The optimal capital structure is the mix of debt and equity that maximizes a firm’s return on capital, thereby maximizing its value.
Explain the influence of a company’s cost of capital on its capital structure and therefore its value.
Capital structure is the way a corporation finances its assets, through a combination of debt, equity, and hybrid securities. In short, capital structure can be termed a summary of a firm’s liabilities by categorization of asset sources. In a simple example, if a company’s assets come from a $20 million equity issuance and lending that amounts to $80 million, the capital structure can be said to be 20% equity and 80% debt. While equity results from the selling of ownership shares, debt is termed “leverage. ” Therefore, a term that has issued no debt or bonds is said to not be leveraged. This is a simplistic view, because in reality a firm’s capital structure can be highly complex and include many different sources.
The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure (though it is generally viewed as a purely theoretical result, since it disregards many important factors in the capital structure decision). The theorem states that in a perfect market, how a firm is financed is irrelevant to its value. However, as with many theories, it is difficult to use this abstract theory as a basis to evaluate conditions in the real world, where markets are imperfect and capital structure will indeed affect the value of the firm. Actual market considerations when dealing with capital structure include bankruptcy costs, agency costs, taxes, and information asymmetry.
One of the major considerations that overseers of firms must take into account when planning out capital structure is the cost of capital. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. A company’s securities typically include both debt and equity; therefore, one must calculate both the cost of debt and the cost of equity to determine a company’s cost of capital. The weighted average cost of capital multiplies the cost of each security by the percentage of total capital taken up by the particular security, and then adds up the results from each security involved in the total capital of the company.
Because of tax advantages on debt issuance, such as the ability to deduct interest payments from taxable income, issuing debt will typically be cheaper than issuing new equity. At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity. This is due to the fact that adding debt increases the default risk and, thus, the interest rate that the company must pay in order to borrow money. This increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock). Management must identify the “optimal mix” of financing, which is the capital structure where the cost of capital is minimized so that the firm’s value can be maximized.
Taxation implications which change when using equity or debt for financing play a major role in deciding how the firm will finance assets.
Explain how taxes can influence a company capital structure.
Tax considerations have a major effect on the way a company determines its capital structure and deals with its costs of capital.
Miller and Modigliani assume that in a perfect market, firms will borrow at the same interest rate as individuals, there are no taxes, and that investment decisions are not changed by financing decisions. This leads to a conclusion that capital structure should not affect value.
When the theory is extended to include taxes and risky debt, things change. Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure then, would be to have virtually no equity at all.
However, we see that in real world markets capital structure does affect firm value. Therefore, we see that imperfections exist; often a firm’s optimal structure does not involve having one hundred percent leveraging and no equity whatsoever. There is much debate over how changing corporate tax rates would affect debt usage in capital structure. In general, since dividend payments are not tax deductible, but interest payments are, one would think that, theoretically, higher corporate tax rates would call for an increase in usage of debt to finance capital, relative to usage of equity issuance. However, since many things fall into tax applicability, including firm location and size, this is a generality at best.
There are also different kinds of debt that can be used, and they may have different deductibility and tax implications. That is why, while many believe that taxes don’t really affect the amount of debt used, they actually do. In the end, different tax considerations and implications will affect the costs of debt and equity, and how they are used, relative to each other, in financing the capital of a company.
Cost of capital is important in deciding how a company will structure its capital so to receive the highest possible return on investment.
Describe the influence of a company’s cost of capital on its capital structure and investment decisions.
One of the major considerations that overseers of firms must take into account when planning out capital structure is the cost of capital.
For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. A company’s securities typically include both debt and equity, so one must therefore calculate both the cost of debt and the cost of equity to determine a company’s cost of capital. The weighted average cost of capital multiplies the cost of each security by the percentage of total capital taken up by the particular security, and then adds up the results from each security involved in the total capital of the company.
If there were no tax advantages for issuing debt, and equity could be freely issued, Miller and Modigliani showed that, under certain assumptions, the value of a leveraged firm and the value of an unleveraged firm should be the same.
Because of tax advantages on debt issuance, such as the ability to deduct interest payments from taxable income, it will be cheaper to issue debt rather than new equity. At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity. This is because adding debt increases the default risk and thus the interest rate that the company must pay in order to borrow money. By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock). Management must identify the “optimal mix” of financing–the capital structure where the cost of capital is minimized so that the firm’s value can be maximized.
The marginal cost of capital is the cost needed to raise the last dollar of capital, and usually this amount increases with total capital.
Describe how the cost of capital influences a company’s capital budget.
The marginal cost of capital is calculated as being the cost of the last dollar of capital raised. Generally we see that as more capital is raised, the marginal cost of capital rises. This happens due to the fact that marginal cost of capital generally is the weighted average of the cost of raising the last dollar of capital. Usually, we see that in raising extra capital, firms will try to stick to desired capital structure. Usually once sources are depleted they will have to issue more equity. Since the cost of issuing extra equity seems to be higher than other costs of financing, we see an increase in marginal cost of capital as the amounts of capital raised grow higher.
The marginal cost of capital can also be discussed as the minimum acceptable rate of return or hurdle rate. The investment in capital is logically only a good decision if the return on the capital is greater than its cost. Also, a negative return is generally undesirable. As a result, the marginal cost of capital often becomes a benchmark number in the decision making process that goes into raising more capital. If it is determined that the dollars invested in raising this extra capital could be allocated toward a greater or safer return if used differently, according to the firm, then they will be directed elsewhere. For this we must look into marginal returns of capital, which can be described as the gains or returns to be had by raising that last dollar of capital.
Trade-off considerations are important because they take into account the cost and benefits of raising capital through debt or equity.
Describe the balancing act between debt and equity for a company as described by the “trade-off” theory.
The trade-off theory of capital structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. It is often set up as a competitor theory to the pecking order theory of capital structure. An important purpose of the theory is to explain the fact that corporations are usually financed partly with debt and partly with equity. It states that there is an advantage to financing with debt—the tax benefits of debt, and there is a cost of financing with debt—the cost of financial distress including bankruptcy.
The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases. Of course, using equity is initially more expensive than debt because it is ineligible for the same tax savings, but becomes more favorable in comparison to higher levels of debt because it does not carry the same financial risk. Therefore, a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.
Another trade-off consideration to take into account is that the while interest payments can be written off, dividends on equity that the firm issues usually cannot. Combine that with the fact that issuing new equity is often seen as a negative signal by market investors, which can decrease value and returns.
As more capital is raised and marginal costs increase, the firm must find a fine balance in whether it uses debt or equity after internal financing when raising new capital. Therefore, one would think that firms would use much more debt than they do in reality. The reason they do not is because of the risk of bankruptcy and the volatility that can be found in credit markets—especially when a firm tries to take on too much debt. Therefore, trade off considerations change from firm to firm as they impact capital structure.
Signaling is the conveyance of nonpublic information through public action, and is often used as a technique in capital structure decisions.
Explain how a company’s attempts at signaling can affect its capital structure.
In economics and finance, signaling is the idea that a party may indirectly convey information about itself, which may not be public, through actions to other parties. Signaling becomes important in a state of asymmetric information (a deviation from perfect information), which says that in some economic transactions inequalities in access to information upset the normal market for the exchange of goods and services. In his seminal 1973 article, Michael Spence proposed that two parties could get around the problem of asymmetric information by having one party send a signal that would reveal some piece of relevant information to the other party. That party would then interpret the signal and adjust its purchasing behavior accordingly — usually by offering a higher or lower price than if the signal had not been received. In general, the degree to which a signal is thought to be correlated to unknown or unobservable attributes is directly related to its value. A basic example of signaling is that of a student to a potential employer. The degree the student obtained signals to the employer that the student is competent and has a good work ethic — factors that are vital in the decision to hire.
In terms of capital structure, management should, and typically does, have more information than an investor, which implies asymmetric information. Therefore, investors generally view all capital structure decisions as some sort of signal. For example, let us think of a company that is issuing new equity. If a company issues new equity, this generally dilutes share value. Since the goal of the firm is generally to maximize shareholder value, this can be a viewed as a signal that the company is facing liquidity issues or its prospects are dim. Conversely, a company with strong solvency and good prospects would generally be able to obtain funds through debt, which would generally take on lower costs of capital than issuing new equity. If a company fails to have debt extended to it, or the company’s credit rating is downgraded, that is also a bad signal to investors. While the issuance of equity does have benefits, in the sense that investors can take part in potential earnings growth, a company will usually choose new debt over new equity in order to avoid the possibility of sending a negative signal.
Managers will have their actions influenced by their firm’s capital structure and the resources that it allows them to use.
Explain how capital structure can minimize a company’s agency problem.
Managers who make decisions about the firm’s corporate behavior will have their actions influenced by capital structure and the resources that it allows them to use.
Managerial finance is the branch of the industry that concerns itself with the managerial significance of finance techniques. It is focused on assessment rather than technique. However, this process can be tainted by the fact that managers may often act in their own best interests instead of those of investors of the firm. This is known as an agency dilemma.
Adopting the right kind of capital structure can help combat this kind of problem, however. When the capital structure draws heavily on debt, then this leaves less money to be distributed to managers in the form of compensation, as well as free cash to be used on behalf of the business. Managers have to be more careful with the resources they are given to use with the purpose of running the firm successfully, since they have to produce enough income to pay back this debt by a certain date, with interest. When managers work with equity heave capital structure they have a little more leeway, and while shareholders may be upset or suffer because of fluctuations in the value of the firm, managers may find ways to make sure their compensation can have some immunity from the market value of the firm.
Therefore, firms that have debt-heavy capital structures have managers with goals that tend to be more aligned with those of the shareholder. The limitation of free cash that managers have provides incentive for them to make decisions for the company that will grow the firm in value and increase the cash they have available to them to pay back debt, pay back into the firm, and compensate themselves.
In corporate finance pecking ordering consideration takes into account the increase in the cost of financing with asymmetric information.
Explain the benefits and shortcomings of using the “pecking order” theory to evaluate a company’s value.
The pecking order of investors or credit holders in a company plays a part in the way a company decides to structure it’s capital. Pecking order theory basically states that the cost of financing increases with asymmetric information. Financing comes from internal funds, debt, and new equity. When it comes to methods of raising capital, companies will prefer internal financing, debt, and then issuing new equity, respectively. Raising equity, in this sense, can be viewed as a last resort.
The pecking order theory was popularized by Stewart C. Myers when he argues that equity is a less preferred means to raise capital because managers issue new equity (who are assumed to know better about true conditions of the firm than investors). Investors believe that managers overvalue the firms and are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity issuance. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required. Thus, the form of debt a firm chooses can act as a signal of its need for external finance. This sort of signalling can affect how outside investors view the firm as a potential investment, and once again must be considered by the people in charge of the firm when making capital structure decisions.
Tests of the pecking order theory have not been able to show that it is of first-order importance in determining a firm’s capital structure. However, several authors have found that there are instances where it is a good approximation of reality. On the one hand, Fama, French, Myers, and Shyam-Sunder find that some features of the data are better explained by the Pecking Order than by the trade-off theory. Goyal and Frank show, among other things, that Pecking Order theory fails where it should hold, namely for small firms where information asymmetry is presumably an important problem.
In corporate finance, a “window of opportunity” is the time when an asset or product which is unattainable will become available.
Identify a window of opportunity.
In corporate finance, a ” window of opportunity ” basically is the idea of a time when an asset or product that is unattainable will become available. It can be extended to a time when a certain product will be attainable at a certain price or from an opposite perspective, the unique time a party will be able to sell a certain product at its highest price point in order to get a maximum return on investment.
For example, when a firm issues an IPO, which allows a company to tap into a wide pool of potential investors to provide itself with capital for future growth, repayment of debt, or working capital. A company selling common shares is never required to repay the capital to its public investors. Those investors must endure the unpredictable nature of the open market to price and trade their shares. However, for a company with massive growth potential, the IPO may be the lowest price that the stock is available for public purchase. Therefore, the IPO presents a window of opportunity to the potential investor to get in on the new equity while it is still affordable and a greater return on investment is attainable. From the firm side, the opportunity to purchase a new plant or real estate at a cheap cost or lower lending rates also presents an opportunity to attain a greater investment on assets used in production. Management of a firm must take this into account in order to keep costs low and returns high, in order to make the firm look like the best possible investment for creditors of all types.
Bankruptcy occurs when an entity cannot repay the debts owed to creditors and must take action to regain solvency or liquidate.
Describe how the risk of a corporate bankruptcy can influence a company’s cost of capital.
Bankruptcy is a legal status of an insolvent person or an organization, that is, one who cannot repay the debts they owe to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor. Generally, a debtor declares bankruptcy to obtain relief from debt. This is accomplished either through a discharge of the debt or through a restructuring of the debt. Usually, when a debtor files a voluntary petition, his or her bankruptcy case commences.
In the U.S. firms that go bankrupt normally file for Chapter 7 or 11. Chapter 7 involves basic liquidation for businesses. It is also known as straight bankruptcy. Chapter 7 is the simplest and quickest form of bankruptcy available. Chapter 11 involves rehabilitation or reorganization and is known as corporate bankruptcy. It is a form of corporate financial reorganization that typically allows companies to continue to function while they follow debt repayment plans. When liquidation occurs one must remember that bondholders and other lenders are paid back first before equity holders. Usually, there is little or no capital left over for common shareholders.
When gaining the financing for capital, firms must take the possibility of bankruptcy into consideration. This is especially important when looking into financing capital through debt. If potential creditors sense that bankruptcy could be likely firms will have a harder time acquiring financing and even if they do, it will probably come at a high interest rate that significantly increases the cost of debt. These firms will have to rely heavily on equity, which once again can be seen as a negative signal about the firm’s current state. It can put a downward pressure on equity values. This places a high cost on raising capital, with potential for low returns. Therefore, it is best that the firm take into consideration any possibilities of bankruptcy and work to minimize them when designing capital structure.
PPSC FIN 2010 Principles of Finance by Cristal Brietbeil and Eric Schroeder is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License, except where otherwise noted.
