Aspects Affecting Capital Structure - Essay Example

Capital Structure Introduction: Decisions about capital structure are very important for a firm, because a bad decision in this area could lead to financial distress and bankruptcy for the firm, as a result of which firms choose different financial leverage levels in order to maintain an optimal capital structure. There are a variety of factors that may impact upon capital structure, such as taxation, bankruptcy, fundraising, as well as managerial decisions, which are all factors that could impact upon capital structure. Analysis: Modigliani and Miller (1958) were the pioneers in examining the effect of capital structure upon a firm’s value. Their study was based upon the assumption that perfect capital markets existed, i.e, there was an absence of taxes, bankruptcy costs and other market friction. Under such a condition, their conclusion was one of capital structure irrelevance, which means that the kind of capital structure chosen by a firm will not impact upon its value and hence there is no advantage to be gained through the creation of debt. The value of the firm will be totally dependent upon its assets and their expected value, as well as the risk of cash flow generated from those assets. However, these same authors later took taxation into consideration and their conclusion then was that one of the features that would promote an optimal capital structure for the firm was the employment of as much debt capital as possible. (Modigliani and Miller, 1963). Once corporate earnings taxes are introduced, then there is an advantage to the firm to be gained by the firm, because the tax shield that can be provided by debt results in a gain from leverage. In this context, Miller (1977) also introduced personal taxes into the equation and he discerns three distinct tax rates in the United States that determine the total value of the firm, which are (a) corporate tax rate (b) tax rate imposed on income of dividends and (c) tax rates imposed on the inflows of interest. Miller stated that the capital structure of a firm will depend upon the relative height of each of the tax rates as compared to the other two. When tax rates on income from stocks and bonds are equal, then the advantage from leverage is zero, hence capital structure of the firm becomes irrelevant. However, for example when the tax rates on the income from the stock is lower than the tax rate on incomes from the debt, then leverage will negatively affect the value of the untaxed firm. With non trivial bankruptcy costs, the introduction of leverage creates a negative effect of debt financing on the value of the firm. However, as discussed by Maris and Elayan (1990), when the firm in question is a real estate investment trust, which is untaxed, the firms may still opt to use debt financing and may choose to be highly leveraged because there may be advantages to the use of debt that are unrelated to taxes, such as for example, the positive stock price responses to announcements of debt offerings by Real estate investment firms. This factor may therefore influence decisions of such firms on the question of their capital structure.(Howe and Schilling), since one of the main benefits to be gained from debt financing is the fact that it provides a tax shield that allows a firm to pay less taxes, because interest payments are deducted while calculating taxable income. Another aspect that may have an influence on the capital and acquisition structure of a firm is the effect of shareholder level capital gains taxes. In a recent study conducted by Ayers et al (2004), the effect of shareholder capital gains taxes on the structure of corporate acquisitions was investigated. The authors analyzed several publicly traded firms and found a positive association between the capital gains tax rate for individual investors and the use of tax free stock for stock acquisitions. These findings support the conclusion that shareholder level taxes will have a significant effect on the capital structure by affecting the choice of taxable cash for stock vis a vis tax free stock for stock acquisitions, with this effect varying with the tax status of the target shareholders. According to Cheng and Shiu (2006), the most important determinant of capital structure is the quality of investor protection. They base their results on sample firms across 45 countries and find that the institutions, environments and firm characteristics are important determinants of capital structure, with investor protection playing an important role. For instance, the findings in this study were that in countries where there is better credit protection, firms have higher leverage, while in other countries where the rights of shareholders are protected better, firms tend to use more equity funds. The authors of this study conclude that differences in institutions and environments explain cross sectional variations in aggregate capital structure across countries. Maloney et al (1993) have examined the relation between managerial decision making and capital structure. They point out that some studies have suggested that the existing capital structure of a firm and the leverage tends to hobble management by making them less able to compete effectively, since their focus is centered on making interest payments. However, other researchers have suggested that a firm’s capital structure is likely to be influenced to a great extent by managerial decisions because debt is a matter of managerial discretion. The common point of the theoretical research that supports this position is that while leverage has costs, extra managerial care and discretion needs to be exercised in making periodic, unalterable payments to bond holders. While traditional models of capital structure are based upon the premise that managers always act in the best interests of the owners and work towards increasing shareholder value, in some instances managers may work to further their own agenda, which in turn may create a conflict of interest that will have an impact upon the capital structure of the firm. For example managerial influence upon capital structures of a firm have been pointed out by several researchers such as Jensen (1986), such as the managerial tendency to take on expensive perquisites despite their ownership of only a fraction of the firm. Similarly, managers may channel away the firm’s funds towards empire building projects to enhance their own reputation rather than the good of the firm, just as they may also resist liquidation and takeovers of the firm, even when it is in the best interests of the shareholders. As a result corporate governance of the firm and its capital structure may also be influenced to a great degree by managerial decisions and attitudes. Conclusions: On the basis of the above, it may be concluded that the most significant aspect that is likely to affect a firm’s capital structure is taxation, which provides the incentive for companies to report higher debts. The relative levels of personal taxes may also affect capital structure, while debt financing may be resorted to by some companies despite an absence of taxation in order to enhance positive stock prove responses. The quality and levels of investor protection will also affect the extent of leverage. Managerial decisions and attitudes may also play a salient role in determining the capital structure of a firm, since the managers are privy to information that may not necessarily be available to stockholder and members of the public and their decisions on debt financing and leverage may be conditioned by such knowledge or by their own attitudes towards bankruptcy and debt leverage. In some instances, managerial controls may also extend towards usurping a higher than optimal level of perquisites, which in turn will affect the financial position of the firm. However, the most important factor is taxation, because it is taxation and its various ramifications that play the most significant role in determining decisions on capital structure. References: * Ayers, Benjamin, C, Lefanowicz, Craig E and Robinson, John R, 2004. “The Effect of shareholder level capital gains taxes on acquisition structure”, The Accounting Review, 79(4) :859-887 * Cheng, Shuenn-Ren and Shiu, Sheng-Yi, 2007. “Investor protection and capital structure: international evidence”, Journal of Multinational Financial management, 17(1): 30-44 * Harris, M and Raviv, A, 1988. “Corporate control contests and capital structure: an empirical test”, Managerial and decision Economics, 15: 563-76 * Howe, J.S. and Schilling, J.D., 1998. “Capital Structure Theory and REIT Security Offerings.” Journal of Finance, 43(4): 983-93 * Jensen, M.C., 1986. “Agency costs of free cash flows, corporate finance and takeovers”, American Economic review, 76: 323-39 * Maloney, Michael T, McCormick, Robert E and Mitchell, Mark L, 1993. “Managerial decision Making and Capital Structure” The Journal of Business, 66(2): 189-218 * Maris, Brian A and Elayan, Fayez A, 1990. “Capital structure and the cost of capital for untaxed firms: The case of REITs”, AREUEA Journal, 18(1): 22-40 * Miller, M.H., 1977. “Debt and taxes”. Journal of Finance, 32: 261-176 * Modigliani, F and Miller, M, 1958. “The cost of capital, corporate finance and the theory of investment”, American Economic Review, 48:261-97 * Modigliani, F and Miller, M, 1963. “Corporate income taxes and the cost of capital: a correction”, American Economic Review, 53: 443-53 Read More