Monday 14 May 2012

Optimal Capital Structure

Lecture 10 discusses whether or not it is worthwhile for organisations to adjust their gearing ratio, and whether it can add value to their business, so that they can ultimately maximise shareholder wealth. The traditional answer is yes however Modigliani and Miller argue against the traditional method and say no.

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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