updated on 25 September 2007
QuestionWhy might firms in the same industry have diverse financial structures?
The study of capital structure attempts to explain the mix of securities and financing sources used by corporations to finance real investment. Most of it has focused on the proportions of debt versus equity observed on the right-hand side of a corporation's balance sheet. Indeed, there is no universal theory of the debt-equity choice. Rather, there are several useful conditional theories, which include the trade-off theory, pecking order theory, free cash flow theory and, most importantly, the Modigliani-Miller theory.
The trade-off theory says that firms seek debt levels that balance the tax advantages of additional debt against the costs of possible financial distress or the possibility of bankruptcy when a firm has too much debt. This theory thus predicts moderate borrowing by tax-paying firms. The pecking order theory states that the firm will borrow rather than issue equity when internal cash flow is not sufficient to fund capital expenditures. Hence, amount of debt will solely be a reflection of the corporation's cumulative need for external funds. The free cash flow theory says that dangerously high debt levels will increase the firm's value despite the threat of financial distress when a firm's operating cash flow significantly exceeds its profitable investment opportunities.
On the other hand, economists Franco Modigliani and Merton Miller argued in 1958 that financing does not and never will matter in perfect capital markets. It was their groundbreaking theory which stated that the choice between debt and equity financing has no material effect on the value of the firm or on the cost or availability of capital. Consider the simple, market-value balance sheet: the market values of the firm's debt (D) and equity (E) adds up to the total firm value (V = D + E). Modigliani and Miller's Proposition I says that V is a constant, regardless of the proportions of D and E, provided that the assets and growth opportunities on the left-hand side of the balance sheet are held constant. In other words, a firm's overall market value (the value of all its securities) is independent of capital structure, so financial leverage (proportion of debt financing) is irrelevant. Stewart Myers aptly put it: "The value of a pizza does not depend on how it is sliced."
Proposition I also says that each firm's cost of capital is a constant, regardless of the debt ratio. Let rD and rE be the cost of debt and cost of equity respectively - the expected rates or return demanded by investors in the firm' debt and equity securities. The overall weighted-average cost of capital depends on these costs and the market-value ratios of debt and equity to overall firm value:
|Weighted average cost of capital||= rA|
|= rD(D/V) + rE(E/V)|
Here, the weighted average cost of capital (rA) is the expected return on a portfolio of all the firm's outstanding securities. It is also the discount or hurdle rate for capital investment. According to Modigliani and Miller, the weighted average cost of capital (rA) as well as total firm value (V) is a constant.
In practice, however, this is not the case. The assumption of perfect capital markets does not hold in the real world. Traditionalists argue that market imperfections make personal borrowing excessively costly, risky and inconvenient for some investors, thus, creating a natural clientele willing to pay a premium for shares of levered firms. They go further and add that firms should borrow in order to appropriate this value.
Although the logic of the Modigliani and Miller results is now widely accepted, financing and capital structures nevertheless do clearly matter. The chief reasons why it matters include taxes, differences in information and agency costs. Certainly, different theories of optimal capital structure differ in their relative emphasis on, or interpretations of, these factors. For example, the trade-off theory gives prominence to taxation, the pecking order theory emphasises differences in information, and the free cash flow theory highlights agency costs.
First, the trade-off theory. In the United States, for example, firms are taxed on corporate income, but interest is a tax-deductible expense. A taxpaying firm that pays an extra dollar of interest receives a partially offsetting interest tax shield in the form of lower taxes paid. Thus, financing with debt instead of equity increases the total after-tax dollar return to debt and equity investors, and should increase firm value. However, the firm is constrained in the amount of debt it can accrue due to the possibility of financial distress. Certain empirical studies, however, seem to contradict this line of thought. Many established, profitable companies with superior credit ratings, including Microsoft and the major pharmaceutical companies, operate at low debt ratios.
Second, the pecking order theory of capital structure states that if external funds are required for capital investment, firms will issue the safest security first. Debt has the prior claim on assets and earnings; equity is the residual claim. Investors in debt are therefore less exposed to errors in valuing the firm. The announcement of a debt issue should have a smaller downward impact on stock price than an announcement of an equity issue.
Moreover, issuing debt minimises the information advantage of the corporate managers. This line of thought interprets those so-called 'optimistic' managers, who believe the shares of their companies are undervalued, will jump at the chance to issue debt rather than equity. Only pessimistic managers will want to issue equity - but who would buy it? If debt is an open alternative, then any attempt to sell shares will reveal that the shares are not a good buy. Therefore, equity issues will be spurned by investors if debt is available on fair terms, and in equilibrium only debt will be issued. Equity issues will occur only when debt is costly - for example, because the firm is already at a dangerously high debt ratio where managers and investors foresee high interest payments, unfavourable terms of borrowing and, of course, the cost of financial distress.
If internally generated cash flow exceeds capital investment, the surplus is typically used to pay down debt rather than repurchasing and retiring equity. As the requirement for external financing increases, the firm will work down the pecking order, from safe to riskier debt, perhaps to convertible securities or preferred stock, and finally to equity as a last resort. Indeed, this theory assumes that managers act in the interest of existing shareholders. However, the theory fails to provide any explicit treatment of management incentives. Some academics, such as Stephen Ross, have conducted significant research into management incentives via signalling equilibriums, arguing that the design and parameters of the manager’s compensation package is the key driver in the choice between whether a firm chooses debt or equity financing.
So far, the trade-off theory and the pecking order theory assume that the interests of the firm's financial managers and its shareholders are perfectly aligned: there is no moral-hazard problem. However, in reality, it is impossible to eliminate the moral-hazard problem completely. Agency costs, triggered by conflicts between debt and equity investors, depict the adverse consequences of the separation of ownership and control in corporations.
It is a well-known economic phenomenon that managers will act in their own economic self-interest. That self-interest can be redirected by share ownership, compensation schemes or other devices, but the alignment between shareholders’ and managers’ objectives is necessarily imperfect. This brings us to the third theory, the free cash flow theory, which Jensen expressed briefly as: "The problem is how to motivate managers to disgorge the cash rather than investing it below the cost of capital or wasting it on organisational inefficiencies."
The answer to Jensen's problem can be debt, which forces the firm to pay out cash. A high debt ratio can be dangerous, but it can also add value by putting the firm on a diet. The leveraged buyouts of the 1980s were of course the classic examples of diet deals.
No two firms have the exact same financial structure. There are numerous theories seeking to explain the firm's capital structure and there are convincing examples of the trade-off theory, pecking order theory and free cash flow theory at work. Moreover, the economic problems and incentives that drive the theories - taxes, information and agency costs - show up clearly and are important in financing tactics. Whether these factors have first-order effects on the overall levels of debt versus equity financing in the real world is still an open question.
Joon-Jae Bahk is a trainee solicitor in the London office of Skadden, Arps, Slate, Meagher & Flom (UK) LLP.