Capital structure is the make-up of a company’s capital i.e. debt and equity. The amount of debt and equity in a company’s capital structure is reflected in the cost of capital. Each type of capital source has benefits and drawbacks, and therefore it is suggested that directors should try to maintain a capital structure that will minimise the cost of capital.
The original view held by Miller and Modigliani (1958) [henceforth referred to as M&M] assumes a perfect capital market, where the cost of capital remains unchanged whatever the level of gearing. The assumption here is that the cost of debt remains unchanged as gearing rises because debt is risk free, therefore the cost of equity increases to offset the change in gearing.
The value of a company is its cash flows discounted at the company’s cost of capital i.e. NPV. The traditional view (low debt levels) suggested that by reducing the cost of capital through increasing gearing, the value of the firm would increase. However, M&M argued that the value of a firm could only be increased by investing in positive NPV projects. Changing the capital structure of a firm should have no effect on the value of the firm and hence the cost of capital.
The problem with this theory it that it is based on some fundamentally flawed assumptions, for example; perfect capital market, all earnings are paid out as dividends etc. Another problem is the fact that the costs and risks differ between corporate and personal borrowing.
As the interest on debt is tax deductible, an after tax cost of debt should be used. This was a major criticism of the M&M theory which ignored tax. By allowing for tax, the cost of capital should fall because debt is cheaper and is tax deductible. M&M (1963) accepted this criticism and reworked the theory to incorporate tax, but all other perfect capital market assumptions still apply. The new model suggests that companies should increase gearing by taking on more debt. However, high debt levels increase the risk of bankruptcy. When these costs are included, it appears that having moderate levels of debt is actually better.
Trade Off Theory (Kraus & Litzenberger 1973)
As some debt is taken on, the cost of equity will increase slightly due to the increased financial risk. However, overall the cost of capital will fall because debt is cheaper and is tax deductible, therefore the company will benefit from these ‘tax shields’.
As more debt is taken on, it will reach a point where the cost of capital increases because of financial risk and risks of bankruptcy etc. At high debt levels, shareholders will require a higher return because of the increased risk. As the cost of capital increases, the value of the firm decreases due to ‘financial distress’.
The optimum capital structure is therefore a trade off between the benefits of debt and the costs of financial distress i.e. having enough debt to maximise the benefits, whilst not having too much to suffer the costs of financial distress.
Pecking Order Theory (Donaldson, 1961; Meyers, 1984)
This theory suggests that there is a particular order by which firms should acquire capital to invest:
- Internally generated i.e. retained earnings
- New equity
By acquiring capital in this way, it aims to minimise the cost of the capital structure, and hence the cost of capital, therefore maximising the value of the firm.
In conclusion, despite almost all theories concluding that debt is cheaper than equity, most companies do not have high levels of debt because of the costs mentioned in the Trade Off Theory. Having moderate levels of debt allows companies to benefit from the tax advantages of having debt, whilst missing out on the costs suffered by having too much debt. This capital structure therefore maximises the capital position of companies and hence maximises their value.
Donaldson, G. (1961), Corporate Debt Capacity: A Study Of Corporate Debt Policy And The Determination Of Corporate Debt Capacity, Boston, Division of Research, Graduate School of Business Administration, Harvard University
Kraus, A., Litzenberger, R. H. (1973), A State‐Preference Model of Optimal Financial Leverage, The Journal of Finance, 28(4), pp.911-922.
Miller, M. H., Modigliani, F. (1958), The Cost of Capital, Corporation Finance and the Theory of Investment, The American Economic Review, 48(3), pp.261-297
Miller, M.H., Modigliani, F. (1963), Corporate Income Taxes and the Cost of Capital: A Correction, The American Economic Review, 53(3), pp.433-443
Myers, S. C. (1984), The Capital Structure Puzzle,The Journal of Finance, 39(3), pp.574-592
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