Capital Structure and Shareholders Wealth

Significance to the shareholders of the company. 13

1.7 Limitations of the Study. 13

1.8 Assumptions of the Study. 14

CHAPTER TWO: LITERATURE REVIEW... 15

2.1 Introduction. 15

2.2 Theoretical background. 15

2.2.1. Miller and Modigliani 1958. 15

2.2.2 The Pecking Order Theory. 16

2.2.3 Market Timing Theory. 18

2.2.4 Agency Theory. 19

2.2.5 Good Management Theory. 20

2.3 Empirical Research. 21

2.4 Research Gap. 23

2.5 Summary of Literature. 23

CHAPTER THREE: RESEARCH DESIN AND METHODOLOGY.. 24

3.0 Introduction. 24

3.6. Summary. 33

CHAPTER FOUR.. 35

DATA COLLECTION, ANALYSIS OF DATA AND DISCUSSION OF RESULTS. 35

4.1.1 Population: construction companies in the United Kingdom.. 36

4.1.2 Sampling for this study. 37

4.1.3 Multiple correlation analysis. 38

4.2. Multiple regression analysis. 39

4.3 Empirical results from the multiple regression analysis. 39

4.3.1 Exploring the degree of correlation between capital structure and profitability. 39

4.3.2 Multiple Correlation Analysis. 40

4.3.3 Testing degree of null hypothesis for best – fit multiple regression analysis. 40

4.4 Evidence of relationship between capital structure and market share price. 41

4.5 Evidence of relationship between capital structure and dividend policy. 49

4.6 Evidence of relationship between capital structure and shareholders’ wealth. 50

4.7 Summary. 52

References. 59

Appendices ............................................................................................................................. 67

Abstract

There is an increasing amount of the construction companies in the UK over the last few years. This increase has contributed a lot to the growth of the nation’s economy. For any company to prosper, it must be able to make wise decisions which can affect the capital composition and hence the shareholders’ funds. Capital structure is usually effected by the operations being undertaken by the company. The sole objective of any company’s management in an ideal situation is to maximize shareholder’s wealth. This means that all the activities being undertaken by the management should be geared towards improving the profitability which would subsequently maximize shareholders interest in the company. Shareholders wealth is seen in terms of dividends being distributed to the shareholders at the end of the year and also in terms of gain in the value of shares (capital gain) as quoted at the stock market. Shareholders wealth can also be seen in terms of the current value of the company which is also indicated by the amount of cash flows arising from the investments decisions made by the company’s management. Investors usually expect a consistent dividend policy from the company’s management so that they can be assured of stable payment of dividends at the end of each year and even growth in the amounts of dividends being paid.

The capital structure of the business unit is regarded quite essential in view of the fact that it sets roadmap for paying dividends. The retained profits section of the balance sheet will be affected by the action. The decision of whether to pay out a certain amount of dividends to the shareholders or not is usually dependent on the desire of the firm. If it is the wish of the company to maximise returns, then it must come up with an appropriate dividend pay-out policy which favours the interest of the shareholders. However, if it is the wish of the company to preserve the interests of the various constituents of the firm such as the creditors and at the same time maintaining its competitive edge, then a conservative approach of maintaining the capital structure of the company should be adopted. For a capital structure of an organisation to be effective, it must be a product of the various mix of securities combined together to give the maximum return to the shareholders and at the same time remaining competitive in a competitive environment. Despite the fact that a company can choose to adopt a certain capital structure amongst many alternatives, it is prudent that the structure adopted should give a maximum return to the shareholders and also ensure there is overall growth in the value of the company over time the capital structure can be heavily financed with debt or it may be financed by much of equity. These two alternatives would have an effect on the value of shares and the number of dividends that the shareholders will receive on year-end.

An appropriate combination of capital items that maximises the overall market value of the company should, therefore, be adopted. There is a number of theories that have been put forward in proposal of the adoption of a capital structure that is optimal for an organisation. Modigliani and Miller postulates a that a kind of capital structure chosen by a firm does not have any effect on the value of the company nor of the shareholder's. The propositions of this theory were countered by Myers and Majluf who came with alternative theory stipulating availability of the solid connection between capital composition of the firm and shareholders' funds. The findings of this research paper will contribute to the knowledge that has been developed by other researchers before. With a sample taken on the following companies: Saint Gobian, CHR, Kingspan Group, Balfour Beatty, Breeden Group PLC, In Stock PLC, Kier Group, James Halstead and Marshall company, the research found out that there is an impact that the capital composition adopted by a firm has on the shareholder's wealth. The study, therefore, recommends that a company should consider financing much of its projects using equity funds rather than using borrowed funds. The reason behind this is to take measures in preservation of the liquidity of the company.

CHAPTER ONE: INTRODUCTION

1.1 Background of the research

Adoption of an optimum Capital Structure usually holds a vital role in an organization regardless specificity of the domestic industry. Achievement of an optimal kind of capital structure is usually dependent on the choices made by the management in relation to the financing of the business activities of the firm. In the recent past, there has been an increasing concern for organizations to take precautionary measures when they are choosing the source of financing to boost the ever-increasing need for funds, especially in the construction industry. It can be deduced that construction companies usually require a huge amount of capital to finance their activities due to the nature of the project's they undertake. Nevertheless, any other firm usually needs funds to finance its operations. This situation usually forces the management to choose a particular alternative of sourcing funds that can be comprised of both equity and debt to form the capital structure (Onaolapo and Kajola 2010, p.78). It is therefore unavoidable that capital structure of the company should be combined of both equity and debt. The primary concern would be the structure in terms of the proportion of the size of equity funds to debt as this would influence the value of the shareholders.

Numerous theoretical approached have been elaborated by scholars in order to address state of the capital structure in the company and its effectiveness. Alienation of such ratios as equity and debt in the capital structure should be optimized such that the leverage level of the firm is maintained. Despite Modigliani & Miller proposition that the capital composition of the firm is not linked stock price of the business unit, an optimal capital structure has been found to be that which reduces the cost of the company in acquiring funds while at the same time maximizing the capital gains attributable to the shareholders. It is, therefore, true to say that the most effective capital structure should be reflected on the performance of the company. Hence capital structure of the company may be relevant to the value of the company and to the wealth of the shareholders. Despite constant investigation of the capital structure as a notion, there has never been a substantial research study that has come up with relevant findings to coin out the most relevant choice of a capital structure by utilizing the existing theories to give finance professionals guidance on the most optimal mix between equity and debt that can be adapted to finance a company (Karani, 2015, p. 15) Nevertheless, there has never been a unifying theory that has supported the choice of either equity or debt as a method of financing The existing theories are ‘‘generally useful’’ in explaining the need for the choice of a good capital structure. This study intends to consider if there is an exact impact of the capital structure over the wealth of the shareholders.

1.1.1 The Firm

The term firm has referred to in this dissertation is intended to mean a company which is a legal entity with rights to own property and rights, sue or be sued in its own the name and capacity. The primary motive for any firm is usually to make a profit and increase the shareholders' value in the long run. Even though the non-profit and charitable organization does not have to make profits, they usually have to make a set of accounts including a statement of assets and liabilities in order to keep pace with the amount of these resources. The firms being referred to in this case are the profit-making companies whose sole motive of operations is to earn a profit. A firm can either be private or public. Private firms are owned by individuals and the government has no control over its ownership (Majumdar, 2008, p. 42). A public firm is a company which has offered its shares to the public and is owned by a group of shareholders who might or might not include the government. The shareholders are the people who invest their funds into the firm trough buying of shares and subscribing to the memoranda of the company. Shares are unit of capital that is often bought at a certain price as dictated by the performance of the company in the stock market. Based on the dealings of the company, the share price can either appreciate in value above the original price or it might depreciate below its initial value. In case of appreciation, the shareholders usually realize a capital gain depending on the number of funds they have invested into the company. The shareholders also receive rewards for their investments in term of dividends at the end of the year. These two components of rewards desired by the shareholders are usually affected by the decisions formulated by the management regarding the capital structure of the company.

1.2 Problem Statement

Construction companies in the United Kingdom have been struggling with the ever-increasing competition from the global companies of other emerging economies. In a world where competition is very high, construction companies have been mitigating on employment of a number of operational and financial measures with a desire to give rise to the changes in the overall performance of the companies in the market. This strategy is the reason behind the major successes of a number of big companies in the United Kingdom. In conjunction with the general global rise of modern construction companies in the world due to the introduction of new technologies in the construction process, the future of these companies has also been promised by the contribution from its shareholders. It is the shareholders with the help of the management that has ensured that the firm is always supplied with enough funds that can be able to finance all of its operations (Arestis, Luintel and Luintel, 2004, p. 162). Despite the commitments by shareholders, constructional companies have been recently hit by a general economic slowdown coupled with rising fuel costs and prizes of construction materials. Despite government’s commitment to support the construction companies, there has been a challenge for other construction companies on the choice of the method of finance to fun the projects they are working on. The decision on whether to adopt the use of debt finance has been a dilemma for the management considering the repercussions on the capital structure that will come with that taking such an action. Furthermore, the market value of shares and the dividend policy currently in place would be affected if an organization decides to rely on debt as a major source of financing Mazur 2007, p. 500). The problem of financing would be more extreme in a case where the economic environment of the country is uncertain especially after the EU ‘‘Brexit'' in 2016. This paper therefore, sought to find out how the capital composition adopted by a company would affect the value of shareholders. In search of the findings, reference has been made to the existing literatures on what has been done before in this area of study by other researchers and also relevant capital structure theories will be considered.

1.2.1 Dividend Policy

Dividends can be defined as the amount of money that is payable to the shareholders in return for the funds they have invested in the firm. The decision whether to pay out dividends to the shareholders or not is dependent on the dividend policy adopted by the company. Moreover, the extent to which dividends are to be paid out is dictated by the profitability as well as the terms of the dividend policy of the company. According to the essence of agency theory, a company must pay the shareholders having determined the amount to pay using the accruals concept. Depending on the management deliberations, the dividends paid out can be as low as possible or as high as possible. For instance, is a company is eyeing involving itself in a major project the following year, it must consider cutting down the number of dividends to be paid out to the shareholders that year-end. In some cases, the management of a company can decide not to pay dividends at all. If this announcement gets to the public domain, the value of shares for the same company is going to reduce in the stocks market because no investor is willing to invest in a company where dividends are not assured.

Several theories in regard to how dividends should be paid out have been put forth. The theories postulate that the payment of payments should be based on the level of the cash flow of the firm. Since dividends are usually paid out in form of cash, the cash flow liquidity of the firm should be sound to permit payment of dividends for a given year end. Most countries usually prefer payment of dividends using cash as per requirements of International Accounting Standards Committee (IASC). The UK and US make use of this system during payment of dividends. The cash flow of a company can be easily tied to the amounts of profits registered by the firm., but that may not be the case. In some situations, a company might be having a lot of cash due to the sale of certain fixed assets without a gain on sale. In such a case, the cash would be realizing not from operations but from disposals of fixed assets (Zeitun and Tian 2007, p 469). For the purpose of this research, the payment of dividends in cash would be assumed to be arising from operating activities undertaken by the firm and not from proceeds of disposal of assets.

1.3 Aims of the Study

This research is intended to look for answers to both general and specific objectives.

General Objectives

To find out the impact that is brought about by capital structure on the value of shares.

To find out the major constituents for the capital composition of a firm.

To determine the ideal capital structure that can be adopted by a firm.

To establish relationship that is present between capital composition and dividend payout policy used to pay out the firm to the investors.

To prove if debt constitutes an important source of finance for a firm or not.

Specific objectives.

Measure effect of the organization of the capital on the shareholder’s wealth by taking a case of selected construction business units of the United Kingdom

1.4 Research Questions

These research aims precede search of the responses to the following research questions.

i. What impact is caused by the capital composition on the value of shares?

ii. What are the elements of the capital structure of the business unit?

iii. Which is the ideal capital structure that can be adopted by a firm?

iv. What relationship does exist between organizational structure and dividend payment process under which shareholders are paid out?

v. Does debt constitute an important source of finance for a firm?

1.5 Research hypothesis

The main focus of the investigation will be paid to the role and impact of the capital structure on the volume of payments to be issued to the shareholders. Hence, this research study is intended to prove the following hypothesis statements.

H01: Simple Hypothesis: Capital Structure has a direct effect on the overall wealth of the shareholders.

H01: Null Hypothesis. There is connection between capital structure and wealth of the shareholders. impact that capital structure has on the shareholder’s wealth.

H02: Alternate Hypothesis: Shareholders wealth is usually affected by other factors beyond capital structure as the most important variable.

1.6 Significance of the Research

Findings to this research will become a vital contribution as to the research field as to the operation of the construction companies in the United Kingdom regarding distribution of wealth in reference to the capital structure of the business unit.

1.7 Significance to the Management.

The management of any company is usually involved in regular operation of the company. They participate in adoption of the important decisions pertaining to the dealings of the firm which can affect the value of the shareholders. The main desire of the management of any organization is to see that the financing strategies that they put in place actually bring an impact to the performance and growth of the company. The findings of this research are intended to enlighten the management on how the capital structure they adopt would impact on the shareholder’s wealth. If indeed the capital structure has an influence on shareholder’s wealth, the management of the companies should consider adopting kind of capital structure that can increase the value of the shareholders.

Significance to the shareholders of the company.

Outcomes of this research should become essential for shareholders of construction companies in the United Kingdom. The motive of shareholders is usually to see that the management of the firm is putting into place financing strategies that can increase their value. Because there is an impact that the adoption of certain capital has on the value of shares they have in the firm, the shareholders should consider compelling the management to adopt a capital financing structure that can improve the value of their investments. In a case where the management of the company is adopting a capital structure that is increasing the shareholder’s wealth, the shareholders can decide to purchase more shares or sell them so as to realize a gain on sale. For prospective investors, they can decide to invest in those companies that have adopted a capital structure that improve their wealth.

1.8 Limitations of the Study

There is a number of construction of companies in the UK. Most of the companies are privately owned while a few are publicly owned –which means they have issued its shares to the public for purchase. This study will, however, focus on a few selected construction companies whose financial statements are publicly available. The targeted companies are Saint Gobian, Cry, Kingspan Group, Balfour Beatty, Breeden Group PLC, In Stock PLC, Kier Group, James Halstead and Marshall. The main reason for the choice of a few companies is because of the inability to get adequate data for the research. The research, therefore, made use of the publicly available financial information found in the press and journals. The information obtained from a few of the selected construction companies may not serve as a representative for other companies not sampled. An assumption is therefore taken that the information that is used has enabled the arrival of the conclusions which serve as a representative of other companies not considered.

1.8 Assumptions of the Study

There are many factors affecting value of shareholders for any firm. Some factors can go beyond the control the of the companies in the construction industry. Factors such as prevailing economic conditions, political climate, the level of employee’s morale and the level of competition in the market can have an effect on the shareholder’s health. The main assumption to this research implies that a capital structure may have an influence on shareholder’s wealth. Another assumption made in regard to this research is also the fact that the selected companies from the UK would give findings that can serve as a representative of other companies not sampled in this research.

CHAPTER TWO: LITERATURE REVIEW

2.1 Introduction

This part of the paper extends to 2uite of the other researchers in regard to the area of study. There have been extensive theoretical as well as research literature as to the influence of the capital structure over independent welth of the shareholders. Primary purpose of this literature review is to identify observations of the previous scholars regarding connection between mentioned variables. In addition, literature review analysis should reveal gaps and limitations to the research field that should be covered in order to increase value of this study. Moreover, literature review gives the research more insightful analysis on improving the methodology that was adopted. From what other researchers have done it becomes evident that capital structure affects shareholder's wealth. However, these findings have not been succinctly given enough evidence to illustrate the relationship between state of the capital structure of the company and value of the shareholders. .

2.2 Theoretical background

The core hypothesis to this study grounds on several theories. Most of the theories approach consideration of the capital structure of the firm, dividend payout policy, relationship between shareholders, management of the companies and stakeholder's theories. The following are some of the theories that were deemed fit for this research study. They are:

2.2.1. Miller and Modigliani 1958

The operation of the business units today grounds on theory developed by Modigliani and Miller in 1958. Their theoretical approach serves the role of solid basis for an effective running of the companies. In fact, this theory envisages that there is no balanced approach to the organization of the capital structure. According to this theory, any kind of capital structure adopted by the firm does not have any influence on its value. However, in 1963, Modigliani and Miller amended their early theoretical model regarding capital structure to be more relevant (Miller M. H. 1977, pp. 478). The amendment was done due to the existence of corporate tax which is deductible from the retained profits. Because of the interest that can be brought about by differed taxation, firms can still replace equity finance with debt capital. Miller and Modigliani's theory has received a number of criticism from a number of finance scholars. Brigham and Gapenski (1996) countered MM theoretical model on the basis that it does not hold in a practical perspective considering the existence of bankruptcy costs which can arise as a result of a trade-off between debt and equity (Brigham E. & Gapenski L.,1978, pp 598). According to Brigham, the value of a firm can be improved by increasing costs linked with capital (Brigham E. & Gapenski L.,1978, pp 599).. Hence, debt financing can be used because interest on the debt is treated as a tax-deductible expense unlike other payments earned in form of dividends which might not be deductible for tax.

From the assumptions postulated by the Modigliani and Miller theory capital structure of a firm does not influence overall value of the shareholders, this dissertation is intended to investigate the same using selected construction companies in the UK. In relation to the existence of corporate tax and the provision provided for deductions of interest payments made by a company as a result of debt financing, this study sought to investigate the if the profits of a firm are affected by a tax shield if much of the capital is composed of debt than equity. And in doing so, how the value of the shareholders is affected.

2.2.2 The Pecking Order Theory

This observation was developed by Myers and Majluf in 1984. It is based on the assumption that for a new to survive, much of the finance should be sourced internally (from the shareholders) rather than using external funds(debts) to support new investments. The theory further proposes that in case the internal funds raised by a firm are not enough to finance increasing operations, the company can opt to seek an alternative source of financing from an external source (Myers and Majluf 1984, p. 45). According to this theory, if an outside source is chosen as a method of financing, the source chosen should be that which ensures that the firm will not incur additional costs in the process of acquisition or repayment of that debt.

Myers trough his pecking order further proposes that the safest security that can be chosen by a firm should be given first priority when there is a necessity for an external source of financing to be used. Firms should, therefore, follow the safest security which begins with long-lasting debt, convertible debt and equity as a final threshold. Through this, Myers proposes that firms should follow the aforementioned hierarchy when it comes to choosing the source of financing. If an internal method of financing is preferred by a firm and there is a need for additional finances which necessitates external financing, then debt should be a priority as compared to equity. This theory has been supported by a number of researchers (Abor 2005, p.440).

In relation to this theory, this research study sought to establish if debt finance as a method of finance is preferred and the implications it would bring to the value of the shareholder's wealth. The propositions of this theory aided in substantiating whether the more profitable construction firms were those who use less debt finance to fund their projects. In a case where external financing(debt) is preferred, the effect of the debt on the level of earnings and firms value was sought. If indeed debt has an effect on earnings so, how does the wealth of shareholders get affected?

2.2.3 Market Timing Theory.

This approach presumes that a capital structure of the company is affected by the timing of the issue of equity shares. According to this theory finance managers, finance managers should do a lot of critical analysis before they issue new shares so that at the time of issue, the shares should be of high value. Consequently, when the shares are low, the firm should have redeemed back to the company in wait of appreciation again. This theory, therefore, proposes that a firm should play about buying and selling of its shares depending on the market value of the shares under consideration. The assumption made in this case is that economic agents that can influence the value of shares are rationale in such a way that when positive information is disclosed about a company, the value of shares will increase and it is the time for the firm to issue shares. Reduced information asymmetry between the management and the stockholders also have value in the evaluation of the price of the shares. Any firm should, therefore, try to reduce information asymmetry with its existing shareholders at the time a positive information is released by issuing shares to potential investors directly. After doing this, the company will be at the discretion to increase stock prices and value because of the existence of the timing opportunity. Researchers have backed up the assertions of this theory from their findings that managers usually place importance on the issue of a firm’s stock at the time the price is high at the stock market and consequently buy them back when the prices are low (Baker and Wurgler 2002, p.4). Depending on the collective efforts placed by the company in the timing of the equity markets, the capital structure of the business unit should be defined based on the positive relations between leverage and measure of market timing.

2.2.4 Agency Theory.

This particular approach was developed by by Stephen Ross and Barry Mitnick in 1973. This theory is based on the principal-agent relationship that exits in a firm. The shareholders are the principles while the agents are the management of the company. Since the shareholders as the principles of the company might not have the capacity to run the affairs of the company, they must appoint the agents to conduct the activities of the company on their behalf. This is a form of delegation where the management is required to serve for the protection of the interests of the principals. In an ideal situation, the management would always act so to meet expectations of the shareholders, however, this might not be the case as the management may at times choose to pursue their own personal interests. In this case, there would be an agency problem. In order to deal with this situation, the shareholders must be willing to incur some agency costs so as to ensure that the actions of the management are geared towards their interest. Agency costs are therefore used to monitor the actions of the management. Agency costs can, therefore, be considered to be the principal loss incurred in trying to monitor the actions of the management.

Agency costs = Building costs + Monitoring Costs + Residual losses

Agency theory tends to suggest that the value of any firm is influenced by the overall number of agency costs incurred by the firm and also depending on the perception of the outsiders on insider trading, the shareholder assumes that they have the capacity to design and organize the organization the way they desire it to be. The external players of a firm are therefore presumed to have a complete understanding of the internal affairs of the firm which affects the market valuation. The agency theory, therefore, prefers the use of much debt finance to support the company so that the principle-agent relationship is shifted into other external players(lenders). Lenders usually receive interests for the number of funds borrowed by the company according to terms of contract beyond profitability rate of the company (Mansor Wan Mahmood and Zakaria, 2007, p. 98). This theory assumes that the management of a company which is highly financed with debt, usually pursue more aggressive projects and production since they are aware that they must be able to pay back the borrowed funds and also benefit the shareholders.

2.2.5 Good Management Theory.

This theoretical approach was developed by Waddock ad Grave. It has become an extension to stakeholder theory that was developed by Donaldson and Preston. It assumes that the management of any organization usually pursues the sole interest of the increasing the shareholders' value without regard to the financial constraints of the firm. It, therefore, recommends that the management of a company should seek the use of alternative competitive advantage techniques to increase the value of the shareholders (Smallbusiness.chron.com, 2018 np.) This theory emphasizes that the management should also concentrate on the use of the existing available resources to enhance the performance of the firm rather than asking for additional funds from the shareholders or sourcing externally. For instance, the management can make use of favourable market and environment strategies as a tool for enhancing the corporate image of the firm to meet the needs of the clients and hence improve the wealth of the shareholders.

Good management theory, therefore, compels the management to practice good m