Basically,
is it possible to maximise shareholder wealth by varying the proportions of
debt and equity in a company’s capital make up?
The
traditional theory of capital structure is that the optimal capital structure
exists, where the WACC is minimised and market value is maximised. (Arnold,
2005)
The
traditional approach argues that a moderate degree of debt can lower the firm’s
overall cost of capital and thereby, increase the firm value. The initial
increase in the cost of equity is more than offset by the lower cost of debt,
but as debt increases, shareholders perceive a higher risk and the cost of
equity rises until a point is reached at which the advantage of lower cost of
debt is more than offset by more expensive equity. (Pandy, 2005)
However,
the contention of the traditional theory, that moderate amount of debt in
‘sound’ firms does not really add very
much to the ‘riskiness’ of the shares, is not defensible. Also, there is insufficient
justification for the assumption that investors’ perception about risk of
leverage is different at different levels of leverage.
In
the traditional view of capital structure, it is also argued that investors do
not always have the information and/or the time needed to closely monitor
changes in the level of debt relative to equity. Consequently there is a period
of time where the expected return or required return on the levered firm’s
stock does not fully account – in the M&M sense – for the added financial
risk that is associated with the higher levels of debt. (Grant, 2002)
Modigliani
and Miller (1958) studied the capital structure theory intensely and from their
analysis, they developed the capital structure irrelevance proposition. Their approach
is opposite to the traditional approach. Essentially they hypothesized that in
perfect markets, it does not matter what capital structure a company uses to
finance its operations. They say that there is no relationship between capital
structure and cost of capital; and changing the capital structure would have no
effect on the overall cost of capital and market value of the firm.
Modigliani
and Miller argued that it would not be possible for one company to remain more
valuable than another, since the overvalued company would be bought and sold
until the prices equalise. However, M&M’s hypothesis relies on a few
assumptions: capital markets are perfect (information is costless, no taxes, no
transactions costs) so the imperfections need consideration.
The
M&M capital structure irrelevance proposition assumes 1) no taxes and, 2)
no bankruptcy costs. Taking these assumptions into consideration, the WACC
should remain constant with changes in the company's capital structure. For
example, no matter how the firm borrows, there will be no tax benefit from
interest payments and thus no changes/benefits to the WACC. Additionally, since
there are no changes/benefits from increases in debt, the capital structure
does not influence a company's stock price, and the capital structure is
therefore irrelevant to a company's stock price. (Graham and Harvey, 2001)
However,
in the real world, taxes and bankruptcy costs do significantly affect a
company's stock price. In additional papers, Modigliani and Miller included
both the effect of taxes and bankruptcy costs.
In 1963,
when Modigliani and Miller admitted corporate tax into their analysis, their
conclusion altered dramatically. As debt became even cheaper (due to the tax
relief on interest payments), the cost of debt fell significantly. Thus, the
decrease in the WACC (due to the even cheaper debt) was greater than the
increase in the WACC (due to the increase in the financial risk). Thus, WACC
falls as gearing increases. Therefore, if a company wishes to reduce its WACC,
it should borrow as much as possible.
There is clearly a
problem with Modigliani and Miller’s with-tax model though, because companies’
capital structures are not almost entirely made up of debt. Companies are
discouraged from following this recommended approach because of the existence
of factors like bankruptcy costs, agency costs and tax exhaustion. All factors
which Modigliani and Miller failed to take in account. (ACCA, 2009)
The
traditional approach assumes that there are benefits to leverage within a
capital structure up until the optimal capital structure is reached. The theory
recognises the tax benefit from interest payments. Studies suggest, however,
that most companies have less leverage than this theory would suggest is
optimal.
In
comparing the two theories, the main difference between them is the potential
benefit from debt in a capital structure. This benefit comes from tax benefit
of the interest payments. Since the M&M capital-structure irrelevance
theory assumes no taxes, this benefit is not recognised, unlike the traditional
theory, where taxes and thus the tax benefit of interest payments are
recognised.
On reflection by the
author, the traditional view appears to be a more worthwhile approach to
achieving optimal capital structure. In the absence of perfect capital markets
and the existence of corporate taxes, M&M’s theory is more unrealistic to
real life situations. It has been suggested that some firms are financed
entirely by equity, but very few firms are financed entirely by debt, and
neither of these observations are consisted with the M&M theory.
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