Capital Structure and Firm Value - Literature review Example

?Capital Structure & Firm Value Table of Contents 3 Introduction 4 Modigliani & Miller Theory 4 Pecking-order theory 7 Trade-Off Theory 8 Setting target leverage levels 12 Managing Short term capital structure 14 Link between credit ratings and capital structure 14 Financing long term investment 16 Financial Engineering and Firm Value 17 Capital Structure Affecting Firm’s Business and Financial Risks 18 Conclusion 19 Reference 20 Bibliography 24 Abstract The capital structure forms an integral part of the financing policies of the company. There have been various theories on capital structure explaining the relevance and irrelevance of capital structure such as trade-off theory, Modigliani & Miller theory, pecking order theory etc. These theories have been discussed in detail under various sections. Finally, the relationship between various aspects like credit ratings, target leverage, short term financing etc and their influence on the firm’s financing policy have also been discussed. Introduction The financial managers of a company work towards achieving an optimal capital mix. In large companies there is a separate financial department that takes care of financing issues. The managers strive hard to achieve a right mix of debt and equity as the capital base of the firm determines the cost of capital. The point at which the average cost of capital is minimum, the value of the firm is maximum. This point is referred as ‘optimal’. Methodology The choice of capital structure and firm value is an important topic in financial literature. This paper examines various capital structure theories like pecking order, trade-off theory etc and its impact on capital structure decisions. Mostly, the secondary sources of data have been used to determine the relationship between the capital structure of the firm and its value. Various journal articles, books and some web sources have been used to highlight the link between the capital and various factors like credit rating, target leverage, project profitability etc. Modigliani & Miller Theory Undoubtedly, one of the trickiest decisions for the financial manager is to decide upon one optimal capital structure for the firm. The capital structure of any organisation is particular arrangement of equity, debt and some other funding sources which would be useful in the long term financing. The significant components of the capital structure include both debt and equity. Back in the year 1958, Modigliani and Miller had established the modern theory of capital structure. According to this theory, the value of a firm does not depend on its capital structure decisions. The Modigliani-Miller theorem is a significant arena of contemporary corporate finance. At its centre, the theory refers to an irrelevance proposition. The Modigliani Miller theory offers cases under which the financial decision of a firm does not have an effect on its value. According to the theorem, “with well-functioning markets ... 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” (Villamil, n.d., p.1). As per Modigliani, the firm value should not be dependent on the portion of debt within the financial structure. The Modigliani Miller theorem is comprised of four separate results which are fetched from a series of research papers. According to the first proposition, under some specific conditions, the debt-equity ratio of the firm would not have an impact on the market value. Among them, the first two are related to the firm’s capital structure. As per the second proposition, the leverage of any firm would not have any effect on the firm’s weighted average cost of capital. This means that cost of equity has a linear relationship with the firm’s debt equity ratio. Miller has given an example for a better understanding of the theorem. For an instance, one can think that the firm is a huge tub of milk. The whole milk can be sold as it is. On the other hand, the cream can be separated out of the milk and can be sold at a significantly higher price than that of the whole milk. In this case, if there is no separation cost involved in this, as per the theorem, both the skim milk and cream together would have the same price as that of whole milk. As the portion of the cream would increase, skim milk would decrease respectively; however, the total value of the milk would remain intact. It refers to the fact that in the market of no transaction cost and tax amount, increasing amount of debt would subsequently reduce the outstanding equity value; however, this keeps the total firm value unchanged. Selling safer cash flows to the debt holders is supposed to leave the organisation with reduced value of equity. In different words, any gain fetched from the cheaper debt would be offset by a higher cost of remaining riskier equity. Provided a fixed capital amount, distribution of capital amount between equity and debt is pretty irrelevant as the weighted average cost of capital for the two firms would be same for all probable variation of debt and equity allocation. The theorem is based on two basic contributions. In the arena of modern finance theory, this theorem was the first to use the ‘no arbitrage argument’. Certain assumptions are there to support this theory. The theorem is based on a market where there is no tax, no transaction or bankruptcy cost, without any capital market restriction. One significant assumption in this case has been that both the investors and firms would lend and borrow at the same rate. In the year 1958, Modigliani and Miller assumed that every organisation belongs to a specific risk class and they refer to a specific set of organisations with same earnings. However, in the year 1969, Stilglitz has shown that this assumption does not have any considerable significance. The assumptions are important to support this theorem, as in a financial market where there is no tax, imperfect information, bankruptcy cost or any other obligation which make credit access difficult, the investors can imitate any firm’s financial activities without incurring any cost. In the original paper published in the year 1958, the significance of the taxes to describe the inappropriateness of debt against the equity is considered to be irrelevant. This theorem by Modigliani and Miller had been able to raise both admiration and criticism in the academia (Bernstein, 1993, p.176). However, in the real world, the assumptions of Miller and Modigliani cannot be held true: all the investors cannot have the same expectation, they do not have access to similar amount of information or moreover, the market cannot do away with taxes and transaction costs. As a result, Modigliani and Miller’s irrelevance approach has raised vehement criticism. As per Mr. Solomon, the theorem which says that the cost of capital of the company does not depend on the firm’s capital structure does not hold any ground. According to E. Walker, due to so very reasons which limit the usage of Modigliani and Miller theorem in the practical situations (Bose, 2006, p.92-93). Pecking-order theory The pecking order theory of capital structure is one of the most important theories on capital structure. As per Myers (1984) the entities prefer internal financing over the external financing sources. In the event of any external funds requirement, the business entities prefer debt over equity due to low information costs relating to debt issues. The equity mode of financing is used very sparingly. Myer (2001) states that the external financing forms a very insignificant proportion in the process of capital formation with the equity issues being of minor importance and debt forming a major part of the external financing. However, these claims have not matched the available evidence in the case of publicly traded firms in America. As per pecking order theory, the firms in the lookout for new finances prefer funds in a hierarchy: first preference is for internal funds then debt is issued and finally equity. This order arises as the managers are not willing to dilute the claim of the shareholders’ issue securities when they are overvalued. This is the reason the market discounts the value of the firm in way that it is reflective of any “adverse selection costs”. Myers & Majluf (1984) report that such costs are higher in the case of equity issue as compared to debt issue never making the issue of equity optimal (Autore & Kovacs, 2004). The pecking order theory states that the high growth firms with huge financing needs have high debt financing ratios as their managers are reluctant to new equity issues. Smith & Watts (1992) and Barclay et al (2001) suggest the opposite i.e. they state that the firms exhibiting high growth use limited amount of debt in their capital base (Frank & Goyal, 2002). In the area of finance, both pecking order theory and signalling theory express the relationship between the financial leverage of a firm and the cash flows arising under conditions of asymmetric information. While the former suggests a negative relation the latter suggest a positive link. Baskin (1989), Wilbricht (1989), Jensen et al (1992) and Claggett (1991) have found evidence in support of the pecking order theory. In the context of signaling theory, Ravi & Sarig (1991) reveal that the firms display their quality by an optimal mix of leverage and dividend. As per their prediction, the better firms are highly leveraged and pay more dividends as compared to the low quality firms (Zhao, et al., 2004). The pecking order finds a common motivation in the adverse selection formulated by Myers (1984) and Myers & Majluf (1984). The main reason behind this is that the firm’s managers know the real value of the assets of the firm and the available growth opportunities. The external investors can merely make a guess of these values. When the manager offers equity then the investors must evaluate the motive of the manager. The managers of firms that are overvalued are more than eager to issue new securities whereas the managers of the firms that are undervalued by the market are unwilling to do this (Frank & Goyal, 2008). Trade-Off Theory The trade off theory is another significant model to dominate the academia in the arena of capital structure (Cotei & Farhat, 2009, p.4). In the year 1958, Modigliani and Miller have illustrated that any firm could not create or destroy the value through the company’s financing preferences in a perfect capital market. However, it has been noticed that there are certain financing frictions as well as market imperfections that exist in the real world which lead to the choices between both the cost of equity and cost of debt funds (Lui, n.d.). According to the trade off theory in the arena of capital structure, the managers would choose specific and optimal capital structure considering the trade-off between both the cost of debt and benefits of the same. This target optimal capital structure is expected to maximise the firm value (Moles, Parrino & Kidwell, 2011, p.644). The theory looks into the trade off between both the pros and cons of various financing firms to find out the optimal capital structure of any organisation. The firms would be able to enhance its profitability by fetching advantages from the interest tax shield on the debt amount in its capital structure. As a result, funding a business with debt rather than with equity would be beneficial to increase the total return to its investors and in turn increasing the firm value. This leads to the conclusion that the companies should drive to maximise their debt financing. Issuing more equity would mean that the firm is moving away from the optimal capital structure. However, the whole concept does not seem to be enough as excessive amount of debt can raise the financial distress probability of the firm and hence would increase the bankruptcy cost. The optimal debt equity ratio can differ among various industries, countries and industry sectors (Beyer, 2010, p.5). Trade-off theory mainly deals with two significant concepts including the agency cost and the financial distress cost. A significant purpose of the theory is to give rationale to the fact that a large number of organisations are financed both with debt and equity. As mentioned earlier, there can be various advantages and disadvantages of debt financing. It has been mentioned that there can be bankruptcy cost with increasing amount of debt. However, there are certain non-bankruptcy costs attached to extreme debt financing. The non-bankruptcy cost includes the suppliers demanding adverse payment terms, infighting of bondholders or the shareholders. With the growing amount of debt amount, marginal benefit in the increasing amount of debt would decline with the increase in the debt amount. As the marginal cost would increase, an organisation, which would want to optimise the firm value, would surely focus on the trade off while deciding on both the equity and debt amount for financing. The significant component of the trade-off theory in capital structure is cost of debt which can also be assumed as the bankruptcy cost and financial distress cost. It is pretty significant to note that this would include both the direct as well as indirect costs of bankruptcy. The trade off theory can include agency costs fetched from the agency theory which is also known as the cost of debt which can explain the relation between the agency theory and the trade off theory of the capital structure (Mapsofworld, 2009). Around 95 % of the empirical research papers have looked into the conflicts between both the shareholders and managers. Rest of the studies have looked into the conflicts between the shareholders and debt holders. These are also pretty significant to explain the relationship between the agency theory and trade off theory in capital structure. The direct financial distress cost refers to insolvency cost of any firm. When the insolvency process starts off, the firm’s assets are expected to be sold off at the distress price. The distress price would be much lower than current value of firm’s assets. Apart from that, a considerable amount of legal and administrative costs are also involved with the firm’s insolvency. . Often the organisations may experience a dilemma in the interests of the firm management, shareholders and debt investors. Generally these disputes can raise agency problems leading to incurring the agency costs. The establishment of trade off theory in capital structure has much more implications in practice. In another research paper, a dynamic model has been used to get the optimal capital structure estimation. In the traditional trade off method, the significant elements have been the bankruptcy cost and the corporate tax shield. In the calibrated continuous time contingent claim model, the firm managers make the decision regarding its capital structure with an objective to maximise the levered firm’s value. The model has certain differences when compared to the traditional capital structure models. The model has dynamic characteristics as the debt with finite maturity has been repeatedly refinanced and issued upon the maturity to attain a pre-specified debt to capital ratio. Another significant assumption has been that as per this model, the bankruptcy boundary is a function which is exponentially related to the time. This bankruptcy boundary would determine the timeline when the firm would be default on its debt obligations (Ju, et.al, 2005, p. 2-3). In a dynamic trade off theory established by Heinkel, Zechner and Fischer, even in case where equity issuance cost is fixed, the organisations may not be able to reach at their optimal capital structure; rather would just adjusting the debt obligations when it exceeds the maximum limit. When a firm pays off its debts, the leverage is supposed to fall automatically. On the other sides, an organisation only periodically does the adjustments for the tax shield of debt obligations. It has been noticed that the profitable organisations generally use comparatively less debt amount as the theory is considered while taking into account the adjustment costs. In the year 1994, Leland had also introduced a dynamic trade off model. In this specific model, the organisations let the leverage amount fluctuate over the time reflecting the accumulated profit amount and losses. In such case, the companies do not carry on the adjustments of leverage to proximate the target; rather they did not make the adjustments until the adjustment costs is more than the lost value due to firms’ suboptimal capital structure. Back in the year 1977, Miller introduces a model which has its resemblance with his balancing model of capital structure. This model has not given significance to issuing debt as it is considered to be offset by the personal taxes. In the year 1980, Masulis and DeAngelo came up with their research which agrees to the existence of tax shield on the debt amount implying equilibrium in the marker where various firms would have different capital structure unique to the firms. Apart from that, tax shield on the non-debt amount also exists such as both investment tax credits and depreciation deduction with the unique corporate taxation which does not discount the losses and can turn over the irrelevance theory of Miller. Both of these researchers argue that the substitution effect is present between the tax shields on the non debt and the corporate tax advantages on the firm’s debt obligations. In the year 1982, Kim has argued that in case the costs related to leverage such as agency costs and the bankruptcy costs are considerable as well as the earnings from the equity amount is not being taxed, the tax rate of the marginal bondholders would be lesser than that of the corporate. There is a positive and effective tax advantage on having the debt amount on the portfolio. In the year 1999, Gul carried out research on 5308 Japanese companies listed on the exchange. The research has revealed that firms with high growth mostly have less amount of non debt corporate tax shield. In the year 1973, Litzenberger and Kraus made a research on both the direct as well as indirect bankruptcy costs and the corporate tax advantage on debt amount. They revealed that “the taxation of corporate profits and the existence of bankruptcy penalties are market imperfections that are central to a positive theory of the effect of leverage on the firm’s market value” (Baker & Martin, 2011, p.79). However, at the same time, the researchers have argued that in a case where the debt obligation of the firm is more than the firm’s earnings, the value of the firm may not be a concave function of the firm’s leverage amount. Setting target leverage levels As per the trade-off theory, the firms maintain a pre-set or target leverage level that optimises the value of the firm on account of the low costs and the benefits associated with leverage. The benefits arise in the form of interest tax deductibility as per Graham (2000) and Miller (1977). The costs include a rise in the probability of bankruptcy costs and growing conflicts between the debt holders and shareholders. . Various studies have focused on the relationship between the characteristics of the firm like growth opportunities, firm size, profitability, tax rates and ownership structure & its leverage. . The trade-off theory has been criticised from various sections. Many authors are of the opinion that the tax savings arising on account of incremental leverage are much higher than those associated with bankruptcy costs and therefore question the move of the firms to remain underleveraged. . Some authors like Myers and Shyam Sunder (1999) have tested the existence of target leverage and found contrary results (Elkamhi, et al., 2010). The empirical findings by Jalivand & Harris (1984), Marsh (1982) and Opler &Titman (1995) reveal that the companies gradually tend to change their capital structure to achieve a target leverage level. This implies that the firms adjust their outstanding debt position when there is a change in the value of the firm so as to achieve the target leverage. The above findings give credence to the “stationary leverage ratio model” developed by Collin-Dufresne & Goldstein (2001). The leverage ratio refers to the ratio of firm’s liability to the firm’s asset value. It has been observed by Collin-Dufresne & Goldstein that the target ratio in the long term is in line with the average debt ratio of the firms with a BBB rating (Hui, et al., 2006). The managers try to balance between the advantages of debt such as low cost and interest tax shield with the associated costs like bankruptcy costs, debt servicing burden to determine the desired level of debt. Though the managers may be tempted to use more debt to avoid dilution but this may not be in the financial interest of the company (Nash, et al., 2001). So the benefits of leverage must be matched with the limitations to determine the target leverage. Managing Short term capital structure The decisions relating to working capital form a part of the firm’s financing decisions. This involves managing the short term assets and short term liabilities of the company. The management of working capital involves maintaining ideal levels of cash and inventory so that the work can proceed uninterruptedly. The short term loans must be financed after giving due consideration to the ‘cash conversion cycle’ of the company (Oduware & Williams, n.d.). The short term sources of financing should be managed in way that the production work can be continued without any major disruption and at the same time, the costs incurred by the business is minimum. Link between credit ratings and capital structure The managers of the firms take credit ratings aspect into consideration at the time of making decisions relating to capital structure. For instance, it was reported by Wall Street Journal (2004) that EDS used the equity route to raise $1 billion in order to avoid and downgrade in its credit ratings. As reported by Barrons (2003) Lear Corp lowered its debt level in order to receive a higher bond rating from the BB-plus from the credit rating agency Standard & Poor’s. In 2002, it was reported by WSJ that the Fiat company was working towards narrowing down its debt exposure on fears of a possible credit ratings downgrade. In the studies conducted by Graham & Harvey (2001), it has been revealed that credit ratings are considered to be crucial by the company CFOs at the time of capital structure determination. Nearly 57% of the CFOs admit that the credit ratings play an important role in the choice of equity and debt. In fact, it has been reported by Graham & Harvey that credit ratings are more crucial than various factors recommended by the traditional theories on capital structure like interest tax shield. The level of credit ratings determine whether certain investor groups like pension funds or banks can invest in the bonds issued by the firm. Moreover, the credit ratings give information to the market participants with regard to firm quality thereby influencing their investment behaviour. If the market participants consider ratings to be informative, the firms are grouped on the basis of this rating and therefore any change in the ratings leads to distinct changes in the cost of capital of the firm. Other than this, a change in the credit rating can trigger events that can result in various costs like change in the coupon rate of the bond, loss of valuable contract or make commercial paper market inaccessible. The empirical tests conducted by Kisgen evaluate whether the decisions relating to capital structure are impacted by credit rating concerns. His studies reveal that business entities with a rating of minus or plus like AA- or AA+ issue lesser amount of debt as compared to firms that do not have a rating of minus or plus like AA. Ederington & Goh (1998) have highlighted that any downgrades in the credit rating leads to a fall in the equity returns. The equity analysts make downward revisions in the earnings forecasts in response to a credit ratings downgrade. According to Cantor & Packer (1994), the financial regulators along with the public authorities monitor banks, securities firms, insurance companies, mutual funds, capital markets and private pensions. Partnoy (1999) and West (1973) the banks are restricted from investing in speculative grade bonds (Kisgen, 2006). . The credit rating agencies view a high debt in the capital base to be unfavourable prompting them to downgrade the credit rating. A high cost of debt implies a rise in the average cost of capital of the company. The companies with a high credit rating can issue bonds at less than market rates. This rating is achieved primarily by a stable level of debt component and good debt servicing record. A low cost means limited pressure on the company earnings thereby, giving it the chance to tap the growth opportunities. It enhances the earnings position of the company pushing up the value of the company. Financing long term investment As per the theory of finance, the long term business investments should be funded from long term sources of financing. Therefore, it implies that the firms with high capitals tend to have heavy amount of long term investment. The logic behind this is that the long term investments generally have long gestation period. So it is not feasible for financing such investments from short term sources. Due to this the firms use a mix of equity or long term debt for meeting their long term investment needs. Many manufacturing firms enjoy limited loan accessibility. Even the ones that manage to procure long term loans face unjustified credit terms from the lender. According to Modigliani & Miller (1958) a borrower can benefit from long term loans only if the return on investment is more than the cost. As per Short (1994) and Stulz (1990), making use of debt in the capital base has appositive impact on the efficiency of the firm provided the firm is having free cash flows (Ishengoma, 2004, p.56). The bond is a traditional form of long term financing. The bonds are generally available to the large business houses as the small sized companies normally have limited accessibility to such financing alternatives (Fried, et al., 2007, p.149). In the financing of the investments also, the adverse selection can give rise to signalling problems. Myers (1984) suggests that the financial resources of the firm are selected in way as to give priority to internal financing then debt and equity should be used only as last resort. The trade-off theory states that the financial managers must balance the cost of debt and the associated benefits in a way as to maximise the firm value. The firms practicing the pecking order theory would prefer to finance long term investments from internal generated funds. This includes retained earnings i.e. the profits ploughed back into the business. Here again care must be taken to ensure that the company is able to generate significant return on the investment. Only if this is true, the managers can convince the shareholders for a lower payout ratio. The internal funds are the best source of financing long term investments as the money remains committed for a long term. However, as the internally generated funds are not enough to meet the financing needs the company resort to debt and equity issue (Castillo-Merino, et al., 2010, p.36). Making use of long term loans saves the company from worrying unnecessarily about debt repayments. The long term loans protect the company from liquidation as the creditors are imperfectly informed about the company and prevent the creditors from demanding forceful liquidation to pocket the profits of the healthy businesses. An optimal mix of short and long term debt is based on a number of parameters like credit rating, project profitability, the firm’s ability to fund through internal resources, age and size of the firm (Caprio & Demirguc-Kunt, 1997). The investment opportunities available to a firm in the future are important in determining its market value. Therefore, a careful consideration must be given to the various factors at the time of financing the long term business investments. Financial Engineering and Firm Value Financial engineering relates to the capital structure optimisation by minimising the after tax average cost of capital of any firm. Financial engineering is done to increase the value of an organisation and a significant tool for the buyout organisations to enhance value. The financial engineering application helps the company to enhance the complicated nature of capital structure by figuring out an appropriate mix between the equity and debt. However, in most of the cases, financial engineering leads to an increase in the value through leveraging the firm at optimal level (Berg& Gottschalg, 2004, p.17) Capital Structure Affecting Firm’s Business and Financial Risks Business risks are the risks related to the company’s asset side as well as the firm’s operational activities. There is a connection between the capitals structure and the business risk. For an instance, if any company would raise the debt amount, it would be able to cut down its deductable expenses by gaining tax shield on the leverage amount, leading to higher profit amount for the company to carry on its operational activities. On the other side, with the increase in the business risk, the firm’s cost of equity would increase reducing the firm’s debt equity ratio. However, in this case, a trade off exists between the financial risk and business risk. By increasing debt, a firm can reduce its business risk; however, at the same time it would increase its probability of default leading to increased financial risk (Groth, n.d., p.2). As a result, the company should separate both the risks and come up with an optimal capital structure minimising both the risks at a point. Conclusion The debt and equity are the two sources of long term capital employed in the business. Both the sources have their own set of merits and demerits. 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