Capital Structure

Theory
Capital Structure Theory

 Began in 1958 published by Franco Modigliani and Merton Miller

(MM)
 They proved that under a strict set of assumptions that a firm’s value
is unaffected by its capital structure
 Results suggests that it does not matter how a firm finances its
operations therefore capital structure is irrelevant
 The assumption where the study was based on was unrealistic so
results were questionable.
 But by indicating the conditions under which capital structure is
irrelevant, MM would provide clues about what is required to make
capital structure relevant
Capital Structure Theory:
Assumptions of MM’s Study
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
Capital Structure Theory: The Effect
of Taxes
 It is recognized that the Tax Code allows corporations to deduct
interest payment as an expense but dividend payments to
stockholders are not deductible therefore encouraging to use debt
in their capital structures.
 It was modified several years later my Merton Millier (without
Modigiliani) by took into account the effects of personal taxes.
 Investors are willing to accept relatively low before-tax returns on
stocks than on bonds. Because dividends are taxed lower, Stocks
have a higher after tax return than bonds.
 It is a matter of judgment and the circumstance of the firm on how
to obtain their optimal capital structure based on taxes
Capital Structure Theory: The effect
of potential bankruptcy
 Bankruptcy related cost have two components: (1) the probability
of their occurrence (2) the costs that will be incurred when financial
distress arises.
 A firm that has potential to be bankrupted are likely to have their
suppliers not grant any more credit, liquidate their assets lower than
their prices, and lenders start demanding higher interest rates.
 Bankruptcy is more likely to occur when a firm has more debt in its
capital structure and firms whose earnings are volatile.
 This is consistent with the view that high operating leverage should
limit their use of financial leverage.
Capital Structure Theory: Trade-off
theory
 This theory states that firms trade off the tax benefits of debt
financing against problems caused by potential bankruptcy
 Debt is less expensive than common or preferred stock and provides
tax-shelter benefits because government pays part of the cost of
debt resulting to reduce in taxes and more operating income to
investors
 But increase in debt means increase chance in bankruptcy
 By equaling the tax shelter benefits and marginal bankruptcy
related costs we can create the optimal capital structure
 This theory is not used by large successful firms such as Intel and
Microsoft as they used less debt than the theory suggest which led
to the development of Signaling Theory.
Capital Structure Theory: Signaling
Theory
 This theory that investors and managers are alike and has the same
information about a firm’s prospects called symmetric information
 However, it is clearly seen in practice that managers have more
information than outside investors. This is called asymmetric information
 Firms with favorable prospects prefer not to finance through new stock
whereas firms with unfavorable prospects do like to finance through
new stock
 So when firms issue new stock it is a signal that the firm’s prospect are
not bright. And if firms finances using debt signals that there is bright
prospect.
 But even if the company’s prospects are bright the company should, in
normal times issue stock and maintain a reverse borrowing capacity as
suggested by the tax benefit/bankruptcy cost trade of theory
Capital Structure Theory: Using
Debt to Constrain Managers
 Conflict may arise if the firm has more cash than is needed to
support its core operations.
 Managers often use excess cash to finance their pet project or
perquisites which may do little to benefit stock prices.
 Firms can reduce excess cash flows through higher dividends or
stock repurchases
 Tilt the capital structure toward more debt to discipline managers
 A leveraged buyout can be used to reduce excess cash flows. It
uses debt to finance the purchase of a high percentage of the
company’s shares but it has its downsides.
Capital Structure Theory: Pecking
order hypotheses
 Pecking Order is the sequence in which the firms prefer to raise
capital: first spontaneous credit, then retained earnings, then other
debt, and finally common equity.
 It is logical to follow this order because first there is no flotation cost
in spontaneous credit ore retained earnings.
 Costs are relatively low in issuing new debt.
 Issuing new stock incurs high inflation cost and the existence of
asymmetric information/signaling effects makes it more undesirable
to finance with new common stock
Capital Structure Theory: Windows
of Opportunity
 The occasion where a company’s managers adjust its firm’s capital
structure to take advantage of certain situations.
 If there is a difference between intrinsic and market value of stocks
 When the stock is overvalued managers can issue new equity at
time when its market value is relatively high
 Likewise, then can repurchase it when stock is undervalued