5) (a) Discuss M & M preposition I of capital structure. (b) What is credit policy? Explain its variables.

 

TUTOR MARKED ASSIGNMENT 

COURSE CODE : MCO-07 

COURSE TITLE : Financial Managements 

ASSIGNMENT CODE : MCO-07/TMA/2022-2023 

COVERAGE : ALL BLOCKS 

5) (a) Discuss M & M preposition I of capital structure.

(b) What is credit policy? Explain its variables.

Answer a)

M&M (Modigliani-Miller) Proposition I is a fundamental principle of modern finance that states that, in a perfect and frictionless market, the total value of a company is independent of its capital structure, and is solely determined by its operating income, risk, and expected cash flows. In other words, the financing decision (i.e., how much to borrow and how much to raise from equity) does not affect the overall value of the firm, and it is possible for companies to create value only through their operations and investment decisions.

The M&M Proposition I assumes that the market is perfect and frictionless, meaning that there are no taxes, transaction costs, or information asymmetries that could distort the pricing of financial assets. It also assumes that investors are rational and can borrow or lend at the same risk-free rate as the company, and that there are no agency costs or other conflicts of interest between shareholders and managers.

According to the M&M Proposition I, the value of a company can be expressed as:

V = EBIT / r

Where V is the total value of the firm, EBIT is its earnings before interest and taxes, and r is the required rate of return of the company's assets, which is equal to the weighted average cost of capital (WACC) in a perfect market.

The M&M Proposition I also implies that the cost of equity (i.e., the return that shareholders require to invest in the company) is proportional to the risk of the company's assets, and is not affected by its capital structure. This is because the shareholders of the company bear the residual risk of the company, regardless of how it is financed. Therefore, the cost of equity can be expressed as:

ke = r + (r - rd) * D/E

Where ke is the cost of equity, r is the required rate of return of the company's assets, rd is the cost of debt, D is the market value of debt, and E is the market value of equity. The term (r - rd) * D/E represents the additional risk premium that shareholders require to invest in the company's equity rather than its debt.

While the M&M Proposition I provides a useful framework for understanding the relationship between capital structure and firm value, it is important to note that the real world is not a perfect and frictionless market, and that taxes, bankruptcy costs, information asymmetries, and other factors can have a significant impact on the optimal capital structure of a company. Therefore, the M&M Proposition I should be seen as a benchmark rather than a prescription for how companies should finance themselves.

The M&M Proposition I is often referred to as the capital structure irrelevance principle, as it suggests that a company's value is not affected by its mix of debt and equity financing. This is because the value of the company is based on its cash flows and risk, which are independent of its financing decisions.

The M&M Proposition I also implies that there is no optimal capital structure that maximizes the value of the company, as any change in the capital structure would not affect the value of the company in a perfect market. However, in the real world, companies need to consider the costs and benefits of different financing options, such as the tax benefits of debt and the risk of financial distress.

Furthermore, the M&M Proposition I assumes that investors have access to perfect information, which is not always the case in the real world. In practice, investors may not have complete information about a company's financial health or future prospects, which can affect the pricing of its securities and the costs of its financing.

Overall, while the M&M Proposition I provides a theoretical foundation for understanding the relationship between capital structure and firm value, it is important to consider the real-world factors that can impact a company's financing decisions and its value.

Answer b)

Credit policy refers to the set of guidelines and procedures that a company follows to manage its credit operations. It determines how the company will extend credit to its customers and how it will manage the associated risks. The goal of a credit policy is to ensure that the company's credit operations are efficient, effective, and profitable.

The variables of credit policy are as follows:

1. Credit Standards: These are the criteria that a company uses to evaluate the creditworthiness of its customers. They can include factors such as credit score, payment history, and financial statements.
2. Credit Terms: These are the conditions under which credit will be extended to customers. They can include the length of the credit period, the interest rate charged, and any penalties for late payment.
3. Credit Limits: These are the maximum amounts of credit that the company will extend to each customer. They can be based on factors such as the customer's creditworthiness, the amount of business they do with the company, and the company's overall financial situation.
4. Collection Policy: This is the process that the company uses to collect unpaid debts from customers. It can include measures such as sending reminders, making phone calls, and taking legal action.
5. Cash Discounts: These are discounts that are offered to customers who pay their bills early. They are designed to encourage customers to pay their bills on time and to improve the company's cash flow.
6. Credit Monitoring: This is the process of tracking the company's credit operations and monitoring for any potential risks. It can include measures such as analyzing credit reports, monitoring payment trends, and reviewing financial statements.
7. Credit Application: This is the process by which customers apply for credit from the company. It can include requirements such as providing financial information, references, and other relevant documents.
8. Credit Approval Process: This is the process that the company follows to approve or reject credit applications. It can include steps such as reviewing the customer's creditworthiness, verifying information, and making a decision based on the credit policy.
9. Credit Review: This is the process of regularly reviewing the company's credit operations to ensure that they are aligned with the credit policy. It can include measures such as analyzing credit reports, reviewing payment trends, and assessing the company's overall financial situation.
10. Credit Reporting: This is the process of reporting the company's credit operations to external credit bureaus. It can include providing information on customer payment histories, credit limits, and other relevant data.

By considering and managing these variables, a company can develop an effective credit policy that balances the need for revenue generation with the need for risk management. The credit policy should be reviewed regularly and adjusted as necessary to ensure that it remains aligned with the company's goals and objectives.