Define capital Structure
capital structure is the mix of securities used by a company to finance it’s operations
Explain why the cost of debt finance is generally lower than the cost of equity finance
- There is less risk associated with debt finance (in the event of financial distress debt holders are paid first)
- Arrangement fees are less for debt issuance than equity issuance
- interest payments are a tax deductible expense
Drawbacks of using lower cost debt to reduce capital costs instead of equity.
- Increasing debt raises default risk and bankruptcy risk
- increased bankruptcy risk causes shareholders/debt-holders to demand greater returns
- Flexibility Loss: More debt can limit company’s operational flexibility e.g. miss investment oportunities due to repayment obligations
Define irrelevancy theory
- Modigliani, Miller 1958,
- Premise: in perfect markets, the value of a firm is unaffected by its capital structure.
Outline the key assumptions of irrelevancy theory
- No taxes
- Individuals and companies can borrow unlimited amounts at the same rate of interest
- No transaction costs
- Personal borrowing is a perfect substitute for corporate borrowing
- Firms exist with the same business risk but different levels of gearing
- All projects, cash flows and debt relating thereto are perpetual
- income generated by the company confirms the company’s value
Outline the propositions of Modigliani miller 1958
- The Market value of any firm is independent of its capital structure
- The expected rate of return on equity in a geared firm is proportional to it’s D/E ratio
Define the traditional approach
- Premise: an optimal debt-to-equity ratio exists where the cost of capital is minimized and firm value is maximized
- Initially, more debt lowers capital costs (due to tax benefits), but past a certain point, costs increase due to higher financial risk.
What does the optimal capital structure mainly depend on (Traditional Approach)?
The business of a specific firm, i.e. if a firm has volatile profits it should have low gearing
Summarise Modigliani, Miller 1963
- Revised version of irrelevancy theory, now includes corporation tax
- Interest payments are tax deductible
- A geared firm is technically more valuable than an identical ungeared firm because tax bill is reduced
- A firms value is maximised by taking on as much debt as possible
How do you calculate the value of a tax shield? (MM63)
Tax shield = r ate of debt * amount of debt * corporate tax rate
how do you calculate the value of a geared firm? (MM63)
Value of geared firm = Value of un geared firm + PV of tax shield PV of tax shield = Amount of debt * corporation tax
MM63 Proposition 3
- Proposition 3: The WACC declines as gearing increases
MM63 Proposition 1
- Proposition 1: The value of a firm is increased as debt is added to the capital structure (optimal capital structure is when debt is maximised)
MM63 Proposition 2
- Proposition 2: As gearing increases, the cost of equity rises at a slower rate than in MM58 due to tax shield benefits.
- This assumes all firms gain from tax shields, in reality, some do not e.g. loss-making firms
Key limitations of Modigliani, Miller 1963
Does not take into account:
- Costs of financial distress (as companies take on more debt they are likely to become more financially distressed)
- personal taxes
Define Trade off theory
According to trade off theory:
- Any tax advantage of using debt is eventually outweighed by expected bankruptcy costs
- implies there is an optimal capital structure
How do you calculate the value of a geared company using trade off theory?
value of geared company = value of ungeared company + (corporate tax rate * amount of company debt) - expected value of bankruptcy costs Vg = Vu +(tc *D) - E(PV(bc))
what is the empirical evidence on signalling theory
- empirical evidence is weak in support of signalling theory
- signalling theory predicts undervalued companies have higher gearing ratios than overvalued companies
- research supports the opposite: gearing ratios are inversely related to profitability
- signalling theory predicts growth firms or firms with high tangible assets would have higher gearing ratios, empirical evidence shows the opposite.
Why is there a preference for debt over equity?
- James 1987 found that share prices typically rise when firms announce bank debt borrowing but fall with equity issuance
- this suggests information costs are higher for equity than for debt
- Gives Rise to pecking order Theory
Define pecking order theory
- Myers Majiluf 1984
- premise: firms financing follows the path of least resistance, in the order:
1- Internal funds
2- debt
3- equity - suggests there is no optimal capital structure
- tax shields and financial distress costs are a second order concern
Define financial slack
having cash or other liquid assets (including unused debt capacity) readily available
Reasons for firms having financial slack
- investment Opportunities: Ensures funds are available for promising projects or investments
- Strategic Flexibility: Allows for quick exploitation of new opportunities without the need to secure external financing
- Internal Financing: Reduces reliance on external capital markets, lowering transaction costs
Problems with too much financial slack
- best discussed by Jensen (1986)
- incentives for managers to exploit free cashflow
- i.e. managers giving themselves higher wages/bonuses
- Managers engage in empire building
solution to financial slack problems
- Jensen (1986) posits that cash-rich companies should increase debt levels to limit free cash for managers, using debt as a control mechanism
- However Jensen overlooks the costs of excessive debt, which can lead to financial distress
