Financial managers are responsible for making optimum investment decisions. They have to make a decision on how to finance the assets of an organization. Managers have to decide on the sources f financing for example debt or equity to maximize the wealth of its shareholders. Managers are responsible for the effective management of the assets of a firm to achieve the desired objective. Financial managers are trying to identify an optimal capital structure that will maximize shareholders wealth and one that leads to the greatest value (Hossain & Nguyen, 2016). The purpose of this essay is to discuss capital structure theories and applications. The essay will identify the applicable theories, their arguments and their applicability to the firm.
Capital structure is the composition or mix of the different types of capital which include debt, equity and preferred shares. There are two major types of capital in the capital structure of a firm which include debt and equity. Different capital structure theories have been postulated to establish whether changes in the capital structure of a firm will have a significant influence on its value (Stewart, Berk & DeMarzo, 2013).
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The Value of a Firm
The value of a firm depends on its earnings and the weighted average cost of capital. The earnings are a function of operating efficiency, investment decision, and WACC. The value of a firm is obtained by capitalizing the earnings of the company by its cost of capital. The value, therefore, changes due to the changes in the cost of capital and earnings or both. The capital structure is unlikely to affect the earnings before interest and tax of a company but can affect the earnings for residual shareholders.
Recent studies have tried to establish the relationship between the capital structure and the financial performance of an organization. Some of the studies have been conducted in different disciplines like financial sector, non-financial sector, oil and gas and textile industry. Some of the studies have tried to understand capital structure during times of economic crisis while others considered its influence during general timeframes (Hossain & Nguyen, 2016). Some studies have identified negative impact of capital structures on the performance of an organization. Different variations of the debt to equity ratio, for example, lead to differences in the performance of a firm. Other factors play a significant role in the capital structure of a firm, for example, the competitive strategies and the general conditions of the market can lead to low cost of debt and improved performance irrespective of the level of leverage (Stewart, Berk & DeMarzo, 2013).
Some proponents argue that debt financing is cheaper due to the fact that interest payments are deducted while computing tax. Financial managers must, therefore, consider the ratio of debt and equity that maximizes the value of the firm. Similarly, they should consider whether a change in the capital structure will have a substantial impact on the value. Understanding the last point is critical as some theories believe that the mix adopted by a firm can affect its value while others are of a contrary opinion (Stewart, Berk & DeMarzo, 2013). Financial managers must, therefore, consider a capital structure that minimizes agency costs while maximizing the value of the firm.
Empirical evidence shows that the profitability of an entity, its liquidity, and assets utilization as well as growth prospects has a significant effect on the capital structure of a firm. It is also evident that debt structure differs across an industry which shows that some factors specific to an industry are at play (Fabozzi, 2014). It is, therefore, necessary to understand a myriad of factors affecting an industry or a given company in addition to the different theories in order to understand the impact of the capital structure of a company. The following are some of the –major theories that try to explain the capital structure of a firm.
Capital Structure Theories
The capital theories assume that firms use either debt or equity and there is no other source of fund. The theories also assume that investment decisions will remain the same and the firm does not retain any earnings. Another assumption is that the business risk is not affected by the mix adopted by the firm. Taxation is also neglected and that investors are optimistic about the future profitability of the firm.
The net income approach opines that there is a relationship between the value of the firm and the capital structure. The capital structure adopted influences the cost of capital, therefore, affecting the value of the firm. According to this theory, the debt-equity ratio does not affect the perception of risk held by investors. The cost of debt according to this theory is also less than the cost of equity and taxes are also ignored. The value of the firm according to this theory is increased when more debt and less equity is used. The value of the firm is computed by dividing the earnings by the WACC. The maximum value is attained when WACC is at its minimum.
Net operating income approach is different from the net income approach because the value of the firm depends on the capital structure. This approach assumes that WACC is constant and the value is computed using WACC. Similarly, the cost of debt is constant and taxes do not exist. According to this approach, more borrowing increases shareholders risk which causes an increase in the cost of equity which neutralizes the benefits gained from the cheaper cost of debt. According to this approach, the capital structure is irrelevant and therefore has no effect on the value of the firm.
The Modigliani Miller model holds the same school of thought that the debt-equity mix of a company does not affect its value. This approach adds a behavioral approach in support of the net operating income. MM assumes that capital markets are perfect where investors can freely buy sell or even switch securities. The securities, in this case, are indivisible and the investors have not borrowed limits. It also assumes that the investors are aware of the risk-return of the securities and there is no transaction cost or tax. It also assumes that there is no retained profit in the firm. The value of the firm according to this approach is not affected by the capital structure and is equal to the EBIT by the appropriate WACC. The value of the firm, in this case, is the market value of equity and the market value of debt. Identical firms according to this approach have similar levels of earnings and if they are different, the arbitrage process will take place.
Traditional approach compromises the net income and the net operating income approach. It recognizes the existence of an optimal capital structure where the value of the firm is maximized. The value of the firm, in this case, increases as the firm use more debt up to a certain point where WACC declines to a point where it stabilizes. An additional increase in borrowing will not affect the cost of debt and therefore the value will remain unchanged. An increase in the debt of the firm increases the risks for the shareholders where WACC start to increase and the value of the firm will decline.
Franco Modigliani and Merton Miller conducted a research in 1958 where they proved that in a complete as well as perfect capital market the value of the firm is independent of its capital structure. According to the study, the total value of the firm is independent the mix of debt and equity. The two drew the conclusion that an optimal capital structure is nonexistent in a perfect capital market. Modigliani and Miller assumed that the perfect market did not have taxes, bankruptcy costs, transaction costs, borrowing costs, no asymmetric information and also had no effect of debt from the earnings of a company before any deductions of interest and taxes.
The assumptions made by Modigliani and Miller have a significant role in identifying the issues that influence the capital structure of the firm. Taxes and other market imperfections are essential for developing a positive theory of capital structure. Absolute debt, for example, can be the optimal capital structure due to its advantages derived from debt in relation to equity in a tax code. When a firm reduces its equity by accepting more debt, it generates a surplus by reducing the tax paid to the government. The surplus can then be passed on to the investors through higher returns.
Miller (1977) showed that a firm can increase its after-tax income for its investors by increasing the ratio of its debt to equity. The additional income according to Miller will generate higher payouts to the stockholders. The value of the firm, in this case, did not have to increase. Firms, therefore, substitute debt for equity and the proportion of their payments in the form of interest //payable to the creditors’ increases relative to the payout for capital gains on equity and dividends. If the firm pays higher taxes compared to the equity returns, the advantages of debt finance are drastically reduced or totally eliminated. According to the model developed by Miller in (1977), investors are exposed to different tax rates as well as tax arbitrage restrictions. Small investors are willing to accept debt at the same risk-adjusted levels like equity. Investors who are exposed to higher tax rates are likely to demand higher yields in order to compensate for the tax disadvantages of the debt (Graham, Leary & Roberts, 2014).
Many theories on capital structure have been developed and some of them focus on the cross-sectional microeconomic perspective. The interaction of the supply of security by firms and their demand determines the aggregate leverage. The trade-.off model by (Myers 1977) suggests that firms have a leverage target and therefore leverage returns to the target. According to this model, high leverage forces firms to substitute debt with equity. The trade-off in the model leads to two frictions one being the agency cost of financial distress as well as the tax deductions for debt finance which end up generating an optimum capital structure. The model, however, has been criticized as being static. It is believed that the optimal level of debt and the actual debt held by the firm cannot be equal at any time. The friction in the market for instance transaction cost and the imperfection in the financial market can inhibit instant adjustment of debt at the desired level (Seferiadis, 2016).
Miller (1977) proposed the neutral mutation hypothesis where a firm follows identified patterns or financial habits with no considerable value. Such habits make a manager feel better and there is no need to change them as they do not harm. The use of such habits to predict the financial behavior of a firm will not be explaining anything. Myers (1984) observed that the neutral mutation hypothesis is relevant as a warning and using it as an exacting hypothesis complicates the research.
Myers (1984) and Myers and Majluf (1984) formulated the pecking order model. According to the authors, the financial hierarchy is selected in order to reduce adverse selection costs for security issuance. The model is based on the theory of asymmetric information issues. Firms, in this case, are more interested in finances with retained earnings as they are more serious about riskier securities. External debts are mostly in the form of debt rather than an issue of new shares (Seferiadis, 2016). Such firms prefer short-term debt over the long term. High price to book growth firms, on the other hand, are interested in new shares over new debt or even retained earnings.
The market condition model poses unique variables. The model proposes that firms with high prices relative to their fundamentals for example book value is likely to issue new shares. The market timing perspective of the model is a new development of the behavioral story in average stock return for value premium (Seferiadis, 2016).
The size of a firm plays a significant role in the capital structure of a company. Large firms with diversified assets have higher leverage and are likely to take advantage of their capabilities to overcome any financial distress. The nature of the assets held by the firm also determines the losses that it will face during times of financial distress. The size of the firm, its growth opportunities and persistence in earning has a significant and positive effect on the stock prices.
References
Fabozzi, F., & Höchstötter, M. (2014). The basics of financial econometrics . Hoboken: Wiley.
Graham, J., Leary, M., & Roberts, M. (2014). A Century of Capital Structure: The Leveraging of Corporate America. SSRN Electronic Journal . doi: 10.2139/ssrn.2223302
Hossain, A., & Nguyen, D. (2016). Capital Structure, Firm Performance and the Recent Financial Crisis. Journal Of Accounting And Finance , 16 (1), 76-87.
Seferiadis, K. (2016). Review of Capital Structure Theories: Empirical Evidence of UK Market. SSRN Electronic Journal . doi: 10.2139/ssrn.2838414
Stewart, C., Berk, J., & DeMarzo, P. (2013). Corporate finance . Frenchs Forest, Sydney: Pearson Australia.
