Capital Structure

Capital Structure

Introduction:

The capital structure of a company is referred to the way in which the company finances itself through debts, equity and securities; it can therefore be referred to as the capital composition of the company taking into consideration its liabilities, Modigliani and Miller propose the Modigliani Miller theorem of capital structure which states that the value of a company in a perfect market is unaffected by the way the company is financed but through the capital structure it employs.

Other theories to describe the capital structures employed by a company include the trade off theory, the agency cost theory and pecking order theory, and however the Modigliani Miller theory provides the basis at which a modern company should determine its capital structure.

The trade off theory recognizes that capital raised by firms is constituted by both debts and equity, however the theory states that there is an advantage of financing through debts due to tax benefit of the debts, however some costs arises as a result of debt costs and bankrupt costs and non bankrupt costs. The theory further states that the marginal benefit of debts declines as the level of debts and at the same time the marginal cost of debts increases as debts increase, therefore a rational firm will optimize by the trade off point to determine the level of debts and equity to finance its operations.

The pecking order theory was developed by Stewart Myers (1984) and it states that firms will adhere to the hierarchy of financing whereby the firm will prefer to finance itself internally and

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Capital Structure

when all internal finances are depleted it will opt for equity, therefore this theory supports the fact that debts are preferred by firms than equity.

The agency cost theory analyses three costs which give explanation to the importance of the capital structure, these costs include asset substitution, underinvestment and cash flow; it gives the importance of management to adopt the most optimal form of capital structure.

MODIGLIANI MILLER THEORY:

This theory was developed by Merton Miller and Franco Modigliani, the theory is based on some assumptions that there are no transaction costs, there are no taxes and that there exist a perfect market and also rational investors exist in the market, through their first proposition they gave the example of two firms where one firm is financed through debts while the other one is not financed by debts but through equity.

In their theory they state that the value of the firm is determined by the debts and equity, where the value of a firm is derived from adding up the debts and equity. The following shows two firms where one firm is financed using debts and equity while the pother is financed by equity only, however as we shall see the value of the firm in the market are same in both cases.

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Capital Structure

FIRM  X

FIRM  Y

EARNINGS

10,000,000

10,000,000

RETURN  ON ASSETS

100,000,000

100,000,000

DEBT  VALUE

0

50,000,000

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Capital Structure

INTEREST  ON THE DEBTS

0

5%

EXPENSES  ON DEBTS

0

2500000

SHARES

10,000,000

5,000,000

PRICE  PER SHARE

10

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Capital Structure

10

MARKET  VALUE OF EQUITY

100000000

50000000

From the above table the market value of

Firm X will be 10,000,000 X 10 = 100,000,000

Where this firm is only financed by share sales and therefore the value of the firm is 100,000,000

Firm Y will be (5,000,000 X 10) + 50,000,000 = 100,000,000

This firm is financed through debts and equity, the value of debts is 50,000,000 and the value of its equity is 50,000,000, when we add this two we get the value of the firm which is 100,000,000, however the firm is required to pay interest on its debts which amount to 50,000,000 X 5% which gives us 2,500,000, therefore the returns on equity will be the earnings minus the interest on debts which will give us 100,000,000 – 2,500,000 = 95,500,000, the returns per share will be 95,500,000/ 10,000,000 = 9.55, therefore the returns on equity will be 9.55/10 = 9.55%, however if this firm had sold its stocks at a premium which is referred to as the

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leverage the firm could generate arbitrage profit.

The Modigliani miller theory also gives us a second proposition whereby there is the existence of tax, this proposition states that a levered firm expected returns will be given by a linear function of the ratio of debt and equity.

Therefore according to this theory the value of a firm is determined by the level of debts and equity, this aids the firm to determine the capital structure to adopt in order to achieve high profitability. However the theory is based on some drastic assumptions that there exist no transaction costs, no taxes, perfect market and that there exist rational investors and loans are obtained at the same rate. The theory is used by modern firms to determine the type of capital structure to adopt.

THE TRADE OFF THEORY:

This theory recognizes that capital raised by firms is constituted by both debts and equity, however the theory states that there is an advantage of financing through debts due to tax benefit of the debts, however some costs arises as a result of debt costs and bankrupt costs and non bankrupt costs.

The theory further states that the marginal benefit of debts declines as the level of debts and at the same time the marginal cost of debts increases as debts increase, therefore a rational firm will optimize by the trade off point to determine the level of debts and equity to finance its operations.

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Capital Structure

However the theory states that as the debt equity ratio increases (D/E) then there is a trade off between bankruptcy and tax shield and this as a result causes an optimal capital structure for the firm, the diagram below demonstrates the optimal capital structure a firm should adopt.

From the above diagram the optimal capital structure is at the point marked “O” where there is the most optimal debt equity ratio that a firm should adopt.

However this theory has faced a lot of critics whereby Miller (1977) whereby he stated that the theory only seem to be an equivalent to a balance between a rabbit and a horse where the theory only considers debts and equity in financing in the absence of other factors that influence capital structure in an organization. Others critics’ state that there are other factors such as the changes in the price of assets will result into the variations in the market structure of a firm.

Despite the various critics the theory still gives us the overall idea about determining the value of firms and how to choose the optimal market structure, it gives the important factors to consider when choosing the most optimal capital structure and it argues that financing through debts is more advantageous than through equity, this is depicted by the argument that as the ratio of debts to equity increases there is an increase in marginal benefits of debts but which will eventually decline and the marginal cost of debts will start rising. The theory takes into consideration the role played by debts, equity in financing a firm and also determining the value of the firm.

The other critic on this theory is that it does not give us the values of debt and equity to be adopted, it only gives a hypothetical approach to the levels of marginal benefits, marginal costs

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and also the bankruptcy cost and the interest and tax shield.

PECKING ORDER THEORY:

This theory was developed by Stewart Myers (1984), this theory states that firms will adhere to the hierarchy of financing whereby the firm will prefer to finance itself internally and when all internal fiancés are depleted it will opt for equity, therefore this theory supports the fact that debts are preferred by firms than equity.

A firm will finance itself internally, and then finance itself using debts and when these debts are depleted then the firm will finance through equity through sales of stock. Therefore equity financing is as a last resort to the firm, therefore the firm prefers to finance through a hierarchy of financing whereby they will finance through available funds, when these funds are depleted the firm will acquire debts and finally when this is depleted they will opt to finance through equity.

This theory is based on the assumption that the firm will always follow the hierarchy of financing, the firm will finance through internal funds and finally as a last resort finance through equity, this may not be true in practical terms because firms may not follow the hierarchy. However the theory advocates for finance through debts than finance by equity, this is the same case with the trade off theory.

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Capital Structure

AGENCY COST THEORY:

There are types of agency cost which tend to give explanation to the importance of the capital structure, they include asset substitution, underinvestment and cash flow.

– Asset   substitution:

This effect is comes as a result of an increase in the debt equity ratio which results into an increase in the incentive for managers to undertake risk to invest in projects, when this happens there will be a decline in the value of the firm which will result in wealth being transferred from the debt holders to the share holders.

– Underinvestment   problem:

The underinvestment problem results when the debts become more risky and therefore the gains from the projects will be accrued to debt holders rather than the share holders; this will result into the firm rejecting projects even if their net present value is positive and have the potential to increase the firm’s value.

–  The free cash          flow:

The free cash flow is a problem whereby there is free cash flow in the firm, if this cash flow is not given to investors then there is a high possibility that the mangers of the firm will destroy the value of the firm.

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Therefore the agency cost theory gives the clear indication of the importance of capital structure; it gives the importance of management to adopt the most optimal form of capital structure.

EVALUATION:

The theories of capital structure give the indication of the importance of adopting an optimal capital structure, the trade off theory, the pecking order theory and the agency cost theory all advocate for the financing of a firm through debts rather than finance by equity, they advocate for an increase in the debt equity ratio, this will result in the firm determining the most optimal capital structure through increased marginal benefits as the marginal cost decline.

The Modigliani miller theory assumes that the value of a firm is determined by the debts and equity, the value of the firm is given by adding up the level of debts and equity, however Merton Miller and Franco Modigliani assume that there are no transaction costs, no taxes and there exist a perfect market. However it is the only theory that gives guidelines to modern firms regarding the capital structure these firms and organizations should adopt, this theory however is based on some drastic assumptions but like all theories there has to be assumptions made to derive the required relationship between variables so as to state the theory, however other theories should not be rejected as they still have their own idea on how firms should adopt capital structure and combinations of equity and debt that are most optimal.

Conclusion:

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Capital Structure

Capital structure is very crucial to a firm’s value; the capital structure will determine the final value of the company whereby the value of the company will be determined by the level of equity and debts, the Modigliani miller theory states that the value of the firm is determined by the debts and equity, where the value of a firm is derived from adding up the debts and equity. They considered two firms where one firm is financed using debts and equity while the other is financed by equity only, however the value of the two firms in the market are same in both cases.

The trade off theory also recognize that capital raised by firms is constituted by both debts and equity, however the theory states that there is an advantage of financing through debts due to tax benefit of the debts, however some costs arises as a result of debt costs and bankrupt costs and non bankrupt costs, the theory also states that the marginal benefit of debts declines as the level of debts decrease and at the same time the marginal cost of debts increases as debts increase, therefore a rational firm will optimize by the trade off point to determine the level of debts and equity to finance its operations, the theory also states that as the debt equity ratio increases (D/E) then there is a trade off between bankruptcy and tax shield and this as a result causes an optimal capital structure for the firm.

The agency cost theory analyses three costs which give explanation to the importance of the capital structure, these costs include asset substitution, underinvestment and cash flow; it gives the importance of management to adopt the most optimal form of capital structure.

The pecking order theory which was developed by Myers in 1984 states that firms will finance through a hierarchy of finance options, therefore this theory supports the fact that debts are preferred by firms than equity, the firm will finance itself internally, and then finance itself using debts and when these debts are depleted then the firm will finance through equity through sales of stock. Therefore equity financing is as a last resort to the firm, the firm prefers to finance through a hierarchy of financing whereby they will finance through available funds, when these funds are depleted the firm will acquire debts and finally when this is depleted they will opt to finance through equity.

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Finally it is clear that the Modigliani miller theory is the only theory that gives a clear guidance to the form of capital structure that firms should adopt. It is the only model that gives guidelines to modern firms regarding the capital structure these firms and organizations should adopt, this theory however is based on some drastic assumptions but like all theories there has to be assumptions made to derive the required relationship between variables so as to state the theory.

References:

Ludwig Lachmann (2000) Capital and capital Structure, University of  Michigan, Michigan

Michael Hank (2003) Credit Risk and Capital Structure, Springer press, New  York

Robin Wood (2001) Managing Complexity, Prentice hall publishers, New  York

Walter B. and Robert F. (2003) Financial Accounting, McGraw Hill publishers, New York

Zane Swanson (2003)The Capital Structure Paradigm: Evolution of Debt and Equity, McGraw Hill publishers, New York

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