Capital structure is concerned with the way a company structures its finance, this is important as it can affect the value of a company. Usually a company will opt for either debt financing or equity financing but more often a combination of both. If a company opts for a combination of debt and equity they can favor one over the other, alternatively they could opt for an equal split. Each combination will have advantages and disadvantages; these are centered around the key characteristics of the different finance options.
The Characteristics of Debt Finance
Considered a lower risk:
It has a definite maturity date and interest rates are set accordingly, taking into account the length of time funds are required for.
Debt is cheaper than equity, partly due to the fact it can attract tax relief on the interest repayments.
Debt financing will not dilute the control of the company.
The Characteristics of Equity Finance
Equity is more expensive due to an investor’s requirement to be compensated for having their money tied up
The risks and liabilities of the company are shared with equity investors, conversely the control of the company and the profits are also shared.
There are a number of theories that consider the effects of the chosen finance method and try to establish the optimum or best balance.
Modigliani and Miller Capital Structure Irrelevance Theory
Modigliani and Miller advocate the Capital Structure Irrelevancy Theory; this is the suggestion that the capital structure of a company will have little or no effect on the value of a company, it will make no difference whether debt or equity or both are used.
It is a very simple argument that forms the basis for this theory, the cash flows into a company will be the same regardless of the capital structure of the company finance. The division of these cash flows i.e. the amounts attributable to different financing arrangements (equity shares and debt, such as bonds) may differ but will not affect the total amount of cash flow into the company when added together.
Financial gearing relates to the degree in which a company uses or favors debt to finance, where a company has a large proportion of finance from debt, it is said to have a higher gearing.
So Modigliani and Miller suggest that the value of a highly geared company i.e. the finance structure has a high debt proportion would be the same as one that is referred to as being ungeared i.e. the finance structure is wholly made up of equity if the operating profits and future prospects are same. In which case if an individual was considering buying shares they would expect to pay the same if buying in to a geared company as they would pay to buy shares in an ungeared company. This ensures that valuation is focused on the earning potential of the company.
Modigliani and Miller make a number of assumptions when advocating this theory:
- There are no taxes.
- There are no transaction costs when buying and selling shares and securities.
- There are no bankruptcy costs.
- Investors and companies can borrow at the same cost.
- Companies and investors have access to the same market information.
The average amount that a company pays for capital and would need to pay to raise more capital is referred to as the Weighted Average Cost of Capital (WACC). Modigliani and Miller’s Capital Structure Irrelevance theory suggests that regardless of the capital breakdown the WACC will remain consistent. This is based on the resultant decrease in the WACC seen when more cheaper debt financing is obtained being offset by the increase in WACC as a result of equity costs increasing due to the greater financial risk.
A number of years later Modigliani and Miller looked at this theory again, this time taking tax into account. This dramatically changed their perspective. Debt in this view became even cheaper when taking into account the tax relief available, which meant the WACC decreased further with additional debt financing. The additional decrease in the WACC outweighed any additional equity costs resulting from the increased risk. As gearing increased the WACC fell. This meant that Modigliani and Miller concluded that a company should finance itself using the highest possible financial gearing that it could manage.
This theory however sparks some criticisms; in the business world companies are advised against using a capital structure made up almost entirely of debt. This is due to a number of reasons:
- In reality it is not always possible to obtain financing in this manner.
- The tax relief is only actually available on tax paid, so once the tax is exhausted this benefit is no longer applicable.
- There is also a very real risk of bankruptcy, with financing relying heavily on debt any increases in interest rates could quickly put the company in a position where it can no longer meet these obligations and it faces bankruptcy.
The Pecking Order Theory
A very different approach to the financing decision, this theory does not try and establish an optimum balance of debt to equity. This very simply suggests that the financing decision should be based on the following established pecking order:
- Retained Earnings/Reserves
If a company bases their decisions following this order and exhausting each option one by one, it is thought to be advantageous.
The company reduces the transaction costs associated with obtaining finance, as using retained earnings will attract minimal costs and the most expensive financing option would be the issue of equity shares. Likewise, the time and expense associated with the options above increase from the minimal amount of time and expense using retained earnings through to the much more significant amounts of time and costs associated with the issue of equity shares.
This theory would suggest that a very successful company would have low levels of debt finance due to their higher retained earnings available for funding investments. I am sure we can all think of companies that may not follow this pattern.
Another school of thought, simply suggests that a company should match the finance to the asset/investment being financed. So a long term or fixed asset should be funded by a long term form of finance and a current asset should be funded by a short term funding method. Thank you for reading about capital structure theory. The are more finance models here.