Corporate Capital Structure - Essay Example

Corporate Capital Structure Introduction The concept of corporate capital structure and cost of capital occupy an important position in modern corporate finance. Considerable controversy has surrounded the question of whether using debt to create financial leverage can affect the average cost of capital and the total value of the firm. However empirical evidence remains inconclusive. a) The Traditional View of Capital Structure: Supporting Arguments In financial theory, disagreement exists with respect to the effect of capital structure on firm value. The traditional view of corporate capital structure and valuation holds that there is an optimal capital structure and thus the total value of the firm can be increased through a judicious financing mix. It had been generally assumed that there is an optimal mixture of debt and equity in a firm's capital structure that results in a shallow, U-shaped average cost-of-capital curve. That is to say, the market value of the firm will rise to a point with an increase in the debt ratio. Beyond that point, any increase in the debt ratio will cause the market value of the firm to decline. (Ariff and Lau, p. 391-410) Precisely, the traditional view states that capital structure may impact the cost of capital and in that way influence the value of a firm. It holds that the reasonable or rational use of leverage will decrease the total cost of capital primarily and therefore also add to value. When leverage turns out to be excessively high, beyond an optimal point, the cost of capital will begin to increase and hence the value will decline. There is no specific recognition of how to measure either a moderate or reasonable or optimal capital structure (Ariff and Hassan, p. 11). Some have accepted a moving average of historical capital structure; others have accepted an industry ratio. This concept is depicted through Figure 1 below: Figure 1: Adopted from Optimal Capital structure Although the traditional view appears to be substantially correct in relation to recognized real world behavior of capital structure, it suffers from lack of rigorous proof. This implies that there is an optimal capital structure but no analytical means of determining it. b) The Independence Hypothesis: Modigliani and Miller (1958) Modigliani and miller 1were the first to develop a modern theory of capital structure supported by rigorous mathematical proof. The M&M (1958) theory is based on several simplifying assumptions: i. Perfect and frictionless capital markets with investors that behave rationally; ii. Individuals can borrow and lend at the same interest rate regardless the amounts; iii. No corporate or personal income taxes' iv. The firm's cost of equity depends upon its business risk class; v. Firms issue only risk-free debt and risk equity, and thus there are no bankruptcy costs; vi. Operating earnings of the firm are not expected to grow. The original M&M theory holds that the average cost of capital is independent of the firm's capital structure and equal to the capitalization rate of an unlevered stream of earnings at the capitalization rate appropriate to its risk class. As a result, the total market value of the firm is independent of its capital structure. Figure 2: Adopted from figure 5 Maugham, 2000, p.1 The original M&M result was obtained assuming perfect capital markets. Subsequent literature has relaxed the underlying assumptions of M&M's 1958 model. Stiglitz (1969) proved, using a state preference framework that the M&M result (1958) holds with risky debt, so long as there are no bankruptcy costs. Hamada (1969), using the CAMP, showed that the M&M result (1958) holds in a world where assets are allowed to have different risk classes. Mossin (1969), using a modified version of Sharpe's single-period asset valuation model, showed that in tax less, frictionless markets where there is no possibility that the firm will go bankrupt, changes in its debt-equity ratio will not alter the total market value of debt and equity. Schall (1972) also showed that Mossin's proposition (1969) holds in the multi-period case. Figure 3: Adopted from figure 4 Maugham, 2000, p.1 M&M's independence hypothesis rests primarily on the conservation of value and homemade leverage arguments. The first argument assumes that all investors have the same estimates of a firm's expected operating earnings (EBIT) and that its risk class can be measured. The increase in expected return to the common stock holders that results from financial leverage created by debt will be exactly offset by the Market capitalizing those higher expected earnings at a higher rate. In other words, as the debt ratio rises, the stockholders required rate of return increases just enough to offset the higher expected return. The increase in the capitalization rate reflects the added risk that results from added financial leverage. The second argument of homemade leverage assumes that any equity investor can make his own personal financial leverage to any degree desired. As there are no transactions costs and because individuals can borrow at the same rate as corporations in M&M's world of frictionless capital markets and rational investors, there is no advantage to stockholders when corporations borrow in order to increase earnings. The mechanism for ensuring that the average cost of capital is equal to the capitalization rate of an unlevered stream of earnings is arbitrage. An excess premium incorporated in the market price of a levered firm's stock would be bid away as stockholders in the levered firm sell their shares, borrow at the same rate as the levered firm, and buy shares in a unlevered firm to duplicate the position of the levered firm. Stockholders in the levered firm will continue to do so until the market values of the levered and unlevered firms are identical. c) Development of M&M's Modern Theory of Capital Structure (1963) Given the underlying assumptions of M&M's independence hypothesis, it is true that the total market value of a firm is independent of its capital structure. Yet we know that those assumptions do not match the real world. In a real world, there are taxes, there are transaction costs, and there are deterrents to investors holding either bonds or stock or to their borrowing to carry securities. Furthermore, all individuals cannot borrow at the same rate. Attempts to relax the underlying assumptions of the original M&M's theory, recognizing market imperfections, have provided the bases for the subsequent development of the modern theory of capital structure. The first attempt to recognize market imperfections was made by M&M (1963) when they modified their original theory (1958) to account for the existence of corporate income taxes. The advantage of debt in a world of corporate income taxes is that interest payments are deductible as an expense for income tax purposes, while dividends or retained earnings are not deductible by the corporation. If corporate income taxes are the only form of taxes levied, there is a linear downward-sloping average cost-of -capital curve with an increase in debt ratios. Consequently, the total value of a levered firm is equal to the value of an unlevered firm plus the present value of the tax shield provided by debt. This result implies that firm value continually increases as the debt ratio increases from zero. Hus the inclusion of the effect of corporate income taxes suggests that an optimal strategy is to employ the maximum degree of leverage. However, the presence of personal income taxes may reduce or perhaps eliminate the corporate tax advantage associated with debt. This expectation originates from Farrar Selwyn (1967), who implies that the personal value of corporate leverage to any investor is a decreasing function of his personal income tax rate, becoming negative once his personal income tax rate exceeds corporate income tax rate by a factor depending on capital gain tax rate. This result was also indicated by Stiglitz (1973). In a subsequent paper, Miller (1977) argued that when both corporate and personal income taxes are recognized, financial leverage and the value of the individual firm are independent, while a unique optimum level of aggregated debt exists for the corporate sector as a whole. Senbet and Taggart (1984) generalized Miller's 1977 argument to other forms of capital market imperfections and incompleteness. In their view, if corporations can borrow and lend advantageously relative to individual investors, corporate capital structure is determinate in the aggregate but not at the individual firm level. Works Cited Ariff, M. and Lau, K. "Relative capital structure and firm value", International Journal of Finance, Vol. 8, 1996, 391-410 Ariff, Mohamed. and Hassan, Taufiq "How Capital Structure Adjusts Dynamically During Financial Crises", Corporate Finance Review, New York, Nov/Dec, 2008, Vol. 13, Issue 3; pg. 11, 14 pgs Farrar, Donald E., and Selwyn, Lee L. "Taxes, Corporate Financial Policy and Return to Investors", National Tax Journal Volume 20, No. 4, 1967, 444-54 Hamada, Robert S., "Portfolio Analysis, Market Equilibrium and Corporation Finance", Journal of Finance, Volume 24, March 1969, 13-31 Maugham, Stewart. How Capital Structure Affects a Company's Cost of Capital - Part 1, April 2000, retrieved April 26, 2009 from: http://www.accaglobal.com/students/publications/student_accountant/archive/2000/4/36961 Miller, Merton H. "Debt and Taxes", Journal of Finance,Volume 32, May 1977, 261-75 Modigliani, Franco, and Miller, Merton H. "The Cost of Capital, Corporation Finance and the Theory of Investment", American Economic Review, Volume 48, June 1958, 261-97 Modigliani, Franco, and Miller, Merton H. "Corporate Income Taxes and the Cost of Capital: A Correction", American Economic Review, Volume 53, June 1963, 433-43 Mossin, Jan., "Security Pricing and Investment Criteria in Competitive Markets", American Economic Review Vol. 58, December 1969, 749-56 Schall, Lawrence D. "Asset Valuation, Firm Investment, and Firm Diversification", Journal of Business, volume 45, January 1972, 11-28 Senbet, Lemma W. and Taggart, Robert A. "Capital Structure Equilibrium under Market Imperfections and Incompleteness", Journal of Finance, Volume 39, March 1984, 93-103 Stiglitz, Joseph E., "A Re-Examination of the Modigliani-Miller Theorem", American Economic Review, December 1969, Volume 59, 784-93 Stiglitz, Joseph E., "Taxation, Corporate Financial Policy, and the Cost of Capital", Journal of Public Economics Volume 2, 1973, 1-34. Optimal Capital Structure, retrieved April 26, 2009 from: http://campus.murraystate.edu/academic/faculty/larry.guin/FIN330/Optimal%20Capital%20Structure.htm Read More