Capital Structure Theories (Modigliani and Miller I (without tax) (This is…
Capital Structure Theories
Optimal Capital Structure
How does the mix of debt and equity finance used by a company affect its weighted average cost of capital?
Is there a mix of debt and equity that achieves an optimal capital structure - minimising the average cost of capital and maximising value?
Increased volatility of equity returns arises with high gearing since interest must be paid before paying returns to shareholders.
Increased risk of liquidity crisis and bankruptcy
Stock exchange credibility falls as investors learn of company's financial position
Short-termism may move managers' focus away from long term maximisation of shareholder wealth. "Fighting Fires"
Alternatively the need for profit and cash in the short term to meet interest payments ensures focus on strong cash flows
The Traditional View
Ke increases as gearing increases due to rising financial risk and, later, bankruptcy risk.
Kd rises at high levels of gearing due to bankruptcy risk
As company starts to replace expensive equity with cheaper debt, WACC falls
As gearing continues to increase, Ke and Kd increase, offsetting the benefit of cheap debt.
There is an uncertain optimal capital structure, where WACC is minimised and value is maximised
Modigliani and Miller I (without tax)
Capital markets are assumed to be perfect.
No risk of bankruptcy so Kd curve is flat
Linear increase in Ke due to increasing financial risk (from gearing)
As company gears up and replaces equity with debt, benefit of cheaper debt is exactly offset by the increasing cost of equity
No optimal capital structure is found since WACC and value remain constant
This is the proposition of irrelevance - financing decision does not alter value regardless of gearing
Unrealistic - YES but acknowledged by M&M
The major flaw in this argument is in the assessment of risk
Assumes that the only risk faced is business risk - ignoring financial risk (gearing risk)
Companies with identical business risk and net income should therefore have identical WACC and value
In the balance sheet - asset values do not depend on the ownership structure i.e. mix of equity and liabilities - the total value is always the same
Modigliani and Miller II (with tax)
Adjusted their first model to reflect the tax deductibility of interest payments
Tax efficiency implies that gearing up by replacing equity with debt gives benefits of a tax shield
Kd curve falls from before-tax to after-tax level, so WACC curve slopes downwards
This implies an optimal capital structure does exist: gear up with as much debt as possible - 100%!
As company gears up, tax shield from interest payments increases the value of the company
At gearing level X, shareholders demand higher return to compensate for increasing risk of bankruptcy
Beyond gearing level Y, tax benefits are more than outweighed by bankruptcy costs so Y is the optimal level of gearing
"Tax exhaustion" also occurs at higher gearing levels i.e. insufficient profit to take advantage of tax saving on interest
There is a value trade-off between the benefits of cheap debt and the "financial distress costs" of the debt.
We can now conclude that companies will fall way short of adopting those 100% gearing ratios
Pecking order theory
Firms would rather use international sources of finance as cheaper issue and transaction costs
Pecking order is:
Prioritised by wider consideration of cost-benefit- not just a simple WACC calculation
Retained Profit features
not subject to external valuations and market signals
No transaction or arrangement costs
Internal or retained profits offer a path of least resistance to financing
Both debt and equity sources have wider costs and financial implications