The purpose of this report was to discuss various aspects in the subject of financial management. The work included the analysis of different theories related to the topic which was supported by a wide range of application and real case examples. There were two parts in two different topics related to financial management. The first part was to discuss the importance of capital structure and the cost of capital in the efficient financial management of large companies.
It is said that there are various sources of capital available to large companies each has both costs and benefits. Besides, two important issues that firms are concerned with including cost of capital and capital structure were brought into discussion. Various theories underpinning were reviewed to derive at the conclusion of whether an optimal capital structure exists. Meanwhile, the efficient market hypothesis was the topic of the second part. It states that in an efficient market, stock price fully reflects all information available.
Based on the level of information, markets are divided into three forms that are weak, semi-strong and strong. Generally, it promotes the idea that no one can beat the market to earn abnormal returns though accuracy varies in different forms. In consequence, it is of great importance for both companies and investors to study the efficiency of the market before making decisions. As far as corporate finance is concerned, it is recommended that companies should use different sources to make the best use of their advantages while minimising the total cost of capital.
Besides, regarding the efficient market hypothesis, it is suggested that investors and companies should take it into consideration when making decisions in the market in order to maximise the profit at the lowest cost possible. It can be said that capital is one of the most important factors for any type of business especially large companies. While there are various sources of capital available, they all have certain benefits and costs that may have impact on the company.
Thus, two issues that are of great concern when dealing with the financial management of the company are capital structure and cost of capital. This paper is prepared to discuss the importance of capital structure and cost of capital in the efficient financial management of large companies. Besides, different theories underpinning capital structure are also analysed to support the discussion leading to the conclusion as to whether an optimal capital structure exists. According to Boone and Kurtz (2011), debt is fund obtained through borrowing whose forms vary widely.
Common debt instruments used by large companies include loans and bonds (Megginson and Smart, 2008). Regarding the first option, loans can be obtained from banks or other financial institutions in a short or long term (Hawawini and Viallet, 2011). Multinational companies such as Coca Cola or Unilever that need a colossal amount of capital may even use syndicated loans which are loans funded by more than one bank (AltunbaA, Kara and Ibanez, 2009). An alternative to loan is bonds, which are long term promissory notes companies issue directly to public investors to raise funds (Jennings, 2006).
Using debt companies are obliged to pay interests (or coupons in the case of bonds), normally at a specified annual rate, and the principal amount by a due date (Megginson and Smart, 2008). It could lead to insolvency if the company relies too much on debt and is not able to meet the obligation (Guerard and Schwartz, 2007). Meanwhile, companies choose to finance by debt because of a wide range of benefits it could bring. The fundamental benefit is that interest payments are tax deductible since it is considered allowable expenses (Block, 2008).
What’s more, using debt also helps avoid the dilution of ownership (Martynova and Renneboog, 2011). The primary form of equity financing is issuing stock to public to raise funds while offering them ownership interest in the corporation in exchange (Graham, Smart and Megginson, 2010). There are two forms of stock offered including common stock and preferred stock. The cost of using this type of finance is the distribution of profit to shareholders in the form of dividends (Hawawini and Viallet, 2011).
While dividends paid for common shareholders fluctuate with the firm’s income, those paid for preferred shareholders are fixed (Boone and Kurtz, 2011). In addition, a dilution in ownership is also a cost of issuing stocks though preferred stock usually carries no voting rights (Jenning, 2006). On the other hand, the benefit of using stock issue is that dividend payments are not compulsory (in the case of common stock) (Guerard and Schwartz, 2007). As a result, companies can keep the profit to reinvest if it fits their business strategy.