Choices for Capital Structure for Firms Undergoing Merger - Essay Example

? Modigliani and Miller Propositions: Choices for Capital Structure for Firms undergoing Merger and Acquisition Transactions Title] [Instructor Name] [Date] Modigliani and Miller Propositions: Choices for Capital Structure for Firms undergoing Merger and Acquisition Transactions “Most research on capital structure has focused on public non financial corporations with access to U.S. or international capital markets… Yet even 40 years after the Modigliani and Miller research, our understanding of firms’ financing choices is limited” (Myers 2001). Introduction The Modigliani – Miller theorem or propositions relating to the formation of capital structure has undoubtedly developed the foundations on which the present concepts and rationales of corporate finance are erected. This paper presents a critical discussion on how and to what extent the capital structure of firms in today’s modern corporate world is formed on the basis of the propositions presented by Modigliani and Miller (1958). The paper discusses the importance given to these propositions when there are instances, such as mergers and acquisitions between two companies, which require raising new capital or reshuffling the existing capital structure. Before going into the details of the same, it is pertinent that a comprehensive overview of the theorem as put forward by Modigliani and Miller (1958) is presented. The Modigliani - Miller Theorem and its Implications The Modigliani – Miller theorem or proposition is regarded as a key element in the development of today’s corporate finance. The bottom line of the Modigliani and Miller theorem is the proposition of irrelevance which argue that the value of a firm is not affected by the type of financial choices preferred by that firm (Villamil 2006). The same has been explained by Modigliani (1980) himself as “…with well-functioning markets (and neutral taxes) and rational investors, who can ‘undo’ the corporate financial structure by holding positive or negative amounts of debt, the market value of the firm – debt plus equity – depends only on the income stream generated by its assets. It follows, in particular, that the value of the firm should not be affected by the share of debt in its financial structure or by what will be done with the returns – paid out as dividends or reinvested (profitably)” (Modigliani 1980). The understanding of the propositions presented by Modigliani and Miller (1958) reveals that there are four different outcomes which resulted from continuous research conducted in late 50s and early 60s (Modigliani and Miller 1958, Modigliani and Miller 1963). At the beginning, Modigliani and Miller (1958) presented the first proposition which established that in the presence of certain conditions the choice of the capital structure of a firm, which comprises of proportions of debt and equity, does not have any impact on the overall value of that firm (Villamil 2006, Modigliani and Miller 1958). The next proposition, which is the second one, puts forward the idea that the extent to which a firm leverages its business does not affect the WACC (weighted average cost of capital) of that firm. In other words, this idea proposed that the cost of capital, i.e. the equity based capital, is directly related in a linear function to the capital structure of the firm, i.e. the debt to equity ratio. The third theorem or proposition established that whatever may be the dividend policy of a firm, the market value is not affected by it. Lastly, the fourth proposition holds that the shareholders of a firm are not interested in the financial policies of their firm (Villamil 2006, Modigliani and Miller 1958). In order to explain the concepts underlying the propositions, Miller (1991) presented a simple example for the purpose of explaining the same. As per Miller (1991), “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.” (Miller 1991). Continuing with this example, “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.” (Miller 1991). The significance of this line of reasoning is that the increase in the debt proportion of the total capital (which in the above example is illustrated by cream) will affect the value of the equity (i.e. the skimmed milk) and lower it down. But this has no impact on the overall value of the firm (Villamil 2006). This concept can also be understood by way of considering the gains which a firm expects to realize by obtaining finance through debt and the costs of equity on the other hand. When a firm does so, the gains resulting from obtaining a less risky debt are outweighed by the increased costs of high risk equity. Therefore, provided that the total capital of a firm remains constant, the apportionment of the total capital among debt and equity is unimportant since the WACC remains constant for every available order or pattern of capital structure devised by the firm (Villamil 2006). The Modigliani – Miller theorem presents two most fundamental ideas in relation to corporate finance. Modigliani and Miller are regarded as the pioneer in today’s corporate finance’s frame of reference to introduce the “no arbitrage argument” without challenging the recurrence of the “law of one price” (Modigliani and Miller 1958, Villamil 2006). On the other hand, the presentation of the theorem also initiated an argumentation as to why the theorem does not hold true while considering the premises on which it is laid down, which include: “There are no taxes required to be paid by the firms”; “There are no transactional costs among the firms or individuals”; “There are no bankruptcy and agency costs”; “The markets in which firms operate are perfect and do not have any friction”; and “The borrowing can be carried out by firms and individuals at a rate similar for both, i.e. there is no information asymmetry” (Modigliani and Miller 1958). In addition to these assumptions, Modigliani and Miller (1958) based their propositions on another assumption that the firms have different classes of risks, which was afterwards tested and concluded to be unrelated by Stiglitz (1969). Before going into the details as to the extent to which the propositions are practical in the real world scenario and to what extent they are applied or hold significance, it is pertinent to understand how Modigliani and Miller (1958) related these propositions to the practical world (Stiglitz 1969). The first paper presented by the authors in the year 1958 included the significance placed on taxation while proving the irrelevance theorem in relation to the capital structure of a firm. After the issuance of their first paper, Modigliani and Miller (1963) together focused on the tax related assumptions and its impact on the capital structure of a firm (Modigliani and Miller 1963). Later on Miller (1977) also considered this issue and explained that the perfect capital structure of a firm can be wholly financed by borrowing due to the tax related advantages (deductions) available to the corporations (Miller 1977). However, this proposition was also regarded to hold true provided that certain conditions existed. As for instance, under the taxation regulations prevalent in the United States, the payments made by the corporations in lieu of interest on borrowings are allowed to be deducted from the total taxes payable to the government, which in turn promote the inclination amongst the corporations to prefer debt financing over equity financing, since it saves a portion of operating income from going into the hands of taxation authorities. This in turn enables the firms to utilize the saved portion of operating income to be distributed among the investors in the firm’s business. However, for stockholders this proposition resulted in a further concern, which was that the equity based firms are paying more tax in comparison to highly leveraged firms. In order to address this concern, Miller (1977) explained that the equity based firms could also increase their earnings after the payment of taxes by way of increasing their debt to equity ratio and avail the deductions of taxes and then distribute the savings from taxes to the shareholders of the firm; however, this explanation could not be inferred as the means of increasing the firm’s value. The core idea behind this explanation presented by Miller (1977) is that the both debt and equity act as substitutes for each other and when equity is replaced by debt, the payments made as the borrowing costs (interest) are replaced by the payments (dividend) made to the shareholders after allowing for the deductions allowed under tax code (Miller, Debt and Taxes 1977). Apart from the tax related assumption, other assumptions presented by Modigliani and Miller (1958) are related to market frictions, which include existence of costs of conducting a transaction or existence of asymmetric information to market players, which forms the basis of arbitrage in the modern corporate world (Modigliani and Miller 1958). In the context of a perfect market, if debt and equity are regarded as the constituents of capital (which is regarded as a homogeneous product), then it is imperative that there will be a single price in the market considering the fact that it is determined by arbitrage. This implies that the interested parties, i.e. the investors, will continue to seek situations in which the differences in the cost of debt and equity are ruled out by way of arbitrage (Villamil 2006). Interpretation of the Propositions Since after the theorem was presented by Modigliani and Miller (1958), critics and researchers in the field started to interpret and comment on the propositions put forward by Modigliani and Miller (1958). The roots of the evolution of irrelevance proposition dates back to 1938 when, according to Rubinstein (2003), Williams (1938) realized the irrelevance proposition and stated in his book that “Bonds could be retired with stock issues, or two classes of junior securities could be combined into one, without changing the investment value of the company as a whole” (Williams 1938). However, apart from this early recognition of the irrelevance proposition by Williams (1938), the work of Modigliani and Miller (1958) is still regarded as the foremost formalized analysis of the determinants of capital structure in the corporate world (Baker and Martin 2011). There are various propositions presented by Modigliani and Miller (1958) in their theorem related to capital structure which are interpreted as follows: Proposition – I: The first proposition is based on the fundamental basis of the theorem presented by Modigliani and Miller (1958). The proposition holds that the value of a corporate entity is not dependent on the constituents of its capital; provided that certain conditions exist which include market perfection and absence of tax (Baker and Martin 2011). Proposition – II: The second proposition states that the rate of return associated with equity portion of the capital structure of a firm grows directly with the debt to equity ratio (Baker and Martin 2011). Proposition – III: The third proposition states that while distributing dividends among the shareholders of a firm, the market value of a firm is not changed; in fact it only affects and changes the proportions of debt and equity in the capital structure of the firm (Baker and Martin 2011). Proposition – IV: While making a decision in relation to entering into an investment, the expectation of the rate of return in relation to that investment shall be equal to greater than that of the cost of capital, notwithstanding the source from which the finance is obtained or raised (Baker and Martin 2011). Practical Implications of the Modigliani and Miller Propositions The interests of the present day researchers have shifted from knowing the influences and impact of a firm’s capital structure on its overall value to emphasizing and understanding the effects of a particular capital structure on the “governance structure” of the corporate entities and which in turn influence the higher level management to proceed with strategic plans and decisions (Hitt, Hoskisson and Harrison 1991). Such strategic decisions which are taken on the basis of the capital structure of the firm are bound to have an impact on the performance of that firm (Jensen 1989). Amongst many issues, the modern corporate world faces the major issue of agency related problems which poses the difficulties in resolving the conflicts between the management of an enterprise and its shareholders (Jensen 1989). Devising an optimum capital structure with regard to the legal and market environment in which an entity operates has always been a matter of great concern. The capital structure, expected by the shareholders of a corporate entity, shall be such that the returns to the owners of the business are maximized; whereas the business runners, i.e. the management of a corporate entity is of the view that apart from the assurance of safe and smooth returns to the shareholders of the business, there shall be long term plans and measures taken to ensure smooth operations of the business in the future also (Roshan 2009). The formation of capital structure which is appropriate in the circumstances and the market environment in which a business entity operates is indispensible since it enables the entity to remain operationally competitive in the market. While arguing in relation to the optimum capital structure of a firm, Modigliani and Miller (1958) state that the existence of an “optimal” capital structure is possible when the risks related to the possibility of a firm going into bankruptcy are negated by the advantages which are attributed to tax savings due to debt financing. Once such a capital structure is established, it would be possible for a corporate enterprise to ensure greater returns to its shareholders and in such a case, the returns are expected to be more than that of the returns given to the shareholders by the business entities which follow a capital structure fully financed by equity (Roshan 2009, Baker and Martin 2011). An overall summary of the propositions presented by Modigliani and Miller (1958) can be iterated in a way that there is no impact on the value of the firm while replacing the debt portion with equity or equity portion with debt. But at the same time, there are certain issues which are being raised while evaluating these propositions in light of optimum capital structure by the critics. As for instance, in accordance with the proposition presented by Modigliani and Miller (1958), the capital structure of the companies shall be fully based on debt financing rather than equity; since it would be possible for such a company to realize more benefits from tax savings and distribute more returns among its owners. However, in practice, this idea lacks justification and prudence and it is due to these reasons that the practical implications of this proposition can be different in contrast to those suggested by Modigliani and Miller (1958). In this regard, Brigham and Gapenski (1996) argued the viability of maintaining a capital structure which is entirely based on debt financing. Brigham and Gapenski (1996), while admitting the theoretical significance of the propositions presented by Modigliani and Miller (1958), argue that when debt is preferred over equity in devising the capital structure of a firm there is a risk that a firm may come across bankruptcy costs which are assumed by Modigliani and Miller (1958) as nonexistent (Brigham and Gapenski 1996). The bankruptcy costs, as argued by Brigham and Gapenski (1996), tend to increase with the increase in debt proportion in the capital structure of a firm and thus are declared to be directly proportional. In order to resolve this problem, Brigham and Gapenski (1996) argue that the attainment of an optimum capital structure with respect to a firm is possible if the advantages related to tax deductions are availed to such an extent that the bankruptcy costs are covered completely by them, however, at the same time the authors also state that the management of the firm or those who are responsible for determining the capital structure shall judge the extent to which debt shall be introduced in the capital structure of the firm and after the identification of a level where the advantages associated with the debt financing are covering the risks involved with debt financing, the management shall maintain that level of debt in the firm’s capital structure (Brigham and Gapenski 1996). This, according to Brigham and Gapenski (1996), is the best possible way to lower down the costs of raising capital and financing costs which in turn results in increased value of a corporate entity and ensures stable performance (Brigham and Gapenski 1996). The field of corporate finance has been updated and upgraded continuously with numerous theoretical and empirical developments and henceforth there are a number of changes brought to the processes and decision makings in relation to structuring the capital of a business entity. Although these developments are principally based on the prior works in the corporate finance field but when corporate practices are taken into consideration, one may find some of them to be challenging at times to or departing from the principles and ideas presented in previous works; particularly challenging the pioneering work of Modigliani and Miller (1958). Be it the establishment of a new business entity or expansion of an existing corporate entity, the decision as to what capital structure a firm is going to adopt is of prime importance. One major area where capital structure of a firm is taken into consideration or strictly speaking it is restructured is when a merger or acquisition takes place. In their paper, “The Trade-Off for Buyers and Sellers in Mergers and Acquisitions”, which deals principally with the considerations exchanged during a merger or acquisition by the firms, Rappaport and Sirower (1999) discuss the use of stock and cash by a firm while entering into an acquisition or merger transaction with another firm (Rappaport and Sirower 1999). This discussion relates to the capital structure theory in a direct manner. Since the consideration moving from the acquirer of a firm is either stock or cash, this implies that the acquirer either increases its equity portion of the capital, when issuing stocks to the owners of the firm being acquired or obtains new debt to finance the acquisition process so as to give cash equivalent to the firm’s value being acquired. Rappaport and Sirower (1999) note that earlier there was an inclination to deal in cash while entering into an acquisition transaction; however, things changed and there has been seen a great shift in this practice. Companies who are acquiring other companies are focusing more on offering stocks as consideration rather than cash. These changes in the preferences of the corporate entities shows that they are aware of the impact of such choices on the capital structure of the business but still they have set their own rationales of doing so. However, it is not necessary that there are rationales set by the companies for doing so who are acquiring or aiming to acquire other businesses. There may be instances where the companies do not have the required capacity to generate cash flows for paying them as consideration in an acquisition deal and therefore are left with the option of issuing new stocks for the purpose (Rappaport and Sirower 1999). From the discussion presented earlier, it has been established that an optimum capital structure is the one which results in equating the marginal costs with the advantages associated with the obtaining of debt. Moreover, according to Modigliani and Miller (1958), there is no relationship between decisions related to investments and financing and it is also assumed that cash flows resulting from the operations of a firm in future are not affected by the proportion of debt and equity in its overall capital structure. However, despite of their theoretical significance these propositions are not the true representative of the practical situations, as for instance, Lang, Ofek and Stulz (1996) have empirically tested and found that there is an inverse relationship between the degree to which a firm is leveraged and the future expansion or growth (Lang, Ofek and Stulz 2005). Reverting back to the issue of mergers and acquisitions again, it is a matter of deep concern for the corporate entities to analyze and formulate a capital structure while entering into an acquisition deal, because such activities are bound to affect the overall capital structure of a company. It is pertinent to find out that how the capital structure of a firm is affected during takeovers and how the existing capital structure affects takeover deals. As noted by Uysal (2006), considering large scale acquisitions, those firms which have low debt proportions in their existing capital structure are more inclined to enter into such acquisition deals as acquirers. In addition to this, it is also important to understand as to why firms present themselves to be acquired (Uysal 2006). Understanding of these factors gives an insight into how capital structure of a firm which acquires another firm is affected or adjusted after acquisition has taken place. As noted by Uysal (2006), the major reason for the firms to present themselves for acquisition, notwithstanding the fact that they do have the opportunities to survive and invest further, is that they are financially distressed. As a result of this financial deficiency, it can be argued that the acquisition of such firms will result in optimizing the capital structure of the acquirer firms (Uysal 2006). Considering the work of Harford, Klasa and Walcott (2007), it can be understood that the firms which aim at acquiring other companies are keen towards taking into consideration the impact on their capital structures (Harford, Klasa and Walcott 2007). While dealing with an acquisition or takeover situation, the management of the companies involved are primarily focusing on the financial benefits of the deal rather than evaluating how capital structure is going to be influenced, in case the takeover takes place. This situation thus develops into a lassies faire scheme of things with respect to the capital structure, in which the firms taking part in the acquisition process are expecting the capital structure to be optimized once the acquisition process is complete. As noted above, the major area of concern for the acquirer and the acquired is the financial benefits attributed to the acquisition process. However, whatever may be the preferential point of focus among the parties to the mergers and acquisitions, capital structure is affected to a great extent of the acquirer. As for instance, in case where a company plans to acquire another company, there are two options available to the company for the purpose of financing the acquisition process. Firstly, the company can offer cash equivalent to the value of the company which is to be acquired. Secondly, the company may decide to issue new shares to the owners of the company to be acquired. Apart from this, the acquirer company may decide to offer a combination of both, i.e. cash and stock as the consideration to the acquired. As noted down in their propositions, Modigliani and Miller (1958) state that the companies may opt for debt financing rather than equity financing while raising capital. However, in practice it is observed that the firms are not inclined to give importance to the debt and equity sides of the capital structure, but in fact are in search of easy availability of finance, particularly in situations involving mergers and acquisitions. When cash resources are scarce, the management of an acquirer company may opt to replenish its cash reserves by way of obtaining new loans and where such debt financing facility cannot be availed, the company may decide to choose equity based payment to the acquired (Harford, Klasa and Walcott 2007). This concludes the discussion on the fact that in practice the firms are less inclined towards giving importance to the irrelevance propositions presented by Modigliani and Miller (1958). Summary While summarizing the discussion presented in this report, it can be concluded that the contributions made by Modigliani and Miller (1958) in relation to the structuring of capital are considerable and have provided a platform for the development of the frameworks for the modern corporate finance. Although the propositions presented by Modigliani and Miller (1958) hold significance in the modern corporate finance world, but due to the fact that they are based on numerous assumptions they are rendered impractical while devising an appropriate capital structure. This impracticality of the propositions have been criticized by various researchers in their works and the empirical evidences in this regard have shown that apart from the factors identified by Modigliani and Miller (1958), there are other issues also which influence the decisions of the firms while they search for an optimum capital structure. Considering the case of mergers and acquisitions, it is revealed that the firms are more focused towards paying for the value of the firm they acquire by issuing new shares rather than offering cash. This implies that there is an inclination to increase the equity portion of the capital rather than obtaining cash through debt financing. In this way, firms are observed to be avoiding situations in which they may find themselves highly leveraged but at the same time the crux of the Modigliani and Miller’s propositions of irrelevance is negated and it is observed that the firms do have regard for the fact that the composition of capital does affect the value of the firm. Similarly, debt financing is also avoided at most by the firms in order to avoid bankruptcy risks without paying significant regard to the proposition that debt financing results in higher returns to the shareholders of the company due to the tax advantages associated with them. List of References Baker, H.K. and Martin, G.S., 2011. Capital Structure and Corporate Financing Decisions: Theory, Evidence and Practice. KOLB Series. Brigham, E. and Gapenski, L., 1996. Financial Management. Dallas: The Dryden Press. Harford, J., Klasa, S. and Walcott, N., 2007. Do firms have leverage targets? Evidence from acquisitions. Working paper. Hitt, M., Hoskisson, R. and Harrison, J., 1991. Strategic competitiveness in the 1990s: Challenges and opportunities for U.S. executives. Academy of Management Executive, 5(2), pp.7-22. Jensen, M., 1989. Eclipse of public corporation. Harvard Business Review, 67(5), pp.61-74. Lang, L., Ofek, E. and Stulz, R., 2005. Leverage, investment, and firm growth. Journal of Financial Economics, 60, pp.2575-619. Miller, M.H., 1977. Debt and Taxes. Journal of Finance, 32, pp.261-75. Miller, M.H., 1991. Financial Innovations and Market Volatility. Cambridge: Blackwell Publishers. Modigliani, F., 1980. Introduction. In Abel, A. The Collected Papers of Franco Modigliani. Cambridge: MIT Press. pp.xi-xix. Modigliani, F. and Miller, M.H., 1958. The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review, 48(3), pp.261-97. Modigliani, F. and Miller, M.H., 1963. Corporate Income Taxes and the Cost of Capital: A Correction. American Economic Review, 53, pp.433-43. Myers, S.C., 2001. Capital structure. Journal of Economic Perspectives, 15, pp.81-102. Rappaport, A. and Sirower, M.L., 1999. Stock or Cash? The Trade-Offs for Buyers and Seller in Mergers and Acquisitions. Harvard Business Review, pp.147-58. Roshan, B., 2009. Capital Structure and Ownership Structure: A Review of Literature. The Journal of Online Education. Rubinstein, M., 2003. Great Moments in Financial Economics: II. Modigliani–Miller Theorem. Journal of Investment Management, 1(2), pp.7-13. Stiglitz, J., 1969. A Re-Examination of the Modigliani-Miller Theorem. American Economic Review, 59, pp.784-93. Stulz, R.M., 1996. Rethinking Risk Management. Journal of Applied Corporate Finance, 9(3), pp.8-24. Uysal, V.B., 2006. Deviation from the target capital structure and acquisition choices. Working Paper. Villamil, A.P., 2006. The Modigliani-Miller Theorem. University of Illinois. Williams, J.B., 1938. The Theory of Investment Value. Cambridge: Harvard University Press. Read More