Stock Price and the Variation of Capital Structure

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The world of business and finance is a rather complicated phenomenon due to the numerous rules and laws that regulate the relations between private persons and the whole business entities in it. One should be aware of the supply and demand conditions, price fluctuations, etc. to become a successful business player (Arnold, 2008). The notion of capital structure is also vital for any business entity as far as capital structure predetermines the value of the company and its ability to compete in the market. The elements of the capital structure of any firm are similar, while the value of each of them might be treated differently depending on the purpose of consideration and the context of the latter (Babbel, 1995). This paper examines the relations of the capital structure variations and stock prices of the organizations through the prism of MM model and Pecking Order theory and exemplifies the ideas with the data obtained from two Hong Kong business companies – CLP and HK Electric. At once, we should consider the basic ideas that surround the notion of the capital structure and see the elements that comprise the latter. Thus, according to Thompson (2005), capital structure is “the combination of debt and equity used to finance a firm” (Thompson, 2005). Being a kind of debt/asset ratio (D/A), the capital structure of any organization (WACC) demands precise calculation through the following formula:

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WACC = 10% D/A (1 – 4) + 14% D/A (1 – 4).

At the same time, the debt and equity of the firm also affect its capital structure and makes the following formula into one of the most precise reflections of capital structure elements and their interaction:

ke = ko + D/E (ko – kd)

In this formula, we can observe ke as the required rate of equity return, ko presenting the cost of the capital of the firm financed only through equity, kd used to denote the cost of debt for the firms that are financed either partially or completely by issuing and selling debt, and D/E expressing the relation of debt to equity of the firm. In this respect, it is obvious that scholars see little connection between the capital structure of a company and the price of its stock. In other words, the company’s value, i. e. the capital structure, is based mainly on the ways of using the capital but not on the ways of its formation.

To support this point of view, the theories by Modigliani-Miller and the Pecking Order theory should be considered. The latter stresses the exclusive importance of stock prices and ways of the company’s funding for the formation of its stock capital, and thus excludes all other ways of capital structure formation making the very question about the relation of stock prices and capital structure irrelevant as both notions are similar in their essence (Cuthbertson and Nitzsche, 2009). However, the Modigliani-Miller model of capital structure rejects the importance of stock prices and ways of the firm’s funding at all from the number of factors that predetermine the capital structure and the value of the firm.

To explain this, the authors use two propositions that deal with the capital structure in the situation when no taxes are involved and in the situation when taxes are to be paid. In the first scenario, Modigliani and Miller consider two firms as an example (Firm U and Firm L for unlevered and levered firm respectively), stating that the stock prices of both will be equal according to the formula Vu = Vl, where V is the value of the firm. However, given the tax involving scenario, Modigliani and Miller find out that the only variable in the value of a firm under these circumstances will be the tax rate and the amount of debt the company has to currently pay:

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Vu = Vl + TcD (where TcD represents the tax rate multiplied by the value of debt)

To exemplify the formulas mentioned above more specifically, let us consider the data retrieved from the Hong Kong companies CLP and HK Electric (CLP, 2006; HK Electric, 2006). Given the same methods of calculating the capital structure values of the two firms, we can see how the different stock prices influence the overall values of the firms. Thus, CLP at 29/12/2006 had 1,077,500 shares of its stock in the market and the average cost of each amounted to 52.8 cents. In the same period of time, HK Electric had 1,250,200 shares in the market with the price per share being 33.62 cents (CLP, 2006; HK Electric, 2006). Accordingly, the total value of CLP stock amounted to $568,920, while the stock of HK Electric cost $420,317 on the given date in 2006. The value of debt HK Electric had at that time multiplied by the tax rate of 16% equaled $148,603:

VCLP (568,920) = VHK (420,317) + TcD (148,603)

Thus, we can observe that the capital structure of both companies remains the same if only the stock prices are taken into consideration. What actually has importance for the variations of capital structure of companies in the debt the companies have to pay as well as the potentially changing tax rate in a specific country.

References

Arnold, G. (2008). Corporate Financial Management. Pearson Education; 4th edition.

Babbel, D. F. (1995). The relation between capital structure, interest rate sensitivity, and market value in the property-liability insurance industry. Web.

CLP. (2006). CLP Share Price from 2003 to 2006.

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Cuthbertson, K. and Nitzsche, D. (2009). Capital Structure and Modigliani-Miller Propositions. Web.

HK Electric. (2006). HK Electric Share Price from 2003 to 2006.

Thompson, S. W. (2005). Capital Structure. Web.

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