turning back to the goal of this study, M M theory holds onl y in efficient market while they do not work in inefficient market. This literary argument needs empirical justification for the reason this study is being designed for a comparison among Karachi stock exchange, London stock exchange and D ubai stock exchange.

RESEARCH QUESTION: What is the application of Capital Structure Theory presented by Modigliani and Miller in the real world; a comparison of efficient and inefficient Markets?

AIMS AND OBJECTIVES: To study the capital structure differences in efficient and in efficient market To study the implementation of MM theory in efficient and inefficient market To compare the effects of MM theory in different economies (taxable and tax free) To study the asymmetric information ef fect on capital structure To challenge the assumption taken by MM theory To suggest improvements in financing theories To add value to existing financial knowledge

SIGNIFICANCE OF THE STUDY: The study will be significant for both academicians and practitioners. Academic Significance : The study will be significant for academicians in the following ways: 1. Revisit of theory will test the propositions of MM theory which will provide the academicians with the opportunity to make comparisons between efficient and inefficient markets of different countries around the world. 2. It will help the academicians in identifying the gap in literature which exists in MM theory in form of no differentiation between financing the business through debt or equity. 3. It will establish the comparability between different economies of the world i.e. developed and developing. Developing economies like Pakistan are bound with taxes and having different arrangements of capital structure as compare to the capital structure arrangements of the developed countries.

Practitioner Significance: Revisit of theory of finance will be significant for the practitioners in the following ways: 1. It will help the practitioners in determining the extent of leverage.

2. It will be helpful in evaluating the optimal capital structure for the smooth running of business. 3. It will help in determining the proportion of debt and equit y in the capital structure of the business.

4. It will help in determining the tradeoff between benefits and costs of having debts for a business. 5. It will be useful for practitioners as it will find out that efficient and inefficient markets should not be evaluated on the same propositions for debt and equit y presented in MM theory.

6. It will help the practitioners in decid ing the best determinants for the capital structure.

Section I has covered the introduction of the study its aims, objectives and significance. Section II will cover the Literature Review surrounding the MM theory. Section III will cover the Research Methodology, data collection methods and its paradigm. Section IV will briefly report the time line of the thesis.

Section II: LITERATURE REVIEW: In the recent years the concept of optimal capital structure was based on as ymmetric information (Abor 2008; Myer and Mujalif 1 984). This means firms prefer to finance internall y if the cost of debt along with risk is high in the market (Abor, 2008). This concept was replaced by theory presented b y Modigliani and Miller that provides an opportunit y to debt financing as it provides tax cover shield. As tax is not implementable on debts hold by corporate, so share holders get high returns . But this income on dividing among shareholders as profit becomes taxable.

Modigliani and Miller (1958) claim that under perfect capital market conditions, a firms value depends on its operating profitabilit y rather than its capital structure. In 1963, Modigliani and Miller (1963) fix the previous paper; argue that, when there are corporate taxes then interest payments are tax deductible, 100% debt financing is optimal. This means that the firms value increases as debts increases.

The theory of optimal capital struct ure Modigliani and Miller value invariance proposition I states that under certain conditions, the value of the firm is independent of its capital structure (Firer, Ross, Westerfield and Jordan, 2008).One of these conditions is absence of tax. However, in the real world taxes do exist and specificall y interest payments on debt are tax deductible. The value of firm will increase as the debt/equit y ratio increases. Another way of stating M&M proposition I, with taxes is that the value of levered firm is equal to the value of firm with no debt plus the present value of the interest tax shield. The interest tax shield is the benefit that results from the benefit that results from the fact that profits are only taxed after tax payments have been deducted. The tax benefits of the debt give a clear reason for the firms to borrow rather than issue the equit y ( Opler et al., 1997).

Along with high interests on debts here comes two primary issues, one is off bankruptcy of a firm (Titman, 1984) and the other is of agency cost that arises between mangers and shareholders of a firm on issuance of more and more equit y. Debt may be a good option for financing but it put management under stress as it lowers the stock price (Illyas, 2008 ). Damodran (2001) advised firms to select their financing plan carefull y. Otherwise they can get themselves into the troubles.

According to the theory, the firm borrows up to the point where tax benefit from extra rand of debt is exactl y equal to the cost that comes from the increased probability of the financial distress. The II proposition of the static trade off theory by MM stated that when proposition I held the cost of equit y as a linear increasing function of debt/equity ratio. The proposition implied that weighted average of these cost of capital to a firm would remain the same no matter what combination of financing sources the firm actuall y chose (Miller, 1988).

Two categories of leverages are in strong connection with financi al risks and operational risks that cumulate as total risk. According to Titman and Wessel (1988) there exist six ways to calculate financial and operational leverage. This includes dividing long term, short term, and convertible debt by market value and booked value turn by turn.

Capital structure is actuall y backed by certain factor these may vary from firm to firm and econom y to econom y. Yet a consensus about certain factor exist in literature these factors are age of the firm, firm size, asset structure,

profitabilit y, firm growth, firm risk, taxation, managerial ownership, t ype of business (Abor, 2008; Illays, 2008; Song, 2005; Harris & Raviv, 1991; Titman & Wessels 1988) .

This propels the discussion toward efficient market hypothesis; it describes stocks are always in equilibrium and it is impossible for an investor to consistentl y beat the market (Brigham, & Houston, 2010). This had become possible with easy availabilit y of information with the help of technology. Now the question is about qualit y and quantit y of information about a particular market as it determines the efficiency level of a particular stock market. First come weak form that states all information contained in past price movements is full y reflect ed in current market prices ( Fama, 1970) . Second is semi - strong form market, here all publicall y available information is reflected in stock prices (Brigham, & Hou ston, 2010) . Finall y strong form market reflects all pertinent information weather publicall y or privatel y available in stock prices ( ibid. ). Here the reason for discussing these market t ypes was related to the intentions of investor to finance capital for a particular firm or not. As their intention vary from company to company and industry to industry thus creating vast difference in capital s tructure.

Section III:

METHODOLOGY: S cope of the Study

The major purpose of this study is to explore and examine the application of MM theory in Karachi Stock Market (Inefficient Market) that will be th en compared to application of MM theory in London Stock market (Efficient Market). For reliabilit y and validit y another market fulfilling the assumption set by MM theory will be introduced as Control group that will justify the results drawn from the above stated two markets.

Research Methodology:
The preferred methodology for the study will be TRIANGULATION. Triangulation is a powerful technique that facilitates validation of data through cross verification from more than two sources. In particular, it refers to the application and combination of several research methodologies in the study of the same phenomenon.

It can be employed in both quantitative (validation) and qualitative (inquiry) studies. It is a method-appropriate strategy of founding the credibility of qualitative analyses. It becomes an alternative to traditional criteria like reliability and validity. It is the preferred line in the social sciences.

By combining multiple observers, theories, methods, and empirical materials, researchers can hope to overcome the weakness or intrinsic biases and the problems that come from single method, single-observer and single-theory studies.

Data collection Methods:

Qualitative & Quantitative Techniques:

Various articles and books written by different scholars helped to gain more information about Karachi, London, and Dubai stock markets and practical application of MM theory its problems and potential solutions.

Following qualitative techniques and tools will be used:

Use of secondary data Informal interviews Focus group discussion

The major focus while collecting data from these resources will be about the potential application of MM theory in real world. Beside the above mentioned sources, Social Science research Network website, Mod igliani and Miller article will help in the study.

Secondary data option is used to carry out the anal ysis and recommendation about the application of MM theory in Karachi and London Stock Exchange.

The quantitative method provides a broad understanding of the concerns and potential recommendations and conclusions using various scholarl y works on t he subject being investigated. The advantages of quantitative research compared to qualitative research are given below: It is an easy way to investigate breadth specific issues, in contrast to qualitative method. It is easy to collect quantitative data for inefficient markets rather qualitative data. The study move according to time series, while comforting researcher due to planned occurring.

Detailed relevant information can be obtained and participants feel no hesitation in their findings. However the existence of relationships and exact numbers to describe the issues is the strength of quantitative research method. Moreover it is eas y to anal yse vast am ounts of information to produce results especiall y in time bounded environment.

The quantitative technique employed in the study will be STRUCTURED QUESTIONNAIRE.

Research Paradigm:

Regardless of which paradigm you are employing, it is important that you pay attention to all features and ensure that there are no contradictions and deficiencies in your methodology (Collis and Hussey, 2003, p -55).

As the study employed both quantitative and qualitative methods. So, the research paradigms for the study will be both positivism and Interpretivism. Positivism associated with quantitative research. Involves hypothesis testing to obtain objective truth. Also used to predict what may happen at a future date. Critical realism is a subt ype of positivism that incorporates some value assumptions on the part of th e researcher. It involves looking at power in societ y. Researchers primaril y rel y on quantitative data to do this. Interpretivism associated with qualitative research. Used to obtain an understanding of the word from an individual perspective. Critical Humanism is a subt ype of the interpretive paradigm. The critical humanism approach is one in which the researcher involves people studied in the research process. Data is used for social change.

Section IV: Time Line for Doctoral Thesis: Sr. No. 1. 2. 3. 4. 5. Activity Initial proposal Literature Review Final proposal Proposal Defense Literature methodology 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. Devise Research approach Draft research strategy and Method Develop questionnaire Pilot test Administrating questionnaire Enter Data into computer Anal yze Data Draft Findings Complete remaining chapters Finalize report Defense 14 Month 15 Month 18 Month 19 Month 20 Month 24 Month 24 Month 26 Month 30 Month 35 Month 36 Month Year 3 Year 2 Review along with Duration 1 Months 3 Months 6 Months 7 Month 12 Month Year 1 Years

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