The capital structure of a company outlines the mix of debt and equity used by the company. The proportion of debt and equity has implications for the overall cost of capital (WACC) and thereby, an effect on shareholder-required return from cost of equity. Modigliani and Miller developed the very first capital structure theory by asking a simple question: ‘does capital structure affect a company’s efficiency in turning project cash flows into cash in the hands of providers of long-term capital. The M&M theory assumes that the capital market is perfect and everyone in the market has perfect information, and no one individual (or company) can influence the price. There is a single rate of interest for borrowing and lending. There are no homogeneous products and investors are rational risk adverse utility maximises. And finally, no personal or corporate taxations exist.
The traditional view of capital structure is that there are both advantages and disadvantages in maximising shareholders value trough corporate gearing. At relatively low levels of gearing the advantages outweigh the disadvantages and the market value of the business rises at first, but the relationship reverses and the disadvantages start to outweigh the advantages. The main advantage of gearing is that debt interest is allowable against taxation. The disadvantages are in terms of increase financial risks. The M&M proposition of the capital structure in a taxed world implies that the tax relief on debt interest would encourage businesses to gear up to a high level as possible (hence, 99.9% debt and 0.1% equity). The greater the level of gearing, the greater would be the tax subsidy on debt financing.
Several regularities have been observed in terms of capital structure in various countries. Firstly, capital structures varies significantly cross nations, for example German and Canadian firms have a lower book value debt than Japanese and Italian companies (Rajan, R., Zingales, L., 1996). The second observation is that capital structure is dependent on the industry the firm operates. Utilities, transportation and capital intense manufacturing firms have gearing then service companies. Thirdly, profitability is inversely linked to leverage. This contradicts the tax based capital structure theory. Other observations made regarding capital structure are that taxation does not affect it, despite various tax rule changes in US; the capital structure decisions of firs have remained the same.
There are three main capital structure theories, the first of which is the trade-off model. This is based on modification to the M&M proposition. The theory states that the capital structure choice of the firm is dependent upon its trade off between tax benefits and increase financial risk associated with high leverage. The empirical evidence for trade-off model is inconclusive. Bradley, M., Jarrel, G., Kim, E. (1984) develop a model where optimal leverage is inversely linked to the cost of financial distress. The evidence from 800 and their leverage ratio over a period of 20 years was consistent with the trade off model. However, they found a strong link between firm leverage and amount of non-debt tax shield.
The second is the Pecking order theory is build on the observation that in the real world companies have all sort of capital structure, some 100 percent debt financed, others 100 per cent equity based and some have a mixture of both. The third model is that of market signals. Given the existence of a semi-strong form efficient financial markets, investors will be aware of the management thought processes and will see the issue of new equity as a signal that management believe the shares to be overvalued. This will cause the investors to sell their shares and prices will fall. The issue of debt will signal that the shares are undervalued and investors will buy and push up the prices.
One of the main reasons why companies in reality do not apply a capital structure in accordance to the M&M proposition suggests that there are some hidden costs of debt capital. One such cost is that of agency costs. Agency costs arise out of what is kwon as the principal-agent problem. This is concerned with the objectives of management of a company, who are acting in their own best interests; also act in the best interest of the company’s corporate objectives. This is a problem of external control of management by shareholders.
The suppliers of debt finance are concerned that the management are responsible with their money. To ensure that the management do not take excessive risk with debt provider’s money they can often impose restrictive conditions such as covenants during the agreement. The restrictions could be in terms of dividend payments, sell of tangible fixed assets or the introduction of more debt into the capital structure. Such restrictions are referred to as agency costs.
A further cost that could result as debt capital increase and is often views as part of the agency costs is that of bankruptcy. Again the M&M proposition assumes that there are no or little costs associated with bankruptcy. However, the cost of bankruptcy is sizeable in reality. The probability of bankruptcy is therefore, a function of a company’s leverage ratio. Therefore, costs in terms of legal and administrational costs, however, there are also liquidation costs of below market value sells of fixed assets.
As a company increases its level of gearing, an increasing proportion of its cash flow each year will be paid out as interest cost. Interest costs by their very nature are fixed; however, future cash flows are uncertain. Therefore, as the debt servicing costs increase the future uncertain cash flows could be insufficient to meet the interest payment obligations. Such default of payment could cause the lender to recall the capital and in turn send the company into bankruptcy and incursion of its associated costs. The cost of bankruptcy is borne by shareholders as well as the management to an extent; in terms of lose of employment.
Reference and Bibliography:
1. Lumby, S., Jones, C., (2004), Corporate Finance - theory and practice 7th edition, Thomson
2. ACCA Paper 3.7 (2001) Strategic Financial Management, The Financial Training Company
3. Rajan, R., Zingales, L., (1996), “What do we know about capital structure? Some Evidence from International Data”, Journal of Finance 50, 1421-1460
4. Bradley, M., Jarrel, G., Kim, E. (1984), “On the Existence of an Optimal Capital Structure: Theory and Evidence”, Journal of Finance 39(3), 857 -878.
 Lumby, S., Jones, C., (2004)
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