Capital Structure is Irrelevant for Studying Corporate Finance Example for Free

What is capital structure? Capital structure is the mixture of sources of funds in cluding long-term debt, specific short-term debt, common equity and preferred equity but excluding all short term credit.. Leverage firm means that firm uses to finance its assets. A firm with a lot of debt in its capital structure is said to be highly levered. A firm with no debt, it is called unleveraged. Difference industies have difference capital structure. Optimal capital structure is how to balance the cost of an enterprise to find a balance between the point of maximizing the value of the company or the cost of capital minimization. Due to changes in capital structure will affect the reported return on equity and stock prices, so the choice of capital structure is a very important decision Modigliani-Miller Theorem is a financial theory suggests that the market value of a firm is determined by its profitability, risk of the corporate and its related assets, it is an independent way to finance its investments or distribute dividends.

The basic idea of the theorem is, the firm value will not affect whether a firm finances with debt or equity, under certain assumptions. The MM irrelevance proposition is developed in a world with perfect markets, so that there are no conflicts. In particular, there are no transactions costs, no taxes and no costs are incurred to induce mangers to maximize the value of the firm. In 1958, Franco Modigliani and Merton Miller (MM) proved, under a restrictive set of assumptions including zero taxes, that capital structure is irrelevant. The first irrelevance proposition, Proposition I in the 1958 paper titled "The Cost of Capital, Corporation Finance and the Theory of Investment" published in the American Economic Review, states that "the market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the (...) appropriate to its class." (Modigliani and Miller, 1958, p.268). That is, a firm's value and cost of capital are not affected by its financing mix. A firm's value will be determined by its project cash flows. The cost of capital will remain constant with leverage. As a firm increases its financial leverage, the cost of equity will increase just enough to offset any gains to the leverage. The method of arbitrage can be used to prove Proposition I. MM did not develop arbitrage but they made it a foundation of modern finance. MM assume that Financial markets are perfect and show that " if Proposition I did not hold, an investor could buy and sell stocks and bonds in such a way as to exchange one income stream for another stream, identical in all relevant respects buy selling at a lower price. The exchange would therefore be advantageous to the investor quite independently of his attitudes toward risk. As investors exploit these arbitrage opportunities, the value of the overpriced shares will fall and that of the underpriced shares will rise, thereby tending to eliminate the discrepancy between the market values of the firms." (Modigliani and Miller, 1958, p.269).

 

Arbitrage mechanism shows what MM's thinking is. Arbitrage opportunities can not be important due to market forces will intervene and make the price right. And MM think that arbitrage is not limited to current financial instruments and institutions. Because of this proof, we know that the value of a firm is not depends on its leverage if the financial markets are perfect. In a subsequent work in 1963, MM took corporate income taxes into account. Interest paid can be deducted before the payment of income taxes. It helps lighten the tax burden. It increases after-tax earnings to shareholders, so companies will choose to use more debit financing, high corporate debt ratios in order to achieve maximum shareholder value. Leverage will increase a firm's value due to the tax deductibility of interest payments, leading to the conclusion that firms should pursue 100% debt financing. Obviously, when the debt ratio to 100%, business value can be maximize. However, in the real world, Finance Manager will not exceed the use of financial leverage, since a large bankruptcy costs may explain why the company did not give more consideration to the use of tax debt settlement. And actually most of the corporate have no debt financing. The evidence on bankruptcy and financial distress costs was that "neither empirical research nor simple common sense could convincingly sustain these presumed costs of bankruptcy as a sufficient, or even as a major, reason for the failure of so many large, well-managed US corporations to pick up what seemed to be billions upon billions of dollars of potential tax subsidies." (Miller, 1991a, p.274). Later work by Miller (1976) that demonstrated the model with personal income tax to correct MM theory. It points out MM theory over estimate the advantages of debt financing.

In fact, the personal income tax offsets to some extent a personal interest income from investment. They have to pay the loss of personal income tax liabilities and reduce the company's pursuit of preferential corporate income roughly equal. (Miller, 1976) The addition of financial distress and agency costs to the MM corporate tax model or Miller model results in a trade-off model, in which the costs and benefits of using debt are balanced against each other, leading to an optimal capital structure that falls somewhere between zero and 100% debt. The MM models concluded that firms should pursue 100% debt financing. However, if firms continue to borrow, hence the larger the fixed interest charges, the greater the probability that a decline in earnings will lead to financial distress (i.e. financial leverage). In this case, the higher the probability that costs associated with financial distress will be incurred. Costs of financial distress include direct costs, indirect costs and costs of bankruptcy which is the most extreme form. Besides costs of financial distress, agency costs will be incurred when firms continue to use debt financing as shareholders might try to exploit the debt holders. When both the costs of financial distress and agency costs are ignored, according to MM, the value of a leverage firm is VL = VU + TD However, by including both the costs of financial distress and agency costs, the value of a leverage firm becomes VL = VU + TD - PV(costs of financial distress) - PV(agency costs). In this case, the optimal capital structure (the amount to be borrowed that maximizes the value of the firm) can be viewed as the trade-off between the benefits of debt (interest tax shield) and the costs of debt (costs of financial distress and agency costs). Financial distress and agency costs Debt Value of all equity financed firm PV of interest tax shields Value of levered firm Optimal amount of debt Maximum value of firm To summarize, the trade-off theory depicts the relationship between debt ratio, cost of debt, cost of equity and the WACC. When leverage increase - both cost of equity and after tax cost of debt increase steadily; and the increase accelerate when debt level is high, reflecting the probability of financial distress and agency costs; the WACC first decreases, hit a minimal and then begins to rise; when WACC is minimized, the firm value is maximized. Implications of the trade-off theory Although the trade-off theory does not answer to the question of optimal capital structure, it helps explain firms' behavior about leverage.

Firms with more business risk tend to use less debt than lower risk firm. Firms that have tangible assets such as real estates can use more debt than firms with mostly intangible assets. Firm that are paying taxes at a higher rate are likely to use more debt than firms with lower tax rates. In addition, the asymmetric information or signaling theory recognizes that managers, who have better information than most investors, tend to prefer a pecking order of financing - first retained earnings and then debt and as a last resort only, new common stock. The signaling theory concluded that firms should maintain borrowing capacity reserve so that they can always issue debt on reasonable terms rather than have to issue new equity at the wrong time. Despite the unrealistic assumptions, MM laid the foundation of modern capital structure theory. Although the capital structure theory does not provide precise answers to the question of optimal capital structure, it provides a systematic way of analyzing the effects of debt versus equity financing. In practice, we observe that there is a wide variation in capital structure, both across industries and among individual firms within industries. The variations across industries can be explained to a large extent by the economic fundamentals of the industry. Variations within industries also reflect fundamental differences, but they additionally reflect differences in managers' attitudes toward debt. An important contribution to the theory of capital structure is not only to put forward the financial proposition "if there is an optimal capital structure" and there is an objective of the optimal combination of capital structure and make our capital structure has a clear understanding of the following: (1) A debt financing is the lowest-cost of financing in various funding sources in the enterprise due to interest paid before enterprise income tax, and the creditors bear the risk is small than investors relatively. They required a lower rate of return, so the cost of debt financing is usually the lowest.

When there is the case of corporate income tax, debt financing can reduce the consolidated capital costs and increase earnings. (2) Lowest-cost means of financing may not be the best means of financing As the role and impact of financial distress costs and agency costs, over-debt will be offset by increased tax revenue. Because, as the proportion of the increase in debt, corporate interest expense to increase, companies increase the possibility of insolvency, corporate financial risk has increased. At this time, both corporate investors and creditors will ask for the appropriate compensation, which called for increased return on capital so that integrated enterprise cost of capital increased substantially. (3) Optimal capital structure is a kind of objective existence Debt financing for capital costs are lower than the other methods of financing, but not with the level of the individual cost of capital as a measure of the standard, only when the total cost of capital of the companies is the lowest, the level of debt is more reasonable. Therefore, Enterprises in the financing decisions need to continuously optimize the capital structure to become more reasonable, until they reach the lowest-cost integrated capital structure' Enterprises to maximize this goal will be achieved.

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