Capital Structure Theory - Financial Management

In this section, we develop some simplified models of the relationship between capital structure, as measured by the ratio of debt to total assets, and the cost of capital (and the value of the firm). These models help isolate the impact of personal and corporate taxes, financial distress costs, and agency costs on the determination of an optimal capital structure. In this section we also consider some other factors that influence the choice of long-term financing instruments, including the impact of signaling and information asymmetries. We conclude with a brief review of the market reaction to various capital structure altering transactions that firms undertake.

Capital Structure Without a Corporate Income Tax

In 1958, two prominent financial researchers, Franco Modigliani and Merton Miller (MM), showed that, under certain assumptions, a firm’s overall cost of capital, and therefore its value, is independent of capital structure. In particular, assume that the following perfect capital market conditions exist

  • There are no transaction costs for buying and selling securities.
  • A sufficient number of buyers and sellers exists in the market, so no single investor can have a significant influence on security prices.
  • Relevant information is readily available to all investors and is costless to obtain.
  • All investors can borrow or lend at the same rate.

MM also assumed that all investors are rational and have homogeneous expectations of a firm’s earnings Additionally, firms operating under similar conditions are assumed to face the same degree of business risk. This assumption is called the homogeneous risk class assumption. Finally, MM assumed that there are no income taxes. MM later relaxed this notax assumption. The results of the tax case follow after the no-tax case discussion.

In the no-tax MM case, the cost of debt and the overall cost of capital are constant regardless of a firm’s financial leverage position, measured as the firm’s debt -to -equity ratio, B/E. As a firm increases its relative debt level, the cost of equity capital, ke, increases, reflecting the higher return requirement of stockholders due to the increased risk imposed by the additional debt. The increased cost of equity capital exactly offsets the benefit of the lower cost of debt, kd, so that the overall cost of capital does not change with changes in capital structure.

This is illustrated in Figure. Because the firm’s market value is calculated by discounting its expected future operating income by the weighted (marginal) cost of capital, ka, the market value of the firm is independent of capital structure. MM support their theory by arguing that a process of arbitrage will prevent otherwise equivalent firms from having different market values simply because of capital structure differences.

Arbitrage is the process of simultaneously buying and selling the same or equivalent securities in different markets to take advantage of price differences and make a profit. Arbitrage transactions are risk -free. For example, suppose two firms in the same industry differed only in that one was levered (that is, it had some debt in its capital structure) and the other was unlevered (that is, it had no debt in its capital structure).

If the MM theory did not hold, the unlevered firm could increase its market value by simply adding debt to its capital structure.However, in a perfect capital market without transactions costs, MM argue that investors would not reward the firm for increasing its debt. Stockholders could change their own financial debt –equity structure without cost to receive an equal return. Therefore, stockholders would not increase their opinion of the market value of an unlevered firm just because it took on some debt.

The MM argument is based on the arbitrage process. If one of two unlevered firms with identical business risk took on some debt and the MM theory did not hold, its value should increase and, therefore, so would the value of its stock. MM suggest that under these circumstances, investors will sell the overpriced stock of the levered firm. They then can use an arbitrage process of borrowing, buying the unlevered firm’s stock, and investing the excess funds elsewhere.

Through these costless transactions, investors can increase their return without increasing their risk. Hence, they have substituted their own personal financial leverage for corporate leverage. MM argue that this arbitrage process will continue until the selling of the levered firm’s stock drives down its price to the point where it is equal to the unlevered firm’s stock price, which has been driven up due to increased buying.

The arbitrage process occurs so rapidly that the market values of the levered and unlevered firms are equal. Therefore, MM conclude that the market value of a firm is independent of its capital structure in perfect capital markets with no income taxes.

Weighted Cost of Capital: Miller and Modigliani (No Taxes)

Weighted Cost of Capital: Miller and Modigliani (No Taxes)

Capital Structure Without a Corporate Income Tax:

Financial Data of Firms U and L

Capital Structure Without a Corporate Income Tax:  Financial Data of Firms U and L

The table contains financial data on two firms, U and L, that have equal levels of net operating income (EBIT = $1,000) and operating risk and differ only in their capital structure. Firm U is unlevered, and firm L is levered, with a perpetual debt of $2,000 having a coupon rate (i ) of 5 percent in its capital structure.

For simplicity, we assume that the income of both firms available for stockholders is paid out as dividends. As a result, the expected growth rate of both firms is zero, because no income is available for the firms to reinvest. The present value of both firms is calculated using the following perpetuity valuation equation:

where E and B are the respective market values of equity and debt in the firm’s capital structure; D is the annual amount of dividends paid to the firm’s stockholders; I is the interest paid on the firm’s debt; ke is the return required on common equity; and kd is the return required on debt.

The required rate of return on the common equity for the unlevered firm (U) is 10 percent. Because of the increased financial risk associated with the $2,000 in debt financing, the required rate of return on the common equity of the levered firm (L) is 11.25 percent. The required return on debt, kd, is assumed to equal the coupon rate on the debt, i. For firm U, the present value of the expected future cash flows is $10,000, calculated as follows:

Thus, the market values of firms U and L are equal. This example shows that the market value of the firm is independent of capital structure, assuming that the MM theory holds and no corporate income tax exists.

Capital Structure with a Corporate Income Tax

Capital Structure with a Corporate Income Tax

Next, the relationship between capital structure and firm market value is considered, assuming that a corporate income tax exists. Table shows financial data for an unlevered firm, U, and a levered firm, L, assuming a corporate income tax rate, T, of 40 percent. The total income available to the security holders of firm U is $600, and assuming a cost of equity capital equal to 10 percent, the value of firm U is calculated using Equation :

Market value of firm U = $600/.10 = = $6,000

Because interest paid to debtholders is a tax -deductible expense, the total income available to the debt and equity security holders of firm L, shown in Table, is $640. This amount is greater than the $600 available to the firm U equity security holders by $40. The $40 amount is the tax shield caused by the tax deductibility of the interest payments. The annual tax shield amount is calculated using the following equation:

Tax shield amount = i *

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