This paper seeks to determine whether changes in a firm’s capital structure can add shareholder value or they merely change the level of risks. This will discuss the different theories of capital structure using examples from both theory and practice.
The different theories of corporate structure
The corporate structure theories are categorized into two with the first one arguing that the source of financing (i.e. debt or equity) is irrelevant in relation to shareholder value as explained by the Modigliani-Miller theory and the second one arguing that it is relevant. Under the second category, this paper will discuss the trade-off theory and pecking order theory.
Under the Modigliani-Miller theory (or M&M), a perfect capital market is assumed where there are no bankruptcy or transaction cost and that there is perfect information. Thus under the theory, firms and individuals can borrow at the same interest; that there are no taxes and that investments decisions cannot be influenced by financing decisions. Thus, the authors argued that that value of is made independent or unaffected by any decision as whatever is the capital structure of the firm. When analysis of the model was extended to presence of interest and taxes, the authors also argued that tax deductibility of interest makes debt financing more valuable than equity financing and that increase the proportion of debt in the capital structure would decrease cost of capital. Thus, the optimal structure, if there is any where there are taxes and interests, is when there is no equity at all.
Under the second category, the trade-off theory and the pecking order theory may alternatively explain what really happens in the actual world. Since this is an imperfect world, some imperfections must be factored in attaining maximum value of stock and thus an optimum capital structure is assumed to exist within what may be contemplated by the trade-off theory and the pecking order theory. These two theories in effect relax some of assumptions under the perfect market scenario.
Under the trade-off theory, there is bankruptcy cost where there is advantage of financing capital via debt due to the benefit of tax deductibility of interest expense but such must be kept in balance with the cost of financing such debt or the so-called bankruptcy cost (Kraus and Litzenberger, 1973; Brealey, and Myers 1996). The additional or incremental benefit therefore for every sterling or dollar increase in debt decreases as debt is increased while the additional or incremental cost rises as the firms want to attain the optimum value of its stock. Thus, a trade off exist between debt and equity financing and striking the proper balance should be objective so as to attain the optimum capital structure. Translated in debt to equity ratios, a firm must find a range within which it must operate from time to time if it aims to maximize shareholder value. The optimum structure however varies in industries and even in firms as each firm may be exposed to different risks.
The pecking order theory, on the other hand takes advantage of the lack of perfect information in the real world as it argues that firms would prioritize the sources of financing by exhausting first internal sources before resorting to external source based on the principle of least resistance with financing through equity is the last choice (Constantinides, G.et al, 2003). Retained earnings as internal source of financing would come ahead first of external financing through debt and when this debt financing is exhausted or cannot be made sensible, that is the only time that equity financing by issuance of stocks should be done (Constantinides, G.et al, 2003).
The basis of prioritizing internal source is that the company could opt not to distribute the retained as dividends by just using the same instead to finance expansion or use for alternative investments that could generate higher rates of return than cost of capital. Hence it should be easier to keep retain earnings than resort borrowing with the use of debt. The basis of using debt over external equity is also based on the assumption that when the company does issue stocks with the knowledge of managers who are expected to know more than the company investors about the true financial status of the company, the said act would be an admission of overvaluation of company’s stocks. Hence, it would probably be issued at a higher cost than debt financing as investors would assign lower values to the new stock issuance.
Do changes in capital structure affect shareholder value or do they merely change level of risk?
Based on the theories introduced on capital structure, the answer to this question depends on what is assumed: perfect market or imperfect market.
As discussed under the Modigliani-Miller theory, where a no bankruptcy or transaction cost are assumed in perfect capital market, it is clear that the shareholder value will be unaffected by the changes in the capital structure as changes would be irrelevant (Brigham and Houston,2002). Since firms and individuals can borrow at the same interest, there would seem to be ease in borrowing that may not fully explain what exist in reality. It is not an easy thing to borrow since creditors do not take risks without expecting any return higher than their cost of borrowing of the funds lent. Since part of the assumption was also the absence of taxes, the same again would go against with the reality that no government in this world would exist as taxes are lifeblood of government (Hinsdale, 2008) that the latter needs at it promotes and meets political and socio-economic objectives. It was also assumed that investment decision could not be influenced by financing decisions, which again may really go against the fact that there is an opportunity cost in everything from an economic viewpoint as long as there is a choice using resources.
The argument of the authors under the M&M model that the shareholders’ value would be unaffected would become more evident when the authors extended the analysis of the model by allowing the presence of interest and taxes in the light of the expected absence of equity as the optimal structure at all (Brigham and Houston,2002). This is due to the tax deductibility of interest, which would make debt financing more valuable than equity financing and given also the expectation in the increase in proportion of debt in the capital structure (Brigham and Houston,2002).
Since the evidence of the existence of perfect capital market to allow the operation of the model may not be fully supported by what happens in the real world, the rest of this subsection would now analyze the impact of the looking at the other assumption of where are imperfections of the market (Van Horne, 1992). The discussion assumed that the trade-off theory and the pecking order theory caused possible bases of changes in capital structure that do affect shareholder value and they do not merely change the level of risk.
Since the trade off theory asserts for the presence of bankruptcy cost with the expected advantage of financing capital through debt due to the benefit of tax deductibility of interests expense that be must be kept in balance with the cost of financing such debt or the so called bankruptcy cost (Brealey, and Myers, 1996), there is to be an assumed optimum capital structure to allow the operation of the theory. This optimum capital structure will be assumed to correspond to the optimum value of its stocks. Since it is assumed that there would decrease in marginal benefit that comes for every dollar increase in debt as debt is increased, the decision maker will have to know when it is possible to still have a marginal benefit of borrowing greater than zero (Brealey, and Myers, 1996). Since the margin benefit must also be match by the marginal cost as debt increases, the same must also be determined by management in order to attain that optimum capital structure that would maximize the value of stocks (Brealey, and Myers, 1996). Hence, the name of trade-off between debt and equity financing fully describe the theory because of the need to keep the balance of the two.
The optimum capital structure is normally within a range and never at fixed point from period and period. Hence, this would mean flexibility on the part of management to attain that balance. This would also require the company to have good source information in order to derive and compute at what range of capital structure should the company operates (Brigham and Houston, 2002). Trade off theory would be closely related to capital budgeting decision if analyzed in a deeper sense since the optimum capital structure would be equivalent to the point where the cost of capital is minimized (Brigham and Houston, 2002). Since the cost of capital could be a function to risk from macroeconomic variables there is strong reason to argue that for the company to fully benefit from the application of the trade-off theory, it must be able to regularly monitor and compute its cost of capital to know at what range it is minimized.
Since capital structure is translated in terms of debt to equity ratios, for a firm to find a range within which it must operate from time to time in attaining maximized shareholder value (Brigham and Houston, 2002), it must have a reliable accounting information to able to compute this. Since its is also expected that the optimum structure however varies in industries and even in firms as each firm may be exposed to different risks, no good reason to necessarily conclude that two firms or two industries may be similarly situated. This would in effect connote difficulty in computing that optimum capital structure since generalizing what may be applicable to a group of firms may not be a safe estimate of the optimum capital structure.
Since the pecking order theory is assumed to take advantage of the lack of perfect information in the real world by having firms to prioritize the sources of financing in exhausting first internal sources before resorting to external source, it is also safe to assume that decisions are relevant to what will give the company to lowest cost of capital in generating the source of financing first in priority (Constantinides, G.et al, 2003). Since prioritization is also based on the principle of least resistance with financing through equity is the last choice, the theory is also arguing from a practical viewpoint. This could be proved in having retained earnings as internal source of financing first before first would go for external financing. If such external financing it thus resorted, it should be through debt and equity financing could only be justified when debt financing is exhausted or not sensible any more under the situation (Van Horne, 1992). Although the theory is not expressly supporting the adoption an optimum capital structure as the trade-off theory, there is strong evidence that management intervention is a great possibility if not a strategy in the firms want to maximize shareholder value.
This should not be difficult since given the internal source is selected first ahead of external source, least cost of financing should matter since funds will not move or come from outside the organization but will just use that retained earnings to be capitalized (Van Horne, 1992). It is in the manner of reinvestment of what would otherwise be made available to investor through dividends. Since resorting to internal financing carries the assumption that some financing decisions would cost less than others, the same should be considered as finding the point where cost of capital is minimized or when looked at in terms of capital structure (Brigham and Houston, 2002), there is also the presumed existence of capital structure.
Since the company will resort to not distributing the retained as dividends but will instead use the money to finance expansion or use for alternative investments that could generate high rates higher than cost of capital, the company must be in effect minimizing cost of capital between two options at such stage. This strategy must also be made similar in the case of choosing between debt financing from external financing where the latter is more costly. It is for such reason about the greater chances to go for that balance situation which approximates the presence of an optimum capital structure which cannot be specifically pointed out since it could vary from firm to firm and from industry to industry (Van Horne, 1992).
That shareholder value is affected by the change in capital structure under the pecking order theory is more evident in the purpose of resorting to a particular choice of financing. The basis of using debt over external equity has its roots from the assumption that a company issuing stocks is presumed have overvalued stocks because of the knowledge of managers, who are deemed more knowledgeable than the company investors from outside about the true financial status of the company (Miller, n.d.). Since what is avoided is the perception that issuance of stocks would be an admission of overvaluation of company’s stocks and contradict corporate objectives of maximized value, there is more reason to believe that capital structure by the choice of means of financing does influence the change of shareholder value. It is also expected that every company decision is geared toward maximizing that value of the company (Van Horne, 1992).
Critical discussion of the above points with some examples from theory and practice
Given the assumptions in the theories there is need to look at the evidence from some research whether there is basis to believe each in practices.
Part of the Modigliani-Miller theorem, given the assumption of a perfect capital market is the view that dividend is also irrelevant to wealth maximization or stock price increase (Frankfurtera and Wood Jr., 2002; Johnsona, et. al, 2006). The same has its underpinning in the article by Miller (n.d.) entitled “Do Dividends Really Matter?” In said paper, Miller exposed his position about the few aspects of corporate financial policy where theory and practice are at variance, on what really is the effect of dividend policy on stock price. Although he knows about the academic consensus about the irrelevance of dividend policy to stock price, Miller admits about the possibility that about generous dividends causing to sell lower due to tax penalties or higher taxes on dividends as against capital gains (Miller, n.d.). On another view, he also knows of the continued claims from corporate officials and investment bankers about the big influence of dividend on market prices because of cited instance where there were sudden increases in price after some announcements of resumption of regular dividends. In explaining his position, however, Miller (n.d.) saw what practitioner’s perception as “an optical illusion” which he illustrated to with his students using a stick in the water. He explained that of one who uses his or her eyes and look at the stick in the water would see it to appear as bent yet if one feels it with his or her finger or if one pulls it out of the water one will realize that the stick is not really bent (Miller, n.d.). He thus argued that same illusion happens with dividends, which do not actually affect the value of stock although they appear to be so if one will not think have a deeper reflection of one’s observations more deeply (Miller, n.d).
Miller (n.d.) with Professor Modigliani, argued that speaking only of a firm’s dividend policy is one sided. Miller explained that the payment by a company of a dividend indicates a use of funds must be balance by the source (Miller, n.d). He argued that if one holds constant the use which represented by the capital budget of the, such is investment spending and such would require raising more funds which could come from bank loans or other sources which could selling stocks or bonds (Miller, n.d.). The author could then be considered arguing that a firm’s decision on dividend policy given its investment policy is really a choice of financing strategy where company will have to choose to finance its growth through heavier reliance on external sources or by cutting or delaying its dividend and thus rely more on internal funds.
At this point, it may be counter argued since dividend policy is a finance strategy then it should be logical to see a consequence of that choice on the matter of either benefit or cost to the decision maker on the ground that a choice has a consequence. It may be counter argued further that if a firm does cut back its present level of dividends then it should be reinvesting said funds, which promise the company a higher return that its opportunity cost or cost of capital (Brigham and Houston, 2002). It could not be that a firm does the cutting back for no reason. In a typical company, the issue of cash flow is a reality, one’s mismanagement of its cash flow could cause some liquidity problem, and liquidity problem could be a working capital problem. To illustrate, there is a difference between having money and not having money to service currently maturing obligations and pay the salaries of employees. Failure on this could cause the creditors not wanting to continue doing business or worse they could petition for bankruptcy and this could cause cessation of operation.
Further, it may be argued from an investors’ point of view, that failure to manage cash flow caused by failing to decide correctly on dividend policy could bring risk to the company and hence the stock price must be affected as a result. Finance theory concurs with the argument that the investors want to be compensated with higher risks of doing business. Although Miller (n.d.) wants to call dividend policy as investment policy or strategy and not a finance strategy, the resulting effect is still the inevitable choice of capital structure that would maximize value (Van Horne, 1992; Weston and Brigham, 1993).
Subjecting trade-off theory and pecking order theory may not add more strength more support to the fact an optimum capital structure is easier to accept given unrealistic assumptions under the Miller-Modigliani theory. In other words, the previous sections have sufficiently made the arguments clear and convincing for trade-off theory and pecking order theory. Providing an example how firms try to balance capital structure with shareholder value may still add value. This may be seen in a firm’s financial ratios of Dell, Inc. on profitability (MSN, 2009a) and on financial condition (MSN, 2009b) being compared with the industry ratios. The fact that these ratios are being extracted for decision-making points to need to keep a balance of these ratios in relation to the corporate objectives to maximize shareholder value as evidenced by the daily stock chart (MSN, 2009c)
This paper has found that changes in capital structure could add shareholder value at a certain point until the optimum capital structure of combination of debt and equity is attained. This position was clearly defended in the case of trade off theory and pecking order theory. Trade-off theory recognizes the trade-off between risk and return so that increasing the return could increase risk. Since not all investors can take a high level of risk, although there return could be very high, it follows that there is such a thing as maximum or optimum acceptable return and with it an optimum capital structure. Since increasing the level of debt in relation to equity could increase profitability of a firm at a certain point (Bernstein,1993; Helfert,1994; Meigs, Meigs & Meigs,1995), it follows modifying the capital structure that could increase advantage could in fact increase profitability. Since increase in profitability could normally cause increase in the value of the stocks or shareholder of the company, it follows that changing the capital structure could indeed increase shareholder value. Pecking order clearly set lower cost of financing from internal sources against external sources and that debt financing is cheaper than equity financing. However, since there is a sensible point to avail each source, an optimum capital structure is also implied. The unrealistic assumptions under the Miller-Modigliani theory would favor the application of trade-off theory and pecking order theory, thus, a capital can be modified to add shareholder value.
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