Advanced Capital Structure Flashcards
Capital structure
Refers to the mix of securities used by the company to finance its operations: debt and equity.
The cost of debt finance is generally lower than the cost of equity finance because:
There is less risk associated with debt finance.
In the event of financial distress debt holders get paid first meaning lower risk.
Arrangement fees where a debt issue is cheaper than an equity issue.
Interest payments are a tax deductible expense meaning that companies can benefit from the interest tax yield.
The possibility exists to lower the cost of capital by substituting cheaper debt for more expensive equity.
Bankruptcy risk
As companies take on more and more debt then they become more vulnerable to bankruptcy risk.
The higher the gearing ratio debt/equity ratio then the more likely they are to become bankrupt.
As companies become riskier, investors and shareholders require higher rates of return.
Modigliani Miller 1958
Irrelevancy theory
Cost of capital and firm value are unaffected by the debt to equity ratio.
Based on a set of assumptions:
1) individuals and companies can borrow unlimited amounts at the same rate of interest
2) no taxes and no transaction costs involved
3) personal borrowing is a perfect substitute for corporate borrowing
4) firms exist with the same level of business risk but different levels of gearing
5) all cash flows and debt of all projects are perpetual
The traditional approach to capital structure
The cost of equity is initially unaffected by an increase in gearing.
Based on the presumption that debt is cheaper than equity.
Substituting debt for equity will lower the cost of capital.
Modigliani Miller 1963
Revised theory with corporation tax now included.
Most countries tax regimes allow companies to offset interest payments on debt are tax deductible which creates a tax saving.
Companies should aim for 100% debt capital structure to maximise value from the tax shield.
Henceforth, the value of a geared firm would be worth more than an identical ungeared company because their tax bill has been reduced because the taxable profits are lower.
However the issue is according to this model there is no issue with taking on more debt e.g no financial distress costs are not considered.
Propositions of modigiliani Miller 1963
1) the value of the firm is increased as debt is added to the capital structure. Optimal capital structure is when made up of 100% debt.
2) the rate of increase in cost of equity is lower as the gearing ratio increases. Companies benefit from the interest tax shield assumption which is not the case. Loss making companies would not benefit because they don’t have any taxable profits to offset the debts against.
3) The WACC declines as gearing increase.
But it doesn’t take into account financial distress costs
A trade-off theory of capital structure
An tax advantage of using debt is eventually outweighed by the disadvantage of increasing expected bankruptcy costs.
Premise behind the trade-off theory is that forms trade-off costs and benefits of debt.
The positive is that firms have a target debt ratio which decreases the risk element. Weighed up the benefits and costs of debt.
Theories of capital structure have been based on information asymmetry
Disparity of information between managers and outsiders.
Number is studies shows that the share price falls when shares are issued.
(Slovan,2000)
Company issues shares, the share price fell overall by 5%
A share issue lowers gearing. D/E ratio is lowered.
Short term cash flow issues due to share price falling.
Overvalued shares signals the share price to fall when issued.
Signalling theory
Based on asymmetric information.
When a company is undervalued, management need a credible message to send to the market regarding the company’s future prospects to try and increase the market value.
Capital structure of the company depends on whether management perceive company to be under or over valued.
Signals of managerial optimism:
One way is through an issue of debt = positive signal as it shows a positive message of the company’s future prospects. When a company issues debt, signals to the market that it is confident that it shall be able to repay the amount borrowed.
Overvalued companies would issue equity, which sends negative message to the market.
Undervalued companies would issue debt.
More information on the signalling theory
Empirical evidence is weak in support of signalling theory.
Signalling theory predicts undervalued companies have higher gearing ratios compared with overvalued companies.
Research support the opposite: gearing ratios are inversely related to profitability.
Signalling theory predicts that the greater the information asymmetry problem, the higher the gearing ratio.
Research supports the opposite: tangible asset rich companies have higher gearing ratios.
Information costs
Information costs are higher for equity than with debt.
When companies issue equity, the share price falls.
When companies issue debt then the share price rises or they remain the same.
Therefore debt would be preferred to equity and this would give rise to the pecking order theory.
Pecking order theory
Developed in 1984 Myers Firms finance in the following order: Internal funds only once been used up they seek: Debt - lower information costs Equity - last resort
Companies follow a path of least resistance.
There is no optimal capital structure to be reached.
Capital structure is determined by needs and the investment opportunities available.
Tax shields and financial distress costs are a second concern.
Pecking explains why the most profitable companies have low debt levels, generally because they have internal funds (retained funds). They don’t need to issue debt. Also explains why the least profitable companies have debt because they don’t have sufficient internal funds and they move down the pecking order, hence the huge amounts of debt withstanding.
Financial slack
Companies who have used up internal funds have to reach out externally.
Companies with loads of debt can not borrow anymore.
They won’t issue equity if the share price is too low, meaning they pass by investment opportunities.
THEY SHOULD HAVE FINANCIAL SLACK.
Having cash or other liquid assets or having unused debt capacity.
Important so they don’t have to forgo good investment opportunities
Free cash flow
Jensen (1986)
Reinvestment risk/free cash flow
Managers do with free cash flow after all positive NPV projects have been invested in.
Jensen suggests higher debt levels of company is cash rich with few investment opportunities. Empire building when companies acquire smaller companies meaning higher status for managers and higher wages extracted. So that is the risk of having
Free cash flow.
Cash rich companies should have loads of debt payments so managers don’t waste cash.
