The Combination of Equity and Debt Finance - Essay Example

8 May In a world with corporate taxes Modigliani and Miller’s view is that a company should issue as much debt as possible. Why is this advice not followed by companies? Modigliani—Miller Theory First, it is imperative to comprehend the term capital structure. It denotes the combination of equity and debt finance utilised by a corporate entity to finance its assets. While some companies are unlevered, others can be financed partially thorough equity and partially through debt. The determination of the ratio between equity and debt finance is known as the financing decision. The composition and determination of the perfect capital structure has been an integral subject of research in corporate finance. The Nobel Prize winner theorem presented by Modigliani and Miller is the cornerstone of capital structure in today’s world. The crux of the theory is that under an effective market where there are no taxes, insolvency costs, agency costs, and asymmetric information, the value of a business is not established by sources of finance (Modigliani and Miller). They advocated that under perfect market condition, without any friction, the capital structure of the company does not influence its market value. Therefore, it is irrelevant whether an entity finances its capital by issuing shares or raising debt and the like ways. Similarly, an entity’s dividend policy is immaterial. Owing to these factors, this thermo is also termed as capital structure irrelevance principle. For instance, suppose there are two firms which are similar in every way except for their capital structures. One firm is financed merely through equity and the financial structure of the other one comprises of both, equity and debt (Miller). According to the ‘capital structure irrelevance principal’, both companies will carry the same worth. Based on this perspective, their article published in the American Economic Review gained widespread eminence. In 1991, Miller delineated the concept with the help of an analogy: “think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as it is. Or he can separate out the cream, and sell it at a considerably higher price than the whole milk would bring”. He went on to elaborate, “The Modigliani—Miller proposition says that if there were no costs of separation (and, of course, no government dairy support program), the cream plus the skim milk would bring the same price as the whole milk”. The heart of this analogy was that expanding debt (cream) diminishes the worth of existent equity (skimmed milk). If secure cash flows are sold to debt holders, the firm will possess lesser worth equity; hence, the aggregate worth of the firm will remain unaltered. In other words, the gain from what appears cheaper debt is set off against the riskier and more expensive equity. Thus, the constitution of capital from debt and equity would be futile, given a certain quantity of aggregate capital. This is because the weighted average for any possible compositions of the two finance alternatives to the firm will remain unaffected. However, the condition of perfect condition is restricted to theorems so businesses in the real world are not subject to this environment. In addition, it is extremely rare for the capital structure of a company to be completely based on debt. Myriad arguments have emerged in opposition to Modigliani—Miller theorem; these accentuate taxation, agency costs, insolvency, equity dilution, credit rationing, conflicting interest of management etc. Modigliani and Miller recommended for firms to have a certain borrowing ability in case of an economic upheaval. Taxes The most evident drawback of the Modigliani—Miller theorem is the supposition the subtraction of interest and corporate taxation. Under most financial frameworks, tax cannot be computed until the deduction of interest owed to debt holders from the corporate profits. Therefore, the amount of corporate tax not charged serves as a subsidy based on interest. For instance, a business would avoid paying 25 cents of every dollar paid, if the corporate tax rate is 25%; however, receivers of interest income will be liable to pay tax. As opposed to this scenario, dividend income is double taxed, at the business and personal level. Thus, a business aiming for minimal tax payments and profit maximization for investors should base its capital structure wholly on debt issuing (Puxty, Dodds and Wilson). An article titled “Determinants of corporate borrowing” by Myers delineated that practical economic conditions are not understood by solely focusing on corporate taxes (Myers). Investors are not necessarily better off from the distribution of interest payments to bondholders for avoidance of corporate tax. They will be liable to escalated individual tax owing to the interest income as compared to investors and businesses if they had not used debt financing. Miller contended that normally taxes on personal dividend and interest income tend to be higher than capital gains. Therefore, a business can reduce the combined aggregate tax payment of the business and investors through no debt issuance. In addition, tax due on capital gains can be put off until the time gains are not realized, which reduces the effect of tax on capital gains even more. Hence, a corporation has an optimal amount of debt finance. Costs of Default Costs related to financial problems, insolvency and bankruptcy play a critical role in restraining a business from extensive issuance of debt finance. These costs can be categorized as explicit or implicit. The former comprise sums paid to lawyers, accountants, such other professionals who provide advice in bankruptcy, liquidity crunches or seeking legal protection. Together these costs constitute a tremendous charge on the assets of a company that investors would lose in case of bankruptcy. Businesses should also bear in mind the additional underlying costs associated with financial trouble that emerge as a business goes bankrupt or defaults. These can consist of increased purchase bills from suppliers who are intimidated that a business might lack the ability to make future payments, and losing consumers who seek to establish a long-standing link with counterparties. Evidently, investors would be inclined to invest in stable and secure businesses for the avoidance of any implicit or explicit costs. The probability of insolvency accelerates as a business finances itself through increased amounts of debt. Therefore, with an increase in debt, the marginal advantage from the increased debt is lowered. Simultaneously, there will be a rise in the marginal cost. Hence, a business that intends for optimal value will carefully decide the equity and debt ratio. This in turn is a primary underlying reason for most businesses to avoid high levels of gearing ratio or debt financing. In addition, this also sheds light on how different debt amounts are maintained by various industries with dissimilar instability. Agency costs The debt and equity markets present several alternatives for raising finance. The conflict amongst these alternatives acts as the determinant of issuance of corporate debt. Sole proprietorships and shareholdings have substantial differences. In companies, it is the management is a representative of the collective external investors or stockholders. Even though the management is appointed as an agent for the owners, yet they often take decisions based on personal interests, which might be opposed to the objectives of the owners. For instance, they might exercise empire building or excessively remunerate themselves instead of fulfilling the aim of profit maximization of the owners. Similarly, they might prefer to obtain more and more loans instead of offering increased dividends to the shareholders. Thus, the capital structure of a business is influenced from such agency costs (Sheeba). Credit Rationing Perfect market conditions form the foundation of the Modigliani and Miller theorem. However, Joseph Stiglitz and Andrew Weiss stated that markets function efficiently in rare situations (Stiglitz and Weiss, Credit rationing in markets with imperfect information.) Under practical circumstances, lenders do not possess perfect knowledge of borrowers; thus, they are motivated to seek higher interest payments especially from riskier borrowings, and to control the supply of credit. However, here the issue is that as the interest rate accelerates, only firms in dire need will borrow. Such firms are more expected to end up as bankrupt. In case they do go bankrupt, the firm will not be liable for the debt owed and the lender will have to bear the burden of failure. This signifies that when firms have access to substantial amounts of debts, then they prefer to invest in riskier projects due to asymmetric risk (Stiglitz, On the irrelevance of corporate financial policy). Normally, smaller and infant businesses that tend to be run by founders will face credit rationing. This can be attributed to the lack of perfect knowledge between the relatively new businesses and creditors. The manager/sole owner will probably have better information of his entity and can modify his managerial or financial strategies in accordance with the debt agreements. On the other hand, businesses that have been in existence for some time or which are externally financed will find it easier to obtain more debts. In a normal scenario, businesses that plan to take on high-risk investments would not mind increased rate of interest. The rise in interest rate instead of credit rationing would escalate the number of borrowers likely to invest in a risky project. Additionally, this would also diminish the gains of the creditor. Equity Dilution A study by Myers and Majluf in 1984 pointed that owners or managers utilize external sources to raise finance (debt issuance and equity) in case of inadequate internal capital for investments in new developments (DeAngelo, DeAngelo and Skinner). They even maintain that mangers show preference for debt financing than equity. The underlying reason for such behaviour is that managers usually are of the belief that they possess better knowledge of their businesses in contrast to external parties (bondholders or equity investors). Owed to this fact, investors would agree to a lesser price of stocks, lower than the value assessed by managers (Jensen). Thereby, managers would be motivated to take on debt rather than issuing stocks for cheaper rates. Managers or owners overvalue their firms; hence, they refrain from selling stocks cheaply. This supports the fact that infant, private, and relatively small businesses favour debt financing over equity. Conflicting Aims of Financial Sponsors The conflict of interest between bondholders and stockholders plays an imperative role in establishing the financial strategy of a business. This is because bondholders and stockholders usually have differing goals and disposition towards risk. Although, stockholders provide the major portion of finance in extremely profit making businesses; however, bondholders reap the benefits too. As a result, bondholders generally are motivated to favour risk-averse plans, as this accelerates the possibility of obtaining their entire investment back (Donaldson). In contrary, stockholders are more prepared to invest in risky schemes. In case the schemes turn out successful, they get to keep the entire profit; but if it fails then bondholders will share the risk. Underinvestment in financial trouble also sheds light on the conflicting aims of both these parties. When corporate default appears likely, stockholders are not likely to invest. This is because their investments will be utilized to compensate bondholders and creditors in case of the corporate default. This scenario is known as debt overhang problem. Equity holders will refrain from investments even if bondholders do not really benefit from the investment. Instead, with impending corporate default, stockholders would be motivated to divert their current investment in high-risk schemes with the potential of great profits. In case the project is a failure, stockholders cannot be worse off since they are to be compensated after all parties. However, under this scenario, the risk for bondholders will rise. On the other hand, if the project triumphs, then stockholders will reap the greatest benefit since they were the major investors. Lastly, stockholders can use assets for dividend payments to themselves. This would not leave behind anything to compensate claims of bondholders if a business is unable to discharge debts. In consideration of this factor, covenants are agreed between debt issuers/banks and businesses to hinder stockholders from using assets for dividend payments. These agreements impose restrictions on the actions of stockholders; and attempt to make risk/reward structures fair between both parties. Nonetheless, not all eventualities can be prevented by bon covenants. A firm is more likely to take on debts where the probability of strategies like risk transfers, underinvestment, distributing significant dividends is greater. Stockholders will prefer policies that are in their interest, even if they are adverse for bondholders. Such motivation exists when it is ambiguous whether businesses possess reasonable cash flow to pay off debts. Conclusion The aforementioned arguments and existing economic theories indicate the existence of optimal finance structure. Such a capital structure would lead to greater profits for stockholders than businesses solely financed through equity. Nevertheless, complications due to competition and the wide variety of diversified organizations also play an imperative role in determining individual capital structure of businesses. . Works Cited DeAngelo, Harry, Linda DeAngelo and Douglas J. Skinner. Corporate Payout Policy. Hanover: Now Publishers Inc., 2008. Donaldson, Gordon. "Financial goals: Management vs stakeholders." Harvard Business Review (1963): 116-129. Jensen, Michael, and William Meckling. "Theory of the firm: Managerial behavior, agency costs and owndership structure." Journal of Financial Economics (1976): 305-360. Miller, Merton. "Leverage." Journal of Finance (1991): 479-488. Modigliani, Amedeo Clemente and Merton H. Miller. "The cost of capital, corporation finance and the theory of investment." American Economic Review (1958): 261-297. Myers, Stewart.C. "Determinants of corporate borrowing ." Journal of Financial Economics (1977). Puxty, Anthony G., J. Colin Dodds and Richard M. S. Wilson. Financial Management: Method and Meaning. London: Van Nostrand Reinhold(International)Co. Limited, 1988. Sheeba, Kapil. Financial Management. New Dehli: Dorling Kindersley Pvt. Limited, 2011. Stiglitz, Joseph E. and Andrew Weiss. "Credit rationing in markets with imperfect information." American Economic Review (1981): 393-410. Stiglitz, Joseph E. "On the irrelevance of corporate financial policy." American Economic Review (1974): 851-866. Read More