Nature of a Company's Asset essay

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While the first chapter was brief, it is important to explain what will be studied and then move forward into the literature review.

In Chapter 2, the literature review provides a review of academic literature by way of journals and textbooks. This information is placed into separate sections which allow for ease of understanding. An introduction is made to capital structure, and information is given on the Indian capital structure specifically.

Chapter 3, the data methodology, provides the methodology that was used for the data. The reasons behind the methodology and what was studied are both discussed.

Chapter 4, data analysis and findings, is the chapter in which the results of the data analysis are presented.

Chapter 5, the conclusion, provides not only a conclusion to the research that was conducted in this paper but questions that are left and areas for further research in the future.

Literature Review

The rationale for this literature review chapter is for the author to review academic articles and books relating to capital structure theory so as to develop a framework of academic theory which can be used as a basis of analysis. Without a clear understanding of what has already been done the researcher may rehash old ground, miss something that was already discussed, or fail to tie things that are being discovered now into things that were discovered earlier -- or questions that were asked in the past but not answered.

Introduction to Capital Structure

A company's financial stability and risk of insolvency depend on its financing sources, as well as the types and amounts of various assets it owns. Capital structure, which depicts the equity and loan financing of a company, is often measured in terms of the relative magnitude of these various financing sources. In his study "Capital Structure," Stewart C. Myers (2001), examines research relating to the mix of securities and financing sources corporations use to finance real investment.

Most current research on capital structure focuses "on the proportion of debt vs. equity observed on the tight-hand sides of corporations' balance sheets" (Myers, p. 81). According to Myers, no universal theory of the debt-equity choice exists and there are no reasons to anticipate one. In other words, Myers believes that asset base and capital structure have no correlation that holds true for all companies. While the research will not be able to confirm or deny that statement here, he will work to show that there are correlations between capital structure and asset base and that these are differentiated based on the type of company in question (i.e. manufacturing vs. service businesses).

Murray Frank and Vidhan Goyal (2003), investigated the importance of 39 different factors in the leverage decisions made by publicly traded U.S. firms. They then argued that the pecking order and market timing theories that are often used by analysts failed to provide high-quality descriptions of the data sets that are typically analyzed. In the study "Capital Structure Decisions," Frank and Goyal (2003) note that evidence from their study proves to be consistent with tax/bankruptcy trade-off theory as well as with stakeholder co-investment theory.

The study by Frank and Goyal (2003) also enhanced the understanding of capital structure in the following four primary ways:

1. It created a level playing field that includes various factors. Much of the analysis is devoted to determining which factors are reliably designated, and reliably important, for predicting leverage.

2. It offered good reason to suspect that patterns of corporate financing decisions may have changed over the decades.

3. It indicated that many firms had incomplete records leading to the common practice of deleting firms for which some of the necessary data items are missing. This can create a missing-data-bias.

4. It offered the argument that different theories applied to firms under different circumstances.

While all four of those points are valuable, it is point four which the researcher wishes to stress. When a universal theory of capital structure is said to exist, it becomes very questionable as to whether the data used to arrive at this conclusion are truly accurate. The argument that no universal theory of capital structure exists is much more logical, but a number of useful conditional theories do exist. They are worth examining.

Indian Capital Structure

The opening up of the Indian economy in the 1990s led to a series of financial sector reforms, the most prominent of which was the capital market reform. These reforms have brought about the development of the Indian equity markets, and attempted to raise them to the standards of the major global equity markets. It all started with the abolition of the post for the Controller of Capital Issues, as this subsequently created free pricing of shares. The dematerialization of shares, leading to faster and cheaper transactions, and the introduction of derivative products and compulsory rolling settlements have all followed closely behind. Unfortunately, the Indian markets are still not widely respected, and there are serious problems and inaccuracies in them.

Despite a series of stock market scams and crises beginning in 1992 with Harshad Mehta's scam and continuing into the Ketan Parekh scam of 2001, the Indian equity markets have transformed themselves from broker-dominated markets to more of a mass market. The introduction of online trading has also given a much-needed impetus to the Indian equity market. Over the years, reforms in the equity markets have brought India up to par with many developed markets on several counts. Today, India boasts of a variety of products including stock futures, an instrument launched only by select markets. This does not, however, make the India markets completely reliable or indicate that they are necessarily a good investment. Management teams and investors still have to look at the markets and the companies very carefully before making any decision.

A growing number of companies are accessing the securities market rather than depending on loans from FIs/banks. The Indian corporate sector is also increasingly dependent on external sources for meeting its funding requirements. There appears to be growing preference for direct financing (equity and debt) instead of indirect financing (bank loans). How capital is gained matters, and that is especially true when the asset base comes into play. Tangible assets are far different based on the leverage they have when they are compared with intangible assets. Many investors are much more trusting of tangible assets they can see and touch, and that can affect how interested they are in helping contribute to a company's capital structure and resources.

Debt and Money Markets in India

The debt market in India can be divided into two categories, the government securities market consisting of central government and state government securities; and the bond market consisting of FI bonds, PSU bonds and corporate bonds/debentures. The government securities segment is the most dominant category in the debt market.

The government borrows funds through the issuing of long-term dated securities, the lowest risk category instruments in the economy. These securities are issued through auctions conducted by RBI, where the apex bank decides the coupon or discount rate based on the responses received. The investors in government securities are mainly banks, FIs, insurance companies, provident funds, and trusts. Foreign institutional investors can also invest in these securities up to 100% of funds in case of dedicated debt funds and 49% in case of equity funds. As compared to the large size of the government securities market, both in terms of primary market as well as secondary market, the corporate bond market is not that big.

Overview of Capital Structure Theories in Relevance to the Nature of Assets

Rather than using an imprecise equation that fails to utilize all valuation effects, according to Robert M. Hull (2007), managers fare better when they analyze all relevant leverage-related wealth effects. In Hull's (2007) study "A Capital Structure Model," the author develops a capital structure model (CSM) that offers perpetuity gain to leverage (G^ sub-L^) equations for debt-for-equity and equity-for-debt exchanges. This practice, Hull stresses, makes managers less likely to error in their decision-making.

Mondher Bellalah and Zhen Wu (2009), point out in their own study, "An Intertemporal Capital Asset Pricing Model Under Incomplete Information," that the capital asset pricing model in Sharpe-Lintner-Mossin, CAPM, constitutes one of the most basic developments in modern capital market theory. The CAPM model, which is still subject to theoretical and empirical criticism, evoked popular theoretical objections to this criterion, since the model assumes the mean-variance criterion. Using the classical dynamic programming principle to obtain the Hamilton-Jacobi-Bellman equation, Bellalah and Wu (2009) examined the capital market structure, asset value, and the economic model. From their studies of two cases, the findings provide two central results. One result suggests that, amidst a riskless asset and information costs model regarding the risky assets in the economy:

1. There exists a unique pair of efficient portfolios known as mutual funds, and

2. The return distribution on the risky fund is…[continue]

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