ADVANCED CAPITAL STRUCRE THEORIES RECENTLY ASKED QUESTIONS 1.Under investment problem or debt- overhang problem 2.

information asymmetry 3. corporate governance 4. Millers equilibrium refer IM Pandey 5. pecking order hypothesis 6. M M hypothesis assumptions (home made liverage) and its violations in ideal capital market 7) MM propotion !,11 and with corporate tax refer IM pandey 7.trade of theory 8.lemon theory and adverse selection Refer pdf 9.valuation of euity Refer prasnna Chandra 10.liverage refer I m pandey or pdf 11.market for lemons refer pdf

Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure in the worst case. Examples of this problem are adverse selection,and information monopoly. Most commonly, information asymmetries are studied in the context of principalagent problems. Information asymmetry causes misinforming and is essential in every communication process. In 2001, the Nobel Prize in Economics was awarded to George Akerlof, Michael Spence, and Joseph E. Stiglitz for their "analyses of markets with asymmetric information.

Information asymmetry models

Information asymmetry models assume that at least one party to a transaction has relevant information whereas the other(s) do not. Some asymmetric information models can also be used in situations where at least one party can enforce, or effectively retaliate for breaches of, certain parts of an agreement whereas the other(s) cannot. In adverse selection models, the ignorant party lacks information while negotiating an agreed understanding of or contract to the transaction, whereas in moral hazard the ignorant party lacks information about performance of the agreed-upon transaction or lacks the ability to retaliate for a breach of the agreement. An example of adverse selection is when people who are high risk are more likely to buy insurance, because the insurance company cannot effectively discriminate against them, usually due to lack of information about the particular individual's risk but also sometimes by force of law or other constraints. An example of moral hazard is when people are more likely to behave recklessly after becoming insured, either because the insurer cannot observe this behavior or cannot effectively retaliate against it, for example by failing to renew the insurance.

Adverse selection
The classic paper on adverse selection is George Akerlof's "The Market for Lemons"(see the pdf) from 1970, which brought informational issues at the forefront of economic theory. It discusses two primary solutions to this problem, signaling and screening.[5]
Signaling

Michael Spence originally proposed the idea of signaling. He proposed that in a situation with information asymmetry, it is possible for people to signal their type, thus believably transferring information to the other party and resolving the asymmetry. This idea was originally studied in the context of looking for a job. An employer is interested in hiring a new employee who is "skilled in learning." Of course, all prospective employees will claim to be "skilled at learning", but only they know if they really are. This is an information asymmetry. Skill in learning is malleable, and depends upon many factors, including diet, exercise and money. Spence proposes, for example, that going to college can function as a credible signal of an ability to learn. Assuming that people who are skilled in learning can finish college more easily than people who are unskilled, then by finishing college the skilled people signal their skill to prospective employers. No matter how much or how little they may have learned in college, finishing functions as a signal of their capacity for learning. However, finishing college may merely function as a signal of their ability to pay for college, it may signal the willingness of individuals to adhere to orthodox views, or it may signal a willingness to comply with authority.

Screening

Joseph E. Stiglitz pioneered the theory of screening. In this way the underinformed party can induce the other party to reveal their information. They can provide a menu of choices in such a way that the choice depends on the private information of the other party. Examples of situations where the seller usually has better information than the buyer are numerous but include used-car salespeople, mortgage brokers and loan originators, stockbrokers and real estate agents. Examples of situations where the buyer usually has better information than the seller include estate sales as specified in a last will and testament, life insurance, or sales of old art pieces without prior professional assessment of their value. This situation was first described by Kenneth J. Arrow in an article on health care in 1963.[6] George Akerlof in The Market for Lemons notices that, in such a market, the average value of the commodity tends to go down, even for those of perfectly good quality. Because of information asymmetry, unscrupulous sellers can "spoof" items (like replica goods such as watches) and defraud the buyer. As a result, many people not willing to risk getting ripped off will avoid certain types of purchases, or will not spend as much for a given item. It is even possible for the market to decay to the point of nonexistence. Application of information asymmetry in research Since the seminal contributions of Akerlof, Spence, and Stiglitz, the pervasive effects of information asymmetry in markets have been documented and studied in numerous contexts. In particular, a substantial portion of research in the field of accounting can be framed in terms of information asymmetry, since accounting involves the transmission of an enterprise's information from those who have it to those who need it for decision-making. Likewise, financial economists apply information asymmetry in studies of differentially informed financial market participants (insiders, stock analysts, investors, etc.).

Capital strucre theories

In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities.. In reality, capital structure may be highly complex and include dozens of sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e.g. by taking a short term loan etc. The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it disregards many important factors in the capital structure decision. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result provides the base with which to examine real world reasons why capital structure is relevant, that is, a company's value is affected by the capital structure it employs. Some other

reasons include bankruptcy costs, agency costs, taxes, and information asymmetry. This analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of the firm.

Capital structure in a perfect market(mm theory)

Consider a perfect capital market (no transaction or bankruptcy costs; perfect information); firms and individuals can borrow at the same interest rate; no taxes; and investment decisions are not affected by financing decisions. Modigliani and Miller made two findings under these conditions. Their first 'proposition' was that the value of a company is independent of its capital structure. Their second 'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk. That is, as leverage increases, while the burden of individual risks is shifted between different investor classes, total risk is conserved and hence no extra value created. Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure, then would be to have virtually no equity at all, i.e. a capital structure consisting of 99.99% debt.

Capital structure in the real world(violations of assumptions)

If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance. The theories below try to address some of these imperfections, by relaxing assumptions made in the M&M model.

Trade-off theory

Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to financing with debt (namely, the tax benefits of debt) and that there is a cost of financing with debt (the bankruptcy costs and the financial distress costs of debt). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Empirically, this theory may explain differences in D/E ratios between industries, but it doesn't explain differences within the same industry.

The Trade-off theory of capital structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits . Trade-off theory of capital structure basically entails offsetting the costs of debt against the benefits of debt.

The Trade-off theory of capital structure discusses the various corporate finance choices that a corporation experiences. The theory is an important one while studying the Financial Economics concepts. The theory describes that the companies or firms are generally financed by both equities and debts. Trade-off theory of capital structure primarily deals with the two concepts - cost of financial distress and agency costs. An important purpose of the trade-off theory of capital structure is to explain the fact that corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc).

The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Modigliani and Miller in 1963 introduced the tax benefit of debt. Later work led to an optimal capital structure which is given by the trade off theory. According to Modigliani and Miller, the attractiveness of debt decreases with the personal tax on the interest income. A firm experiences financial distress when the firm is unable to cope with the debt holders' obligations. If the firm continues to fail in making payments to the debt holders, the firm can even be insolvent. The first element of Trade-off theory of capital structure, considered as the cost of debt is usually the financial distress costs or bankruptcy costs of debt. It is important to note that this includes the direct and indirect bankruptcy costs. Trade-off theory of capital structure can also include the agency costs from agency theory as a cost of debt to explain why companies don't have 100% debt as expected from Modigliani and Miller. 95% of empirical papers in this area of study look at the conflict between managers and shareholders. The others look at conflicts between debt holders and shareholders. Both are equally important to explain how the agency theory is related to the Trade-off theory of capital structure. The direct cost of financial distress refers to the cost of insolvency of a company. Once the proceedings of insolvency starts, the assets of the firm may be needed to be sold at distress price, which is generally much lower than the current values of the assets. A huge amount of administrative and legal costs are also associated with the insolvency. Even if the company is not insolvent, the financial distress of the company may include a number of indirect costs like - cost of employees, cost of customers, cost of suppliers, cost of investors, cost of managers and cost of shareholders. The firms may often experience a dispute of interests among the management of the firm, debt holders and shareholders. These disputes generally give birth to agency problems that in turn

give rise to the agency costs. The agency costs may affect the capital structure of a firm. There may be two types of conflicts - shareholders-managers conflict and shareholders-debt-holders conflict. The introduction of a dynamic Trade-off theory of capital structure makes the predictions of this theory a lot more accurate and reflective of that in practice.

Pecking order theory

In corporate finance, pecking order theory (or pecking order model) postulates that the cost of financing increases with asymmetric information. Financing comes from three sources, internal funds, debt and new equity. Companies prioritize their sources of financing, first preferring internal financing, and then debt, lastly raising equity as a last resort. Hence: internal financing is used first; when that is depleted, then debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required (equity would mean issuing shares which meant 'bringing external ownership' into the company). Thus, the form of debt a firm chooses can act as a signal of its need for external finance. The pecking order theory is popularized by Myers and Majluf (1984)[1] when he argues that equity is a less preferred means to raise capital because when managers (who are assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think that the firm is overvalued and managers are taking advantage of this overvaluation. As a result, investors will place a lower value to the new equity issuance.

The pecking order theory was first suggested by Donaldson in 1961 and it was modified by Stewart C. Myers and Nicolas Majluf in 1984.[2] It states that companies prioritize their sources of financing (from internal financing to equity) according to the cost of financing, preferring to raise equity as a financing means of last resort. Hence, internal funds are used first, and when that is depleted, debt is issued, and when it is not sensible to issue any more debt, equity is issued.

Theory
Pecking order theory starts with asymmetric information as managers know more about their companies prospects, risks and value than outside investors. Asymmetric information affects the choice between internal and external financing and between the issue of debt or equity. There therefore exists a pecking order for the financing of new projects. Asymmetric information favours the issue of debt over equity as the issue of debt signals the boards confidence that an investment is profitable and that the current stock price is undervalued (were stock price over-valued, the issue of equity would be favoured). The issue of equity would signal a lack of confidence in the board and that they feel the share price is over-valued. An issue

of equity would therefore lead to a drop in share price. This does not however apply to high-tech industries where the issue of equity is preferable due to the high cost of debt issue as assets are intangible [3]

Evidence
Tests of the pecking order theory have not been able to show that it is of first-order importance in determining a firm's capital structure. However, several authors have found that there are instances where it is a good approximation of reality. On the one hand, Fama and French,[4] and also Myers and Shyam-Sunder[5] find that some features of the data are better explained by the Pecking Order than by the trade-off theory. Goyal and Frank show, among other things, that Pecking Order theory fails where it should hold, namely for small firms where information asymmetry is presumably an important problem

Profitability and debt ratios

The pecking order theory explains the inverse relationship between profitability and debt ratios: 1. Firms prefer internal financing. 2. They adapt their target dividend payout ratios to their investment opportunities, while trying to avoid sudden changes in dividends. 3. Sticky dividend policies, plus unpredictable fluctuations in profits and investment opportunities, mean that internally generated cash flow is sometimes more than capital expenditures and at other times less. If it is more, the firm pays off the debt or invests in marketable securities. If it is less, the firm first draws down its cash balance or sells its marketable securities, rather than reduce dividends. 4. If external financing is required, firms issue the safest security first. That is, they start with debt, then possibly hybrid securities such as convertible bonds, then perhaps equity as a last resort. In addition, issue costs are least for internal funds, low for debt and highest for equity. There is also the negative signaling to the stock market associated with issuing equity, positive signaling associated with debt]

Agency Costs

There are three types of agency costs which can help explain the relevance of capital structure.

Asset substitution effect: As D/E increases, management has an increased incentive to undertake risky (even negative NPV) projects. This is because if the project is successful, share holders get all the upside, whereas if it is unsuccessful, debt holders get all the downside. If the projects are undertaken, there is a chance of firm value decreasing and a wealth transfer from debt holders to share holders. See the slide. FOR MORE INFORMATION

Underinvestment problem (or Debt overhang problem): If debt is risky (e.g., in a growth company), the gain from the project will accrue to debtholders rather than shareholders. Thus, management have an incentive to reject positive NPV projects, even though they have the potential to increase firm value.

The term debt overhang originated in the corporate finance literature and indicates a situation in which a firms debt is so large that any earnings generated by new investment projects are entirely appropriated by existing debt holders, and hence even projects with a positive net present value cannot reduce the firms stock of debt or increase the value of the firm (Myers, 1977). The concept of debt overhang migrated to the international finance literature in the mid-1980s, when the debt crisis motivated a series of influential papers by Krugman (1988, 1989) and Sachs (1989). These authors argued that, as sovereign governments service their debt by taxing firms and households, high levels of debt imply an increase in the private sectors expected future tax burden. Debt overhang characterizes a situation in which this future debt burden is perceived to be so high that it acts as a disincentive to current investment, as investors think that the proceeds of any new project will be taxed away to service the pre-existing debt.a A weaker version requires only uncertainty by investors as to whether the government will expropriate the return on their investment, or even uncertainty on the part of lenders to investors who may not be sure whether their claims will take precedence overor be superseded by the governments taxing power.b Lower levels of current investment, in turn, lead to lower growth and, for a given tax rate, lower government revenues, lower ability to pay, and lower expected value of the debt. Countries that suffer from debt overhang will have no net resource flows because, by definition, any new loan that might be issued would be worth less than its nominal value, and no new creditor will be willing to lend when a loss is certain. Countries that suffer from debt overhang may be located on the wrong side of the Debt Laffer curve described in the figure on the facing page and are characterized by a situation in which partial debt cancellation that reduces the expected tax burden can make both lenders and borrowers better off by increasing investment and growth and thus tax revenues and the value of debt. Even if creditors could be better off by canceling debt, debt cancellation requires a coordination mechanism that forces all creditors to accept some nominal losses. In the absence of such a coordination mechanism, each individual creditor will prefer to hold out while other creditors cancel part of their claims. The key question is, at what level does debt become a debt overhang? It is easy to find this level in a theoretical model with the help of convenient assumptions (Borensztein, 1990). But it is harder to find debt overhang in the data. There is also an important distinction between emerging markets (which economists had in mind in the 1980s when the issue was first debated) and developing countries, where there is little borrowing from private sources and repayment obligations on official debt tend to be soft, as debt is often rolled over continuallyAccording to Krugmans (1988) definition, a country suffers from debt
overhang when the expected present value of future country transfers is less than the current face value of its debt.
b

Corden (1989) extended the concept of debt overhang to explain a lack of motivation on the part of governments to implement economic stabilization and policy reforms, in the expectation

that any revenues generated by an improvement in the domestic economy will go entirely to servicing debt..

Free cash flow: unless free cash flow is given back to investors, management has an incentive to destroy firm value through empire building and perks etc. Increasing leverage imposes financial discipline on management

See the slde FOR MORE INFORMATION

Return on Equity Return on equity (ROE) is the best way to learn how much money a company is making for its investors. It is calculated by dividing the company's net profit by shareholder's equity. It is represented mathematically (in percentage terms) as follows: ROE = Net Profit *100/Equity ROE can reveal how much the company is making compared with how much it has invested to make that. Just to use a simple example, if you invest $100 in a rare baseball card and sell it for $120, your net profit will be $20 ($120 - $100 = $20), and your ROE would be $20/$100 or 20%. The $100 in the denominator is your equity in the card business. The latest available ROE figures at the time of this writing for Microsoft Corporation, PepsiCo, and Motorola, were approximately 28.4%, 29.8%, and 5%. When looking at a company, it is important to look at the trend in ROE to make sure that it is not steadily declining. Seasoned investors sometimes look at the ROE of other companies in the same industry to make sure that the ROE of the company they are looking at is in line with its competitors'. Earnings per Share Earnings per share , or EPS, is the amount of money the company actually earns for each share of stock that is outstanding. It is calculated, in percentage terms, as follows: EPS = Net Profit*100/(#Of Common Shares Outstanding) EPS should increase each year. As discussed earlier, companies report their earnings for each quarter-in other words, every three months. Just before companies announce their earnings to the world, investment analysts make predictions about the amount of money these companies will

make for each share of stock outstanding for the current quarter and for the year (or years) to come. This information can give you a good idea what the best minds on Wall Street think about certain companies. Wall Street analysts publish their best EPS estimates for big, publicly traded companies. When these companies finally report their earnings, most investors usually compare the Wall Street analysts' projections with the companies' actual earnings per share for the quarter. If the actual EPS is less than the Wall Street analysts' projections, the stock price of the company usually goes down. The opposite can also happen. We recommend that Teenvestors ignore analysts' earnings projections for the current quarter and focus on long-term projections and the reasons why those projections were made. What should matter to you is what the analysts feel the stock will do in the next year or two. See if their logic makes sense to you; invest for the future, not the present. Price-Earnings Ratio The price-earnings ratio , or PE (also known as PE ratio), is one of those topics that we have to discuss, not because it is so important to Teenvestors, but because a lot of other investors focus on it. The PE is one way investors use to determine how much a stock costs compared with how much the company earns. The PE is today's price of the stock divided by the amount of money per share made by the company over the past year. Mathematically, it is calculated as follows: PE = Today's Price Per Share/EPS Like most of the data in this chapter, PE can be found in a number of good financial websites. The way to interpret PE is that it tells you how many years it will take for you to get back your investment if you buy one share of a company's stock (and all of the company's net profit each year gets distributed as dividends). By way of example, suppose you buy a share of Teenvestor Inc. at $30 and the yearly EPS (earnings per share) is $2. This means that the first year after buying the stock, you would earn $2. You'd earn another $2 for the second year; and another $2 for the third year. If we keep going, you will see that it will take 15 years to earn back a total of $30-your initial investment. You could have figured out how long it will take to earn back the $30 investment by dividing the stock price by the earnings per share ($30/$2 = 15). Investors refer to stock as either cheap or expensive based on PE levels. For a given stock, a PE of, say, 20 is more expensive than a PE of 15. Some investors believe that, over a long period of time, the PE of companies stays stable, so they watch PEs to see when it is cheap for them to buy the stock. For example, if the PE ratio of Teenvestor Incorporated has been 50 for the past 10 years, and is suddenly 30, these types of investors will buy more of Teenvestor Incorporated's stock in hopes that the PE ratio will move back up to 50, meaning that the stock price may go back up. But one major flaw of focusing on PE ratios is that PE can increase even if the stock price does not go up. If EPS goes down, the PE ratio can go up. What this means is that if you buy Teenvestor Incorporated's stock when it has a PE ratio of 30, and it later goes to a PE ratio of 50, it would not necessarily mean that the company's stock price went up. It could mean that earnings per share went down.

Growth stocks (or companies whose earnings grow by 10-20% per year for about 5 years or more) usually have high PE ratios. PE ratios are typically high for technology and Internet companies if they make money at all. For example, at the height of the Internet boom in 2000, the PE ratio for eBay, the online auction house, was over 2300. This high level of PE is not really meaningful to an investor since the only reason it was so big was because eBay was making very little money at that time. In other words, eBay's tiny earnings at that time, which is used in the denominator of the PE formula (Price Per Share/Earnings Per Share) made the ratio very big. To drive the point home, what will be the PE ratio of a company that has no earnings? Mathematically, when you divide any stock price by 0 (which represents no earnings), you will get an infinite number. Of course, an infinite PE ratio is meaningless. For new industries (such as the industries created from the Internet), you can't use the PE ratio as a measure of whether companies are cheap or expensive until these companies have steady earnings over a 3 to 5-year period. And even then, using PE ratio to spot bargains is flawed. The latest available PE ratios at the time of this writing for Microsoft Corporation, PepsiCo, and Motorola, were approximately 49.5, 25.8, and 66.4, respectively.

What Is Dividend Yield And Dividend Payout Ratio?

As lingering concerns and uncertainties over the developments onEuropes debt crisis continued into the first half of 2012 against the backdrop of low growth and low interest rate environment, the consensus among many research and fund houses for investors is to stay defensive and pursue a yield-oriented investment strategy. Investors get to participate in potential share price appreciation while earning a regular income in the form of dividends well above the paltry interest rates on bank deposits. So, what is Dividend Yield and Dividend Payout Ratio? Dividend Yield measures the rate of return in the form of cash dividends while Dividend Payout measures the proportion of a companys net earnings that are being distributed as dividends to shareholders. Dividend Payout thereby offers an indication of the companys ability to maintain the level of dividend payment. They are computed as follows:

where Annual Dividends Per Share exclude the one-off special dividend payout (where applicable) since it does not constitute a shift in the companys dividend policy. Example: If the dividends per share of a company is $0.50 per annum and the stock is trading at $10.00 per share, the stock currently gives a yield of $0.50 / $10.00 x 100% = 5.00%. With an Earnings Per

Share of $0.80 for the year, the company has a Dividend Payout Ratio of $0.50 / $0.80 = 0.625 times. Dividend-based or Income-based Investing Dividends are of great interest to income-oriented investors who seek a minimum and regular income stream from their investment. Dividend-paying stocks may also appeal to investors with a smaller risk appetite as they are typically stocks of well-established and stable companies in mature industries with modest growth opportunities. This is especially so in times of market downturns or market uncertainty where capital gains in the stock market are hard to come by. Moreover, unlike share price appreciation, which is determined by numerous factors including non-fundamental influences such as market sentiment and momentum as well as the global economies, dividend returns represent actual cash payout by companies to their shareholders in accordance with the companys dividend policy. Dividends thus provide investors with a steady return even at times when share prices are volatile. Furthermore, stocks with high and stable dividend yields tend to be more resilient or resistant to a decline in price in market downturns than lower-yielding stocks because they are in effect yield supported. Hence, investors are more willing to hold on to these high dividend yielding defensive stocks through a bear market. Considering the hefty financial commitment required of the company in paying stable cash dividends to its shareholders at regular intervals over time out of its earnings, dividend-investing strategy can assist investors in sifting out companies with steady earnings and good financial health. The companys ability to make regular or steadily increasing cash dividends over time is also an indication of confidence in the companys future business prospects. In current times of low interest rate environment, investors also look to dividend-paying stocks as attractive substitutes for offering better returns on investment. Nevertheless, not every company pays dividends. Rapidly growing companies are likely to retain most or all of their profits for reinvestments into the business in the hope of creating shareholder value through share price appreciation and capital gain. Hence, Dividend Yield does not provide for a meaningful evaluation for such companies. What to look out for in High Dividend-Yielding Stocks? As with all other financial metrics, investors should not rely solely on a single metric in stock evaluation. High Dividend Yield can be a result of a substantial fall in the share price relative to the same level of annual dividend payments. Thus, investors should always keep in mind the following considerations when investing in high dividend-yielding stocks:

Consistency of the companys dividend payment history. Companies with a credible track record of stable or rising dividends payments over time are preferred over erratic dividend payment history to provide the safety buffer income-oriented or value investors are seeking. Sustainability of the companys current high Dividend Yield.

Investors ought to pay heed to the companys ability in sustaining its current level of yield and the prospects of increasing the level of dividends in the future by looking at its Dividend Payout policy. Rapidly growing companies and companies where earnings fluctuate with the economic cycles tend to have lower Dividend Payout Ratios while the converse applies to companies in mature industries. Nonetheless, a high Dividend Yield together with a low Dividend Payout Ratio suggests that the company has enough room to sustain its dividend when times get tough and is thus favoured. As dividends are ultimately paid with cash not earnings, investors should check a companys Dividend Payout Ratio against a comfortable margin of free cash flow to ensure that the payout is sustainable.
What Is Price/Earnings (P/E) Ratio?

Price/Earnings (P/E) is a valuation metric based upon the expected future earnings of the company as perceived by the market. Expressed as a price multiple of the Earnings Per Share (EPS), the multiple represents the number of years of todays earnings it would take for the company to equate to its perceived present market value. The higher the multiple, the higher the premium investors are willing to pay per dollar of EPS. Simply put, P/E ratio is computed as follows:

Example: If a company were to earn $1 per share with its share trading at $15, its P/E ratio is $15/$1 = 15 times.
Historical P/E

Typically the reported P/E ratio of a company is the historical P/E ratio. This is based on the EPS reported for the past financial year. Since the EPS does not change until the end of the next reported financial year, a disadvantage of the historical P/E ratio is that it will not accurately reflect the valuation of the company. In order to get a more accurate picture, some analysts turn to the rolling P/E ratio. The rolling P/E ratio is still calculated based on the historical financials, but in this case, it is based on the EPS of the last 4 financial quarters of the company. A caveat: it should be noted that historical earnings are not representative of the companys future earnings. At ShareInvestor, we provide both historical and rolling P/E ratios in our Factsheet.

Forward P/E

In order to value a company, research analysts will project the earnings of a company into the future. The forward P/E ratio is derived from the projected earnings of the company and this can then serve as a basis of valuing the company. Since this is based on projections rather than factual figures, a common issue is the differences in forward P/E ratios which are reported by different research houses, since all of them make different assumptions in deriving their projections. A quick summary of the various P/E ratios is given in the table below.
Historical P/E Derived from the EPS Computation for the past financial year Computation is based on actual earnings as reported by the company. Rolling P/E Forward P/E

Derived from the EPS Derived from the projected earnings for for the past 4 quarters the company for the future 4 quarters Computation is based on actual earnings as reported by the company. Takes into account projected earnings growth of the company similar to the way the market prices a stock based on the projected future earnings.

Advantage

May not be accurate as it is based solely Historical earnings are Historical earnings are on projections and assumptions rather Disadvantage not representative of not representative of than factual figures. Different research analysts have different ways of future earnings. future earnings. estimating future earnings of a company How do we use and interpret the P/E ratio?

Typically we use the P/E ratio of a company for comparison in the following areas: 1. Against its 2. Against other companies with 3. Against the industry or sector average past comparable performance models

business

For example, if the P/E ratio of a company in the Maritime industry is 10 while the average P/E ratio of the entire Maritime industry is 7, the company may be overvalued and we will want to look at the reasons contributing to the higher valuation. A high P/E ratio is attractive to growth investors who are willing to pay a higher premium for todays earnings in anticipation of higher future earnings growth of the company. However the downside risk is higher as investors will have higher expectations for that stock and if the companys future earnings do not meet the expectation of the market, the share price may fall. A

case in point is the badly-hit technology stocks which were excessively priced for their growth potential during the dot-com boom at the turn of the millennium. Unlike growth investors who view high P/E ratio stocks as attractive investments, value investors are less inclined to buy stocks which are deemed to be overpriced. Instead, value investors would prefer undervalued stocks which are trading at low P/E ratios at a bargain. It is in their belief that the market price will ultimately gravitate towards the stocks fair value over time given the companys growth potential. One important point to note is that P/E ratios vary over time due to business earnings cycles and across industries as well as markets. In addition, P/E ratios of companies in mature industries tend to be lower than companies in relatively rapidly growing industries with more robust prospects. The EPS and P/E are trailing ratios as derived from the actual net earnings for the last reported financial year and are adjusted for the latest number of issued ordinary shares. The Rolling EPS and Rolling P/E are trailing ratios as derived from the actual net earnings for the last reported 4 quarters or 2 half-years, where available, subsequent to the earnings release for the last financial year and are adjusted for the latest number of issued ordinary shares. In this example, the stocks valuation has improved slightly as the stock is trading at a higher price multiple (Rolling P/E: 12.920 which provides for a more up-to-date view of the current market sentiment as opposed to P/E: 12.793). The price-multiple range within which it is trading as compared to the P/E of the Straits Times Index (STI) nearing its historical low at 12.500 times in Year 2011 suggests that it is relatively attractive. Where companies incur net losses, the resultant P/E ratio becomes negative. Negative P/E ratios are not meaningful as investors would not be able to draw valuation comparisons for such stocks against other stocks on the basis of future earnings prospects. Hence we do not show negative P/E ratios.
What are the shortcomings or caveats of P/E?

When evaluating a companys performance, investors ought to watch out for the quality and sustainability of earnings reported according to accounting conventions as these are susceptible to assumptions, interpretations and management manipulation to meet near-term expectations. The accounting treatment of exceptional one-time gains or losses can also distort the resulting P/E ratios since such non-recurrent components of earnings are not incurred in the ordinary course of business and hence have no implications on the companys future earnings prospects. As a rule of thumb, over the longer term, earnings should be consistent with rather than exceeding free cash flow. Lastly, investors ought to ensure accounting policies in measuring earnings should be applied consistently across before performing any form of comparisons.

Hence, while ratio analysis can be a useful technique in evaluating a companys financial position and performance when appropriately applied in context, the astute investors should endeavour to look beyond the numerical measurements and examine further into the underlying corporate and macroeconomic developments in the interpretation and analysis of the financial ratios. By the same token, investors should never rely on a single financial ratio in making investment decisions.

Agent-Principle Relationship
Potential Agency Problems An agency relationship occurs when a principal hires an agent to perform some duty. A conflict, known as an "agency problem", arises when there is a conflict of interest between the needs of the principal and the needs of the agent. In finance, the two primary agency relationships that exist are between: Managers and stockholders Managers and creditors 1. Stockholders versus Managers

If the manager owns less than 100% of the firm's common stock, a potential agency problem between mangers and stockholders exists. Managers, at times, may make decisions that have the potential to be in conflict with the best interests of the shareholders. For example, managers may grow their firm to escape a takeover attempt to increase their own job security. However, a takeover may be in the shareholders' best interest.

2. Stockholders versus Creditors

Creditors decide to loan money to a corporation based on the riskiness of the company, its capital structure and its potential capital structure. All of these factors will affect the company's potential cash flow, which is the main concern of creditors. Stockholders, however, have control of such decisions through the managers. Since stockholders will make decisions based on their best interest, a potential agency problem exists between the stockholders and creditors. For example, managers could borrow money to repurchase shares to lower the corporation's share base and increase shareholder return. Stockholders will benefit; however, creditors will be concerned given the increase in debt that would affect future cash flows.

motivating Managers to Act in Shareholder's Best Interest Four primary mechanisms are used to motivate managers to act in stockholders' best interests:

Managerial compensation Direct intervention by stockholders

Threat of firing Threat of takeovers

1.Managerial Compensation Managerial compensation should be constructed not only to retain competent managers, but to align managers' interests with those of stockholders as much as possible.

This is typically done with an annual salary plus performance bonuses and company shares. Company shares are typically distributed to managers either as: o Performance shares, where managers will receive a certain number shares based on the company's performance. o Executive stock options, which allow the manager to purchase shares at a future date and price. With the use of stock options, managers are aligned closer to the interest of the stockholders as they themselves will be stockholders.

2.Direct Intervention by Stockholders Today, the majority of a company's stock is owned by large institutional investors, such as mutual funds and pensions. As such, these large institutional stockholders have the ability to exert influence on mangers and, as a result, the firm's operations. 3.Threat of Firing If stockholders are unhappy with current management, they can encourage the existing board of directors to change the existing management, or stockholders may even re-elect a new board of directors that will accomplish the task. 4.Threat of Takeovers If a stock price deteriorates because of management's inability to run the company effectively, competitors or stockholders may take a controlling interest in the company and bring in their own managers. corporate governance

If corporate collapses like Enron, Global Crossing and World Com have taught us anything, it's that investors can't afford to ignore the issue of corporate governance. When conducting fundamental analysis, investors need to keep a close eye on the way that companies keep management in check and ensure financial disclosure, board independence, and shareholder rights. Recent studies suggest that the benefits of scrutinizing governance extend beyond simply avoiding disasters. Good corporate governance can increase a company's valuation and boost its bottom line. What Is Corporate Governance? Corporate governance is a fancy term for the way in which directors and auditors handle their

responsibilities towards shareholders and other company stakeholders. Think of it as the system by which corporations are directed and controlled. Typical corporate governance measures include appointing non-executive directors, placing constraints on management power and ownership concentration, as well as ensuring proper disclosure of financial information and executive compensation.

Surprisingly, corporate governance has been considered a secondary factor impacting a company's performance. That is, as opposed to a company's financial position, strategy and operating capabilities, the effectiveness of governance practices was largely seen as important only in special circumstances like CEO changes and merger-and-acquisition (M&A) decisions. But recent events prove that governance practices are not merely a secondary factor. When the company's share price tanks because of an accounting scandal, the importance of good governance practices become obvious. Corporate disasters show that the absence of effective corporate controls puts the company and its investors at tremendous risk.

What the Studies Prove For years, investors ignored corporate governance because academic research found no clear causal link between governance and financial performance. But that is starting to change. A paper by Harvard and Wharton business professors entitled "Corporate Governance and Equity Prices" (2003) concluded that investors that sold U.S. companies with the weakest shareholder rights and bought those with the strongest shareholder rights earned an additional return as high as 8.5%. The study analyzes 1,500 companies and ranks them based on 24 corporate governance provisions. Those companies with the lowest rankings were less profitable and had lower sales growth. Moreover, the returns on these companies lagged far behind those of higher ranked firms. The paper also shows that for each one-point increase in shareholder rights, a company's value increased by a whopping 11.4%. Meanwhile, a study produced in 2000 by global consultancy McKinsey found that 75% of the 200 institutional investors it surveyed regard board practices as important as financial metrics for assessing companies. The study showed that companies that moved from the worst to the best governance practices could expect a 10% increase in market valuation. Investors Are Starting to Take Notice Amid all the hand wringing about corporate governance, investors are getting help in steering clear of misgoverned companies and finding well-governed ones. Governments, stock exchanges and securities watchdogs are coming up with new rules and regulations that try to put a stop to some of the worst cases of corporate failure. Proposals at the New York Stock Exchange and the SEC that push for more

boardroom independence and greater financial expertise in audit committees certainly accelerate improved practices and reassure investors.
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At the same time, a veritable cottage industry has sprung up among ratings agencies and consultants issuing corporate governance ratings. Investors can turn to Standard & Poor's Corporate Governance Score and Institutional Shareholder Services' Corporate Governance Quotient. Both of them report and grade public companies' governance practices. In addition, the Investor Responsibility Research Center, along with corporate governance watchdogs like the Corporate Library and Governance Metrics provide governance performance ratings. While new regulatory proposals and rating systems are valuable to investors, they are no guarantee that companies are well run. Investors need to evaluate corporate governance for themselves. Here is a quick list of key issues for investors to consider when analyzing corporate governance:

Board Accountability - Boards of directors (BODs) are the links between managers and shareholders. As such, the BOD is potentially the most effective instrument of good governance and constraint on the top managers. Investors should examine corporate filings to see who sits on the board. Make sure you seek out companies with plenty of independent directors who have no commercial links to the firm and who demonstrate an objective willingness to question management choices. A minority of independent directors make it difficult for the board to operate outside the sphere of management influence. Do directors own shares in the company? If not, they may have less incentive to serve shareholders' best interests. What are directors' attendance records at board and committee meetings? Finally, does the board adhere to a set of published governance principles? Financial Disclosure and Controls - Investors should insist that corporate structure includes an audit committee composed of independent directors with significant financial experience. Ideally, the committee should have sole power to hire and fire the company's auditors and approve non-audit services from the auditor. Persistent earnings restatements or lawsuits challenging the accuracy of financial statements provide a clear signal to investors that financial disclosure and controls are not functioning properly. Top management compensation should be determined by measurable performance goals (shareholder return, ROE, ROA, EPS growth), and, if possible, the compensation rate should be set by an independent compensation committee and fully disclosed. Shareholder Rights - Be wary of companies with dual-class stock. Class A and B shares can place major constraint on shareholder rights, enabling insiders to accumulate majority power by virtue of owning vote-tilted class B shares. Voting should always be routine through mail, telephone and Internet, and shareholders should have the right to approve major transactions, including mergers, restructuring and equity-based compensation plans. Market for Control - Management power can become entrenched by strong takeover defense provisions, such as poison pills or the issue of blank check preferred preferred stock. These mechanisms protect against hostile takeovers and subsequent management change, but investors should cheer poison-pill plans only when fully trusting and supporting management.

Be aware also that directors - especially executive board directors - have a habit of granting generous stock options to top managers. While stock options offer management an incentive to perform well, overloaded stock-option accounts create the possibility of unwanted share value dilution. The more stock options management owns, the bigger the drop in share value will be when these options are exercised.

Because the quality of corporate governance determines how a company allocates shareholder rights and aims to maintain the value of shares, investors should vigilantly analyze and evaluate the governance of their current and potential investments.

Economic Impact of Asymmetric Information Theory

Introduction:

The attempt is m ade in the first article of this series trying to explore the impact of economics of asymmetric information on the decision making process in the two secto rs vital to the macroeconomics. They are the financial sector market and the capital sector market of the economy. Each article will address the content issues of the asymmetric theory and the practical application thereof on the particular aspect of these two markets.

In the beginning, while reviewing the existing literature on this theory, on the electronic and print media; authors have taken references of the articles written by international scholars from different websites and the views expressed by the Indian scholars through paper presentation in one of the national level conference, which are further edited in the book form by Economics of Asymmetric Information by Nachane and Chatterjee, (2006). There are endless references as the topic is widely accepted by the theoreticians and the practitioners.

The dictionary meaning of the term is a 'condition in which at least some information is known to some but not to all the parties to the transaction'.

According to economists, ' information asymmetry causes market to become inefficient; since all the market participants do not have access to the information they need for their decision making process'.

One can begin his study by referring to the outstanding work by the Nobel Prize winning trinity-Akerlof, Spence & Stiglitz (2001), who demonstrated that ' market may break down completely in the presence of asymmetric information and the three distinct consequences emerging,

(a) Adverse selection, (b) Moral hazard, & (c) Monitoring cost

CAPITAL STRUCTURE THEORIES . Draw the following two graphs, one above the other: In the top graph, plot firm value on the vertical axis and total debt on the horizontal. Use the graph to illustrate the value of a firm under M&M without taxes, M&M with taxes, and the static theory of capital structure. On the lower graph, plot the WACC on the vertical axis and the debt/equity ratio on the horizontal axis. Use the graph to illustrate the value of the firms WACC under M&M without taxes, M&M with taxes, and the static theory. Briefly explain what the two graphs tell us about firm value and its cost of capital under the three different theories.

The student should replicate and explain Figure 17.8 from the text.

PREPACKAGED BANKRUPTCY . What are the advantages of a prepackaged bankruptcy for a firm? What are the disadvantages?

A prepack allows a firm to minimize its stay in bankruptcy court and should allow the firm to minimize its bankruptcy costs as well. In either case, management is freed up to spend time on more productive tasks such as operating the firm. The negative side of a prepack is a little more difficult to discern. Astute students will recognize that prepacks take time to negotiate, that is, they may save time during bankruptcy, but they are likely to take more time up front than a straight bankruptcy filing. Furthermore, it is also likely that the firm must give creditors a better deal in order to get them to sign on to the bankruptcy agreement. Should this be the case, the firm may actually get better terms from its creditors by going through with a full bankruptcy process.

CAPITAL STRUCTURE THEORY . Is there an easily identifiable debt-equity ratio that will maximize the value of a firm? Why or why not?

Students should explain that in a world with taxes, transaction costs, and financial distress costs, there are both benefits and costs to higher debt loads, and there is no way to target exactly what the ideal capital structure should be.

BUSINESS AND FINANCIAL RISK . Describe some of the sources of business risk and financial risk. Do financial decision makers have the ability to trade off one type of risk for the other?

Students should intuitively recognize that some of the observed variation in capital structures across industries reflect the differences in the nature of the industries themselves i.e., business risk. Similarly, intuition would suggest that firms with large capital requirements and stable cash flows (e.g., electric utilities) are more likely to be willing to raise funds via large amounts of borrowing. Alternatively, firms with lower tangible asset needs and highly uncertain cash flows (e.g., small software companies) are more likely to employ equity.

CAPITAL STRUCTURE THEORIES

Based on M&M with taxes and without taxes, how much time should a financial manager spend analyzing the capital structure of their firm? What if the analysis is based on the static theory?

Under either M&M scenario, the financial manager should invest no time in analyzing the firms capital structure. With no taxes, capital structure is irrelevant. With taxes, M&M says a firm will maximize its value by using 100 percent debt. In both cases, the manager has nothing to decide. With the static theory, however, the manager must determine the optimal amount of debt and equity by analyzing the tradeoff between the benefits of the interest tax shield versus the financial distress costs. Ultimately, finding the optimal capital structure is challenging in this case.

HOMEMADE LEVERAGE

Explain homemade leverage and why it matters.

Homemade leverage is the ability of investors to alter their own financial leverage to achieve a desired capital structure no matter what a firms capital structure might be. If investors can use homemade leverage to create additional leverage or to undo existing leverage of the firm at their discretion then the actual capital structure decision of the firm itself becomes irrelevant.

COST OF EQUITY

In each of the theories of capital structure the cost of equity rises as the amount of debt increases. So why dont financial managers use as little debt as possible to keep the cost of equity down? After all, isnt the goal of the firm to maximize share value and minimize shareholder costs?

This question requires students to differentiate between the cost of equity and the weighted average cost of capital. In fact, it gets to the essence of capital structure theory: the firm trades off higher equity costs for lower debt costs. The shareholders benefit (to a point, according to the static theory) because their investment in the firm is leveraged, enhancing the return on their investment. Thus, even though the cost of equity rises, the overall cost of capital declines (again, up to a point according to the static theory) and firm value rises.