Capital Structure Theory - Term Paper Example

Capital structure theory Theories of capital structure MM approach Pioneering work on the theory of capital structure has been done by Modigliani-Miller (MM) which is also called the MM approach. As per this approach (Mittal). The value of the firm is independent of the capital structure of the firm. This implies that the cost of capital and hence the value of the firm remains unchanged no matter what the debt to equity ratio is maintained. Secondly, the cost of equity is equal to capitalization rate of a free equity stream plus a premium for financial risk. Financial risk increases with the increase in debt component of the capital structure (Mittal). Finally, the cut off rate for investment purposes is completely independent of the way an investment is financed. The operational justification of the MM approach is the “arbitrage mechanism” (Modigliani and Miller, 1958). Arbitrage is process of buying things from a market which are at a lower rate and selling them in the market where they command higher rate. Thus, this leads to equilibrium in price of the product over time as when the product is purchased from the market where it has lower price, it will result in the reduction in supply and increase in demand resulting in increase in price of the product. In the same way, when the product is sold in the market where it fetches a higher price, the supply will increase (as all investors will tend to sell here) and hence eventually, demand will go down resulting in the increase in price. Thus finally, equilibrium for the price of the product will be achieved in both the markets. The same process applies to the securities market. For two firms which are homogeneous in all respects except for their capital structure the arbitrage mechanism will work to increase the value of the undervalued firm and decrease it for the overvalued one. The investor will buy as much stock as possible of the undervalued firm so as to take advantage of the arbitrage. He might take personal debt also called personal leverage to buy shares of undervalued firm. Thus, even though the unlevered firm (which is undervalued) has not borrowed externally, the investor does this for the firm in the form of personal leverage. However, there are a number of limitations of this theory. The basic assumption of a perfect market itself is questionable. Some of the reasons why arbitrage mechanism will not work as expected are (Mittal). Difference in the cost of borrowing for firms and individuals: Because of this difference, personal leverage cannot be substituted for corporate leverage. Secondly, there are transaction costs involved in buying and selling of securities. This results in lower sale realization and higher purchasing costs. Thirdly, the risk of corporate borrowing is much lesser than for an individual borrower. Next, corporate and personal taxes also change the returns a firm gives to its investors. In their work Modigliani and Miller themselves have recognized the fact that value of the firm will increase and the cost of capital will decrease with leverage, if taxes are introduced in the exercise (Khan 2008). Finally, in the third proposition of the MM approach regarding the cut-off rate, the authors themselves recognize the fact the proposition only says that “the type of instrument used to finance an investment is irrelevant to the question of whether or not the investment is worthwhile. This does not mean that the owners or managers have no ground whatever of preferring one financing plan to another, or that there are no other policy or technical issues in finance at the level of the firm” (Modigliani and Miller, 1958). Traditional approach According to this approach leverage has an impact on the cost of capital and thus on the firm’s valuation which can be explained in three phases. In the first phase the value of the firm rises when debt is increased from 0 levels. This is because of the fact that debt is a cheaper source of funds. As the amount of debt increases, the perception of the firm’s risk also increases and hence the cost of equity begins to increase. However, the speed with which the cost of equity rises is not fast enough to counter the advantages of cheap debt. Up to a certain limit the cost debt remains more or less constant or might increase marginally as the exposure to risk on account of increased debt component in the capital is still perceived to be within safe limits. Because of this perception, debt is available at lower rates till a particular limit. The cost of capital keeps falling. After reaching a particular level of leverage, any moderate increases in debt proportion does not have any impact on the market value of the firm (Khan 2008). This is the second phase or the middle range where the cost of capital as well as the firm value remain constant and do not get impacted by changes in leverage. After a particular level of leverage, any increase in debt is seen as risky leading to increased cost of debt and hence the cost of capital. This results in decreased firm value. This is the third phase. The point from which the cost of capital rises is the optimum capital structure point. After this point the debt portion should not be increased. There are other theories of capital structure as well. Trade-off theory is one such theory which says that “firms optimize their capital structure by trading the tax deductibility of interests, bankruptcy costs and agency costs” (Kashefi-Pour and Lasfer). Another theory called Pecking-order theory proposes that firms prefer external financing, safe debt being favored as compared to risky debt and equity issues rank the lowest (Myers 1984). Capital structure theory and practices with reference to the UK market Studies have shown that UK firms are less leveraged as compared to other countries in Europe (Rajan and Zingales, 1995). Conscious financial choices impact the level of leverage of firms in UK. It has been found that UK firms prefer raising capital from external sourcing but their leverage is low because they focus on equity issuance for funds rather than debt as an external source of hiring. Other factors that affect capital structure decision of a firm are bankruptcy laws, tax codes, level of bond market development and patterns for ownership. A study by Kashefi-Pour, E. and Lasfer, M. was conducted on large and small firms in the UK market. Their study found that the leverage of large companies is positively related to the effective tax rate while that of the small companies is not (Kashefi-Pour and Lasfer). They also found that tangibility is directly related to leverage. In fact, their findings suggested that leverage had more significant impact on smaller firms as compared to the bigger ones. This could be mainly because the lenders are unable to assess the risk of such companies and hence the lenders need greater collateral to hedge the risk posed by small firms. This theory also supports the study by Berger and Udell (1998) also said that asset based lending has a significant effect on small and medium sized companies in UK. Another result found by Kashefi-Pour and Lasfer shows that market to book ratio is negatively related to all leverage measures for big companies in UK. But for small companies, the study suggests an opposite trend showing a positive relationship between leverage and growth opportunities. The financing difficulties of small companies would result in debt financing to cover their growth opportunities (Kashefi-Pour and Lasfer). They also find that the companies have target debt ratios and they keep adjusting for any deviations at differing speed. Small companies in the main markets of UK adjust more rapidly than the larger ones. There have been controversial results regarding the impact of taxes on the capital structure. Michael et.al (1999) found that non-debt tax shields are unimportant for SME (Small and Medium Enterprises) in UK. An explanation to this finding could be seen in studies by Pettit and Singer (1985) who say that since the SMEs operate in less concentrated markets, greater competitive pressure and lower profit margins lead to lower tax rates being applied on them. Hence, they may not take tax benefits of debt. Bankruptcy costs also show mixed relationship with leverage. Volatility of earnings is considered as proxy for bankruptcy costs. Accordingly Michael et.al (1999) have found a positive relationship between leverage and volatility of earnings in UK SMEs. This changes completely in other markets, like developing countries. Frank and Goyal (2003a) have used tangibility as a proxy for bankruptcy costs and find that leverage is positively related to tangibility. This is because tangible assets which can be easily liquidated in case of bankruptcy, leading to lower risk for the lenders. There is also a negative relation between debt ratios and market-to-book ratio as a proxy for growth opportunities across large companies listed in UK (Kashefi-Pour and Lasfer). Opposite is true for small companies. Agency costs show an inverse relationship with leverage as per Rajan and Zingales (1995). However, as per Pecking order theory, growth opportunities of small firms may be financed by accumulated debt. The results of research show that as companies grow in the UK market, their debt increases which means that small companies hold more cash and rely less on debt. Also for big companies listed in the Main and AIM markets of UK, the effective tax rate has a significant effect on capital structure but not for small companies. Companies have a target leverage ratios and they adjust to this over time. As per studies by Flannery and Rangan (2006), the speed of adjustment towards this ratio is much higher in small firms as compared to the larger ones. The study of UK Main market by Kashefi-Pour and Lasfer is also consistent with the findings of Flannery and Rangan. This is mainly because of the reliance of large companies on public funds which are more expensive and hence have higher switch over costs. However, the opposite result was true for the AIM market. This could be because of the financing difficulties of companies listed in the AIM market (Kashefi-Pour and Lasfer). Way ahead for our company Looking at the various theories and practices of firms with different sizes we need to first look at the industry that we are operating in. For example, companies whose value depends to a greater extent on intangibles, like semiconductor and drug industries tend to have lower debt ratios. Also companies operating in volatile markets like electronic and communications also have lower debt ratios (Fabozzi et al. 2007). Another important outcome of the previously discussed theories is that debt provides advantage up to a certain level of leverage. It reduces the cost of capital only till a particular level of leverage, after that point it becomes more expensive as the risk increases. Since our company is new and a fast growing company, it implies that the earnings of the company are more volatile hence, it might not have easy access to cheap debt. Another important factor in this case is that of the tax benefits of debt. Since the company is still small and would not have very high profits, its tax liability will be much lower. Thus, debt may not give it much tax shield. Tangibility of assets also affects the firm’s leverage. If the firm has more tangible assets, its bankruptcy costs will be low and hence it will be able to get cheaper debt as it will be perceived as less risky by the lenders. Thus the company needs to balance out on debt vs equity decisions. Let us look at the following example and understand how to decide based on certain assumptions (Brigham and Ehrhardt). The following example shows how the weighted average cost of capital (WACC) decreases till a particular level. Thus in our case 40% would be the best level of financing depending on the following assumptions. Also, Interest rate is assumed based on market rate. References Berger, A.N. and Udell, G.F. 1998, The economics of small business finance: The roles of private equity and debt markets in the financial growth cycle, Journal of Banking and Finance 22, 613 – 673. Brigham, E.F and Ehrhardt, M.C, 2008, Financial management: theory and practice, Cengage Learning Fabozzi, F.J, Drake, P.P and Polimeni, R.S, 2007, The complete CFO handbook: from accounting to accountability, John Wiley and Sons Frank, M.Z and Goyal V.K, 2003a, Testing the Pecking order theory of capital structure, Journal of Financial Economics, 67, 217-248 Flannery, M. and Rangan, K, 2006, Partial adjustment towards target capital structures, Journal of Financial Economics, 79, 469-506 Khan, 2008, Cost accounting and financial management for CA Professional Competence Examination, Tata McGraw-Hill Mittal, R.K, Management Accounting and Financial Management, F K Publications. Michaelas, N, Chittenden, F and Poutziouri, P, 1999, Financial policy and capital structure choice in UK SME: Empirical evidence from company panel data, Small Business Economics, 12, 113-130 Modigliani, F and Miller, M.H, 1958, The cost of capital, corporate finance and the theory of investment, American Economic Review, 48.3. Pettit, R.R. and Singer, R.T. 1985, Small business finance: A research agenda, Financial Management, 14, 47-60. Rajan, R.G. and Zingales, L. 1995, What do we know about capital structure? Some evidence from international data, Journal of finance, 50.5, 1421-60. Kashefi-Pour, E. and Lasfer, M. The determinants of capital structure across firm’s sizes: The UK main and AIM markets evidence, Cass Business School, London. http://www.pfn2010.org/papers/1268395102.pdf Myers, S.C. 1984, The capital structure puzzle, Journal of Finance, 39, 575-592. Read More