Capital structure

Capital structure decision stands for how to finance investments

The goal of capital structure decision is to maximize company
value by minimizing cost of capital (WACC)
Cost of capital is the cost to raise additional capital. So It is
marginal rate. It is the current rate (not the rate used to raise
capital in the past)

Modiglani & Miller

proposition

Assumptions

Expectations are homogenous: Investors have same expectations

regarding cash flows from investments in stocks or bonds
Bonds and shares of stock are traded in perfect capital markets
Perfect capital markets are characterized by the absence of
transaction costs, taxes, bankruptcy costs
Any two investments with identical cash flows and risk trade for
the same price in perfect capital markets
Investors can borrow and lend at the risk free rate
Managers always act to maximize shareholder wealth

MM Proposition 1 (Without taxes)

Market value of a company is not affected by the capital

structure of the company
The importance of Modiglani & Miller proposition is It shows that
increase in the value of company can not happen by changing the
capital structure
VL(Value of levered company) = VU (Value of unlevered company)
This happens as capital structure decision has no impact on cash
flows of the company and cost of capital of the company

MM Proposition 2 (Without taxes)

The cost of equity is a linear function of the companys

debt/equity ratio
Debt is a cheaper source of capital
Proposition 1 says that changes in capital structure have no
impact on cost of capital
Cost of equity increases when the use of debt in the total capital
increases so as to keep the cost of capital same
This happens as the risk of equity depends on financial leverage
also
Increased use of debt results in an increase in cost of equity

MM Proposition 1 (with taxes)

Interest paid is deductible from income for tax purposes

This translates into tax savings which has a value enhancing effect
on the company
MM Proposition 1 (with taxes) states that the value of a levered
company is higher than value of an unlevered company by an
amount equal to the tax rate multiplied by debt
MM Proposition 2( with taxes) states that cost of equity increases
with the increase in use of debt but the rise is less than in no-tax
environment

Modiglani & Miller proposition 1 & 2

Without taxes

With taxes

Proposition 1

VL=VU

VL=VU+tD

Proposition 2

Re=r0+(r0-rd)D/E

r0+(r0-rd)(1-t)D/E

Other arguments

Miller argued that if investors face higher tax on income from debt
instruments compared to dividends they may demand higher
return on debt. This will increase the cost of debt
In Miller model depending on tax rates adding debt may not have
any impact on value, increase the value, or decrease the value of
a company
However tax is not the only factor which has an impact on levered
company
Other factors like cost of financial distress, agency costs, and
asymmetric information also play a major role in the
determination of value of levered company

Costs of financial distress

Financial leverage has a negative effect during economic

downturns. It may lead to financial distress
Expected costs of financial distress can be classified into 1) direct
costs, and 2)indirect costs
Direct costs are the costs associated with bankruptcy process
Indirect costs include lost investment opportunities, and inability
to conduct business
Probability of bankruptcy has a linear relation with leverage

Agency costs

Agency costs arise as most of the companies are managed by nonowners

Agency costs have three components 1)Monitoring costs 2)Bonding
costs 3)Residual loss
Monitoring costs are the costs to monitor the management of the
company. Board of directors expense, and board meeting expense
come under this category
Bonding costs are borne by management to give the assurance to
the owners that they are working in the best interests of owners
Residual loss is the cost that is incurred in spite of monitoring and
bonding
Agency theory predicts that agency costs will come down with the
use of debt
Jensens free cash flow hypothesis states that higher debt levels
will instil discipline among agents as the company has to make
interest and principle payments

Costs of asymmetric information

Asymmetric information stands for unequal distribution of

information
Managers have more information about the company than
outsiders
Asymmetry in information is especially very high in high tech
industries
Providers of capital (both equity as well as debt) demand higher
rate of return from companies with high asymmetric information

Optimal capital structure static trade-off

theory

Modiglani & Miller theory proposes that any capital structure is

good
Static trade-off theory differs from MM theory as it proposes
optimal capital structure
Optimal capital structure is found at a point where any additional
debt would cause the costs (agency costs, financial distress costs,
asymmetric information costs) outweigh the benefits (tax benefits)
Optimal capital structure depends on companys business risk, tax
situation , corporate governance practices etc.....
Costs of both debt as well as equity increase as the proportion of
debt increases in capital. So WACC has U shape