Debt or Equity?

Every businesses and firms try to maximize value and maintain it.  Should they aim to achieve optimal capital structure? What is the right mixture of debt and equity should a firm take? Does optimal capital structure exist in the real world? Is it possible for a firm to achieve optimal capital structure? I don’t think so because it is hard to predict the market value of an equity share exactly. Different causes from the market that affect market value of equity share are extremely complicated. A rise in debt will decrease the equity in capital structure, causing imbalance between debt and equity. I think that aiming to achieve optimal capital structure is somehow not necessary if the company is well financed.

Furthermore, I personally think that it is hard for a firm to measure that whether they should finance the company  by debt,by equity or by both as both have its own advantages and disadvantages. To me, I think that debt financing is a better option due to its cheaper cost. Let’s take Wal-Mart as an example. Wal-Mart has capital structure which contain a mixture  of debt and equity. According to Ycharts, the debt-to-equity ratio of Walmart was at 0.5621 back to July of this year, which is lower than the industry average. This demonstrates that Wal-Mart has been successful in managing their debt than equity level. From there,I can conclude that Wal-Mart has lower risk and higher solvency. This may be due to the reduced tax paid, the fall in claiming on company’s asset from debt holders, and cheaper transaction cost for debt compared to ordinary shares.

the chart above show the debt to equity ratio of Wal-Mart Stores
source from https://ycharts.com/companies/WMT/debt_equity_ratio

However, Modigliani And Miller's theory (1958) argue that financing by debt or equity does not matter, it will not affect the WACC. Thus, no optimal structure exists. They assume that there is no taxation, no bankruptcy cost, perfect information is available to all economic agent with no cost of transaction and individuals can as much as they want as they can borrow as the same rate as companies. They believed that the company’s value depends purely on business risk. Are these true? Can these be accepted in the real world? I disagree with the assumption that M&M have made. Bankruptcy costs and taxes do make changes to the stock price of a company and the stock price will finally affect the performance of a company. Income taxes exist and its beneficial to debt whereas bankruptcy cost is is large in amount in the real world.

Besides that, information available to economic agent is not always perfect. Individuals too cannot borrow as cheap as companies as interest rate usually go up as they ask for more money. Therefore, i don't think it is acceptable in the real world. However, after realizing the importance and impact of tax on business, M&M decided to revised their paper and take tax into account in 1963. in this assumption, debt is more favorable because it is a tax deductible expense which can be offset against profit. in other way, it assume that an increase in gearing will reduce weighted average cost capital (WACC). 


Is it a good idea if a company keep increasing the gearing to reduce WACC? NO! Definitely not. Although debt has its own benefit at some point, but company should not keep accumulating their debt just to reduce their WACC. These debt will drag down the reputation of their own company. The debts have to be repaid anyway, so a company should stop accumulating their debt at certain level. 

Bank that ran out of money?

The Royal Bank of Scotland (RBS) which was founded in 1727 , is one of the oldest banks in the UK that had gone through their up and down in the past. The bank had successfully made billion of profits previously and was once the world’s largest bank with great bonus and reputation. However, the profit-making bank turned out to be a disaster in late 2008. The bank suffered the biggest loss in UK corporate history,which was worth 24 billion pounds that led to damaged in reputation of the bank and finally the lack of liquidity inside the bank. What were the main factors that cause the bank to suffer? Was that failure of management by Fred Goodwin? Financial crisis? Or any others?

From the video that I have watched, I got an idea that Fred Goodwin had the potential to become an executive and  lead the bank with his skill in cost cutting. I agree an management style like Fred’s would made the whole organisation more efficient and effective, and that was part of the reason why RBS grew bigger and bigger. However,  there were pros but also cons in his management style. The video mentioned that Fred had the reputation on being quite hard on the staff, inhibited others to express their view and quite difficult as a boss. Was this the one of the internal reason why bank did not perform well? I do think so! Imagine a leader with good attitude and behavior who get along well with the staff and employees.  Wouldn’t the employees be happier to work under him? Wouldn’t the employees become more effective and productive? Yes it would! Not only that, Fred could have came up with better strategy to cope various obstacles by having discussion with other seniors and staffs.

 The acquisition of one of the Europe’s largest bank, ABN AMRO played a primary  role in the bank’s failure. How the acquisition did made the bank failure?  I think the board and Fredwin should not go for acquisition with risk which is already identified. The poor decision made caused RBS to increase their reliance on short-term wholesale funding and also increased credit risk exposures in its trading portfolio. Why did Fredwin made the move to acquire ABN ARMO? Did he think that acquiring ABN AMRO would make profit in both short run and long run? Well, he probably did.  As what stated in the video, almost all the loss are in the sub-prime market of America, and related to the acquisition of ABN AMRO.  From the statement, I think that Fredwin had done poor decision making, especially in relation to risk. The bank might not fall into crisis if Fredwin did a clear and logical background research of ABN AMRO before acquiring it.  The failure of RBS can be clearly seen after the American bubble burst. The involvement of RBS in sub-prime lending made the shareholder and public lose their trust on the bank, no one was willing to lend money to RBS despite the lack of liquidity. Therefore,british government had to paid $45.5 billion to bail out the bank to avoid the collapse of the bank. However, some of these could be avoid if RBS had a better management.

Does diversification helps?

In this week’s lecture, I have learned that portfolio theory helps investor to maximize their return by holding a diversified portfolio of assets with various level of risk. Most of the investors are believed to receive a return for taking risk, the type of risk can be categorize in 2 different category, which are systematic risk, and unsystematic risk. Systematic risk affects all investment of a business. Unfortunately, this type of risk cannot be diversified, whereas unsystematic risk  is the risk which can be diversified in different ways to reduce the risk of one specific share or more. However, in a world of high correlation, it is hard to deal with diversification.

Research has confirmed that the act of diversification for most companies had cut down their profitability. Therefore, an investor must take serious consideration of the risk and return while taking diversification into account. However, a proper diversification reduces the unsystematic risk of business by spreading the risk into different investment. Other than that, a well diversified portfolio would maximize the profit of one’s business  . Amazon, the biggest e-retailer in the United State started their business as an online bookstore, and then diversifies to sell wide variety of stuffs such as DVDs, electronics, software and video game. What made Amazon successfully diversify into different investment in a competitive market? Is it by considering the risk and return of spreading their assets? Or by analyzing the capital asset pricing model (CAPM) including capital market line (CML) and security market line(SML) in the company? In my opinion, I think we have to take 

consideration of all of those I have mentioned.

Now, what strategy had IKEA used on their diversification in China to make it effective? In return of higher market share return,  IKEA chose to take the risk  of investing in foreign country like china. Firstly, IKEA identified its own competitive advantage among other competitors, then globalizing in Asia country with strategies like pricing strategy and joint venture. These strategies, together with other right strategy that IKEA implied over the year has successfully expand their product sales, leading to an increase in revenue as return. The graph below shows the total revenue of Ikea over the years until 2014. in the year 2015, IKEA's total sales increased by 8.9 %.

Furthermore, diversifying in china and other countries will too minimize the risk of IKEA than investing in only one country. I think that IKEA definitely made the right choice as china has become the top 1  purchasing country of IKEA’s product in 2015. China remained to be the fastest growing IKEA Group market in 2015, followed by Russia.

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Lastly, I think that a business could enhance their efficiency by analyzing CAPM, a model that show the relationship between risk and expected return for any risky asset. Since CML define efficient portfolios, therefore it is useful when measuring risk factor. If all the stocks and portfolios lie on the SML, it means the market portfolio is efficient, if not, then adjustment need to be done to ensure an efficient portfolio. Do you agree with the statements above? Tell me what you think. :)

Digby Jones- the troubleshooter

From the video that I have watched, Digby jones , the champion of British business has returned to TV screens as a troubleshooter .In this episode, the Digby's mission was to solve urgent problems encountered by a medium size furniture company called Hereford furniture.

after watching the video, I agree with Digby that Hereford furniture should just focus on one thing first instead of doing all manufacturing, importing and retailing at the same time. Although this range they provided was what made them survive during recession, but this will not last long as threat from competitors in the same firm keep increasing, that will lead to a contract in the market share. In addition to that, the managing director of Hereford furniture, Mike Muxworthy could not provide an excellent reason on what specialist knowledge they have. Therefore, it is most likely better if they just focus on either manufacturing, importing or retailing at the moment. In my opinion, focusing on one task at one time is more efficient and effective than multitasking at one time to focus on their workforce, working capital and maximize their value.

Does launching a new brand help the business? A brand is not just a logo to represent themselves, it is also something that link the company and customer together .An outstanding design or brand name may become a topic of discussion among us on social media., As social media is the largest influence in the 21^st century, it is important for a brand name to become a hot topic on the net. it is a way to grab attention of others and make them start questioning about the  brand, searching for products of the brand, looking for information or  and start talking about the brand, which will then lead to an increase in the brand reputation. A rise in product sales might be seen as customers has built a good amount of interest on the brand, which will lead them to buy the product with the brand on it. All these can be achieved by  Hereford furniture once  they launched the brand Hygge, which is the wonderful Danish word with no definition in English.

Another issue discussed in the video was the poor management of  Mike Muxworthy. As the head of a company, he should ensure that every area including production area, spray shop area and machine shop area in Hereford furniture to work together as a whole, and not just work together in one specific area. This will not only improve the communication among employees, it will also increase the productivity of the company. Furthermore, Mike should have strengthened the bond between himself and his employers to further improve productivity. As what I watched from the video, the impression of Mike in the eyes of his employer is not great.  Other than that,Mike should have employed another accountant who can come out with forecast and statement of cash flows because it approximately show how well or how bad is the company doing. Without it, the business may be drove to ground.

At the end, the video did not mention if the advice of  Digby works for Hereford Furniture. However, it is great to see how Mike is willing to accept the new challenges for himself as well as the business.