Capital Structure Theory PDF

FIN 400:Notes 7 Capital StructureTheory  INTRODUCTION  Capital structure is the Debt-to-Equity composition used to finance the operations of a firm  The importance of capital structure is that it is one of the key factors used to maximise the value of a firm  Poor capital s...

FIN 400:Notes 7 Capital StructureTheory  INTRODUCTION  Capital structure is the Debt-to-Equity composition used to finance the operations of a firm  The importance of capital structure is that it is one of the key factors used to maximise the value of a firm  Poor capital structure can increase the cost of capital, thereby lowering the NPVs of potential projects, and thus:  limit the number of projects that can be undertaken  reduce returns from investment  Optimal or Targeted Capital Structure  Optimal or Targeted capital structure is that composition of debt and equity that:  minimise the overall cost of capital  and maximise the value of a firm  In every capital structure decision, there is always a trade-off between risk and return:  Increased debt increases the bankruptcy risks to the shareholder (because of increased financial commitments)  Debt carries a lower cost, and therefore reduces the cost of capital, which means increasing returns from investments (maximises value of the firm) In summary, higher risk tends to lower a firm’s value, while increased returns increase firm’s value  Factors that determine Capital Structure 1. Financial Risk and Business Risk Financial risk  Is the resultant change/increase in the riskiness of the firm’s stock caused by introducing debt into the firm’s capital structure  Financial risk depends only on the types of securities issued, i.e. more debt, more financial risk. Business risk  is the baseline riskiness of the firm’s stock if it used no debt  this risk is attributable to the firm’s operations.  it is determined by projections of the firm’s returns on invested capital  Business Risk Business risk varies across industries and among firms in the same industry. Also it can change overtime depending on:  Uncertainty about demand (sales)  Uncertainty about output prices  Input cost variability  Ability to timeously adjust effectively to changes in the industry, i.e. product innovations  Operating leverage, thus the degree to which operating costs are fixed The greater the firm’s business risk, the lower its optimal debt ratio  2. Firm’s tax Position The interest amount payable from debt is a tax-deductable expense, which is an incentive for using debt. A firm that is 100% equity financed pays more tax than that which is 100% debt financed, ceteris paribus. However, is a firm that already has its income sheltered by other tax shields, i.e. tax-loss carry forwards, additional debt would not add value  3. Financial flexibility The ability of the firm to raise additional debt in a reasonably short period of time and on reasonably good terms Effective utilisation of business opportunities depends on the steady supply of capital Lenders prefer firms with strong balance sheets  4. Managerial conservatism or aggressiveness Management have a philosophical stand when it comes to style of management While some are conservative (prefer certainty), others are aggressive (risk-takers) Debt is a risky instrument of capital because:  It commits the future income of the firm  Installment payments to interest and principal are a compulsory obligation. Default will result in bankruptcy.  Increased debt is associated with the probability of bankruptcy The returns from using debt are normally good, and hence aggressive managers are more inclined to use debt  Capital structure theory Although capital structures of firms in the same industry tend to show similarities, they differ from one firm to the next. As already discussed, firms have an incentive to determine and achieve an optimal capital structure. There are many theories that suggest the importance of capital structure and how the optimal capital structure should be attained.  1. Modigliani-Miller Irrelevance Theory M&M (1958) provided the earliest theory in capital structure. In their analysis, they concluded that the firm’s value not affected how the capital is spilt between debt and capital (finance), but rather by how effective and efficient the resources of the company are utilised. In their analysis, M&M used a very restrictive set of assumptions which made the model unrealistic: – No capital acquisition and transfer costs (i.e. no brokerage fees) – No taxes – No bankruptcy costs – Standard borrowing costs across the economy – No information asymmetry between investors and managers Although unrealistic, M&M provided the breakthrough theory which formed the foundation for studies that followed  2. The Traditional (trade-off) Theory The trade-off theory recognises the importance of taxes and bankruptcy costs in minimising the cost of capital and maximising the value of the firm. Income Tax Savings Interest payments emanating from debt are tax-deductable (unlike dividends due to shareholders), and therefore shields the firm’s income from high tax bills. In this light, the higher the debt ratio (leverage) in the capital structure, the larger would be the tax savings. The tax deductibility of debt related interest rate reduces the cost of debt. Bankruptcy Costs In contrast, high levels of debt are associated with increased probability of bankruptcy because of:  Less financial flexibility due to high committed levels of future income  Increased cash out flow due to high installment payments  The obligation to service both the interest and principal amounts regardless of the firm’s performance  The Traditional (trade-off) Theory Bankruptcy costs include:  Legal costs  Accounting expense  The business reputation  Interruption to regular business (financial distress)  Higher interest rates on additional debt sourced Note: the mere threat of bankruptcy may also bring about bankruptcy related costs Given the opposing effect that tax and bankruptcy have on the value maximisation objective of the firm, the optimal capital structure under this theory is given as that level of debt where the net tax benefits start to be eroded (less) than the increasing bankruptcy costs  3. Signaling Theory Assumptions: Managers have better information about a firm’s long-run value than outside investors. Managers act in the best interests of current stockholders. What can managers be expected to do? Issue stock if they think stock is overvalued. Issue debt if they think stock is undervalued. As a result, investors view a stock offering negatively--managers think stock is overvalued.  Pecking Order Theory The theory states that firms will prefer retained earnings to any other source of finance followed by debt and lastly Equity. The order of preference is as follows: – Retained Earnings – Straight debt – Convertible debt – Preference shares – Common Equity  Reasons for the perking order preference Easier to use retained earnings than to endure trouble associated with sourcing external financing. Retained earnings have no floatation costs and the floatation cost for debt are less than that for common equity. Investors prefer saver securities, that is debt with its guaranteed income and priority on liquidation. Some managers belief that debt issues have a better signalling effect than equity issues. Their point of contention is that the market will interpret debt issue as a sign of confidence that the company will make enough earnings to meet debt obligations and that the shares are undervalued.  Cont’nd By contrast, the market will interpret equity issues as a measure of last resort that managers believe the equity is currently overvalued and hence are trying to achieve higher proceeds as they can.  Behavioural Theories The herd theory state that the business will stick closely to the industry average capital structure. The average may however hide wide variations that are acceptible to different companies There is however evidence to suggest that companies that are high geared that the industry average will struggle to get further debt finance.  Behavioural Theories Benchmarking, occurs where businesses identifies a leader in the market and adopt a similar capital structure. However the capital structure that is appropriate for the market leader with the investment opportunities that it faces may not be appropriate for the less successful business in that industry.  Behavioural Theories Past experience may be a important influence The argument is that managers are aware of the advantages and disadvantages of both debt and equity, and choose the source of finance that experience suggests will cause them few or no problems