Discussion of the theories on Optimal Capital Structure - Essay Example

?Discuss the theories on Optimal Capital Structure. For each theory the assumptions clearly. Explain the theories in detail and the conclusions of each theory. Use appropriate diagrams to highlight the relationship between the gearing level, cost of equity capital, cost of debt capital, weighted average cost of capital and the market capitalisation. Answer: It is always expected that the capital structures vary considerably across industries. And the optimal capital structure is also different for different industries. The question is “what factors explain these differences?” Many researchers and practitioners have come up a number theorise and some of them are explained in the following sections. Modigliani and Miller: No Taxes This study by Modigliani and Miller was based on the following assumptions: 1. There are no brokerage costs. 2. There are no taxes. 3. There are no bankruptcy costs. 4. Investors can borrow at the same rate as corporations. 5. All investors have the same information as management about the firm’s future investment opportunities. 6. EBIT is not affected by the use of debt. This theory says that if these assumptions hold true, the value of the firm is not affected by the capital structure. This situation is expressed as follows: VL = VU = SL + D. Here VL is the value of a levered firm, VU is the value of an identical, unlevered firm, SL is the value of the levered firm’s stock and D is the value of its debt. As we know that WACC is a combination of cost of debt and cost of equity. The cost of debt is lower than the cost of equity. As a company raises capital through debt, the weight of debt increases and hence, it drives up the cost of equity as equity gets riskier. According to the assumptions by Modigliani and Miller, the cost of equity increases by an amount to keep the WACC constant. In other words, under these assumptions it does not matter whether the firm uses debt or equity to raise capital. So, capital structure decisions are irrelevant in such conditions. Modigliani and Miller: The Effect of Corporate Taxes In 1963, Modigliani and Miller relaxed the assumption that there are no corporate taxes. The corporate tax laws favour debt financing over equity financing because the tax laws allow companies to deduct interest payments as expense and on the other hand dividends are not deductible. So this treatment encourages debt financing. Interest payments reduce the amount the firm pays to the government in the form of taxes and more of its cash is available for its investors. Hence, tax deductibility of the interest payments acts as a shield for the firm’s income before tax. Modigliani and Miller presented this concept as follows: VL = VU + Value of side effects = VU + PV of tax shield. They further simplified the concept as: VL = VU + TD. Here T is the corporate tax rate and D is the amount of debt. This relationship is expressed in the graph below. If the corporate tax rate is 40%, then this formula implies that every dollar of debt will increase the value of the firm by 40 cents. Hence, the optimal capital structure is 100% debt. Under this theory, the cost of equity increases as the amount of debt increases but it does not increase as fast as it does under the assumption that there are no taxes. As a result, under this theory the WACC falls as the amount of debt increases. This relationship is shown in the following graph. Miller: The Effect of corporate and personal taxes Later Miller brought in the aspect of personal taxes in this model. He said that income from the bonds is considered as interest which is taxed as personal income at a particular rate (Td). On the other hand, income from stocks comes in the form of dividends and capital gains. The tax on long-term capital gains is deferred until the stock is sold and the gain is realized. Of the stock is held until the owner dies no capital gains tax is paid. So he concluded that the returns on stock are taxed at a lower effective tax rate (Ts) than returns on debt. Looking gat this, Miller argued that investors are willing to accept low before-tax returns on stock relative to before-tax returns on bonds. Miller came to a conclusion that corporate taxes favour debt financing because of the deductibility of interest and personal taxes favour equity financing because of favourable tax treatment of income from stock. The relationship is expressed as follows: 0. Here Tc is the corporate tax rate, Ts is the personal tax rate on income from stocks and Td is the tax rate on income from debt. Trade-off theory The trade-off theory of Capital structure refers to the point of view that the debt to equity ratios will vary from company to company. The company’s financial managers decide upon the level of debt financing and equity financing. The companies which have tangible and safe assets and a high amount of taxable income to shield have a higher debt to equity ratio in comparison with an unprofitable company which have risky and intangible assets and mainly rely on equity financing. The theory suggests that companies should continue to borrow until the marginal tax advantage of additional debt is offset by the increase in present value of the expected costs of the financial distress involved. As the debt to equity ratio of a firm increases there is a trade-off between the interest tax-shield and bankruptcy which causes an optimal capital structure. The advantage of having a high target debt ratio is the tax benefits the firm gets from have a high level of debt. Whereas the disadvantage of high debt ratio is the bankruptcy costs and non-bankruptcy costs involved. The theory is successful in explaining the differences of capital structure in different industries. For example airline companies have safe tangible assets hence they can borrow heavily whereas software companies and high-tech companies have intangible and risky assets hence they normally have little debt. The problem with thus theory is that it fails to explain which some of the successful companies have little debt. Trade-off theory suggests that higher profits would mean high debt/equity ratio meaning more taxable income to shield but successful companies who have little debt negate this theory. Pecking Order theory The pecking order theory commences with asymmetric information which states that managers of the company have more information and know more about the company’s risks, prospects and valuations rather than the outside investors. This information has an important effect in choosing between the internal and external sources of financing and making a decision between borrowing debt and raising money through equity financing. Hence this leads to a pecking order in which future investments are first financed by company’s internal funds which are the retained earnings, then by issuing more debt and then finally as a last resort issuing new shares. Issue of new shares is an indicator that the company feels that their shares are overvalued in the market hence they send a negative signal in the market whereas borrowing more indicates the company’s confidence that the investment will be profitable and that the current stock price of the firm is under-valued. The pecking order theory gives a good explanation as to why the highly profitable firms tend to borrow less. This is not because they have low target debt ratio but the reason is that they do not need to finance their projects from external sources of financing. Pecking order: 1. Firms usually prefer internal finance. 2. If external finance is required then the company starts with issuing new debt, then possibly hybrid securities like convertible bonds. 3. The last resort of financing is equity financing. Free cash flow theory The free cash flow theory assumes that as the company’s free cash flow increases, its performance decrease because of the agency costs involved. The agency cost arises because there is a conflict between managers and the shareholders of the company. Shareholders want that the managers try to maximize the shareholders wealth which is the stock they hold, whereas managers may have their own personal agendas try to increase their perks and benefits. Mark Jensen stated that those managers who have ample cash in their hands try to invest in ill-advised acquisitions or businesses which have matured. Hence he suggested that increase debt may be the answer to this problem as interest payments and principal repayments of debt would mean that less cash flow is available for the managers. The debt forces the company to pay out the cash and the optimal debt level would be such that it leaves enough cash in hand after repaying interest and principal amounts and financing all those projects which have a positive net present value. Bibliography Anon., n.d. Modigliani-Miller Theorem - M&M. [Online] Available at: HYPERLINK "http://www.investopedia.com/terms/m/modigliani-millertheorem.asp" \l "axzz1VeDD3I42" http://www.investopedia.com/terms/m/modigliani-millertheorem.asp#axzz1VeDD3I42 [Accessed 20 August 2011]. Anon., n.d. Theories of Capital Structure. [Online] Available at: HYPERLINK "http://www.smallstocks.com.au/investment/theories-of-capital-structure/" http://www.smallstocks.com.au/investment/theories-of-capital-structure/ [Accessed 20 August 2011]. Brealey, R.A., Myers, S.C. & Allen, F., 2006. Principles of Corporate Finance. 8th ed. McGraw-Hill. Brigham, E.F. & Ehrhardt, M.C., 2005. Financial Management: Theory and Practice. USA: South-Western Cengage Learning. Goldstein, R., Ju, N. & Leland, H., 2001. An EBIT-Based Model of Dynamic Capital Structure. Journal of Business, 4(74), pp.483-512. Leland, H., 1994. Risky Debt, Bond Covenants and Optimal Capital Structures. Journal of Finance, (49), pp.1213-52. Rajan, R. & Zingales, L., 1995. \What do we know about capital structure? Some evidence from international data. Journal of Finance, (50), pp.1421-67. Westphalen, M., 2002. Optimal Capital Structure with Agency Costs of Free-Cash-Flow. Read More