The capital structure of the firm is made of two things, one is the level of debt and the other is the proportion of equity. The management of the firm has to decide an appropriate mix of both the funding sources for the smooth running of the firm and the maximization of the shareholders wealth. Traditional view was that to increase gearing level to get weighted average cost of capital (WACC) low which will consequently give a higher present value of future cash flows and enhance shareholders wealth. However the higher level of debt will require a higher payment of interests before dividends which in turn leads the firm to become financially distressed and in extreme circumstances to be liquidised. Therefore, getting an optimal capital structure is essential. In this study I will discuss the two theories, ‘optimal capital structure theory’ and the ‘pecking order theory’ with the help of literature.
Franco Modigliani and Merton Miller (1958) developed a theory for optimal capital structure. At first they assumed that there is a perfect capital market which means that there are no income taxes and transaction costs. If the market is ideal then the firm’s capital structure is inappropriate to its value as the investors are prudent, the required return of equity is directly proportional to increase in gearing. There is thus a linear association between cost of equity and gearing. The boost in cost of equity precisely offsets the benefits of the cheaper debt finance and therefore the WAAC remains unaffected. A number of practical criticisms were made at the assumptions of perfect market specifically at the supposition of no taxes which seemed unrealistic because the debt interest is tax deductible the effect of tax could not be neglected. However when corporation income taxes and transaction costs came into play Miller and Modigliani(1963) changed their view of having a perfect market and rephrased their theory saying that because debt interest is tax deductible the optimal capital structure can be complete debt finance as substituting debt instead of equity generates extra tax savings which can not be achieved otherwise. Firms can then pass on this extra saving to share holders and other investors in the form of higher returns. Arnold. G (2004) further explains this modified view as a firm financed with 99% of debt and 1% of equity serves its shareholders better then one funded by 50% debt and 50% equity. This in turn means that debt finance is cheaper then equity and using as much debt as possible in a firm’s capital structure will make the performance and outcome outstanding in terms of returns to its investors. This raised a further question that if the debt reduces the tax payments and results in the higher dividends to share holders then does this mean that the firms financed largely by equity are paying unnecessary corporation tax on the share holders funds? Miller (1977) discussed this problem as by increasing the debt finance in capital structure of the company we can save money on tax payouts but this will not change the value of the entity because the money saved by increasing the debt finance is paid back to the share holders in the form of dividends. In other words if the interest payments of debt is greater than the equity returns then it removes the advantage of debt finance. (Anne P. Villamil) The problem with Miller and Modigliani’s theories is that if the company is financed by 99% debt it will put the company in the utter most degree of risk because debt is riskier than equity as well as cheaper. What is meant by risk here is that lenders will want their return before company can do anything else with its earnings and if company have to pay large amounts of its revenue towards the lenders then other obligations such as payments to suppliers, dividends, wages and salaries and other business expenses will not be met by the company. This can also result in poor rating by agencies and will stop investors to invest in the company in future and there will be no other way then to liquidise the company.
This theory is managerial type in which Myer (1984, p581) gives the idea that there is no such thing as optimal capital structure instead he argues that firms should raise finance in three different ways in order to save costs. Firstly they should generate funds internally secondly the debt finance should be used and thirdly there should some new share issues as well if needed. The ranking of fund raising in this particular way is entirely based upon the issue costs of the three different types. Because internally generated funds have the lowest issue costs then issuing debt has moderate issue costs and issue new equity has the highest costs. Therefore firms when ever they need funds for what ever reason should first generate funds internally and then move on to the next category if they need to. The pecking order theory is best explained by perspective of asymmetric information and the existence of transaction costs. Asymmetric or uneven information costs exist when firms produce funding for them internally to bring an investment’s net present value (NPV) to be positive. The outside investors, when the market price of the equity is greater than the actual value can under or over estimate the price of equity because usually they have very limited information about the company as compared to the managers and this gives chance to the managers to issue securities at a higher price (Myers and Majluf 1984). Some elegant investors are aware of the incentives behind the issue of new equity when the market overvalues the existing equity therefore they will adjust the price accordingly and as a result of this the new securities will be under priced in the market. The impact of under priced new equity issue will be a loss to existing share holders because new investors detain more of the NPV of the new project. The managers acting in the favour of existing share holder in such circumstances will reject the project even if the NPV is positive. This under investment can be avoided by financing the new project internally. (Mayer and Majluf 1984). The pecking order theory can also be explained by way of transaction costs. The costs linked with external fund raising are the key to select the source of finance. The sources can be ranked in order of the transaction costs associated with them as explained in the start of the pecking order theory section. There is another reason for the managers to give internal financing preference over external financing that is the managers or owner do not want to lose control over the entity by giving chance to the new share holders to enter in the company and exercise control (Holmes and Kent, 1991; Hamilton and Fox, 1998) therefore managers will attempt to finance their activities as much as possible with internally generated funds. However if there are no sufficient funds available to support the activities then the next option manager will choose for financing will be the one which gives the investor no or very less control over the entity such as short term and long term debt and the final choice if there is no other way to raise finance will be issue of new equity. The problem with the pecking order theory is that it presses the point of giving preference to internal funds. If this is the case then the firm would have gearing ratio equal to zero. However, for being able to have enough internally generated funds and to cope with growth or to finance the activities the firm should be well established and mature. In reality this is not possible for most of the growing firms which do not have that level of internal funds therefore they have no other choice but to rely on debt finance which means the gearing ratio tends to move away from zero.
There is no any optimum capital structure which a firm can adopt and start running its businesses. A firm can get the point of gearing where it can maximize the shareholders wealth but finding that point is the problem in the real world. The point of optimum level of gearing is different for different type of industries like some of them have small level of borrowings,
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