6.1 Theories of Capital Structure
Capital Structure refers to the way a company finances its operations through a combination of debt and equity. Several theories have been proposed to explain how companies should structure their capital for maximum value.
Modigliani-Miller Theorem (M&M):
Proposed by Franco Modigliani and Merton Miller in 1958, this theory suggests that in a perfect market, the value of a firm is not affected by its capital structure (the mix of debt and equity). The assumptions include no taxes, bankruptcy costs, or asymmetrical information.
The key insight is that in the absence of these market imperfections, the firmās value depends on its profitability rather than the way it is financed.
However, once taxes are introduced (M&M with taxes), firms can benefit from the tax shield provided by debt since interest payments are tax-deductible. This makes debt financing more attractive as it can reduce a companyās taxable income, thereby increasing its value.
Trade-Off Theory:
This theory builds on the M&M Theorem by acknowledging that there are costs associated with both debt and equity.
The trade-off theory posits that firms seek to balance the tax benefits of debt (interest tax shield) against the costs of potential financial distress and bankruptcy. As a company takes on more debt, the risk of bankruptcy increases, and at a certain point, the cost of financial distress outweighs the tax benefits of additional debt.
Firms aim to strike a balance where the marginal benefit of debt equals its marginal cost.
Pecking Order Theory:
This theory suggests that firms prefer to finance new projects first using internal funds (retained earnings), then with debt, and finally by issuing new equity.
The reason behind this preference is the asymmetric information between company managers and outside investors. Managers know more about the firmās prospects than investors, so issuing new equity may signal that the company is overvalued, which could lead to a drop in stock prices.
As a result, firms tend to avoid issuing new equity unless absolutely necessary, and they prefer debt over equity when external financing is required.
6.2 Determining Optimal Capital Structure
Optimal Capital Structure is the proportion of debt and equity that minimizes a firmās cost of capital and maximizes its value. Determining the optimal capital structure involves considering various factors, including:
Cost of Debt vs. Cost of Equity: Debt is generally cheaper than equity because interest payments are tax-deductible, and debt holders have a prior claim on assets in the event of liquidation. However, excessive debt increases financial risk, leading to higher required returns for both debt and equity.
Risk Tolerance: A companyās willingness to take on debt depends on its tolerance for risk. More conservative firms may prefer equity to avoid the risk of financial distress, while more aggressive firms may take on more debt to leverage potential returns.
Industry Standards: The optimal capital structure may vary by industry. Companies in industries with stable cash flows (e.g., utilities) can afford to take on more debt, whereas companies in more volatile industries (e.g., technology) may prefer to rely more on equity financing.
Market Conditions: In certain economic climates, debt financing may be more attractive due to low-interest rates, while in other periods, equity financing may be preferred due to favorable stock market conditions.
6.3 Operating Leverage and Financial Leverage
Operating Leverage:
Operating leverage refers to the degree to which a company uses fixed costs in its operations. A company with high operating leverage has a higher proportion of fixed costs relative to variable costs, meaning that changes in sales volume will have a greater impact on profitability.
Firms with high operating leverage can benefit significantly from increases in sales because fixed costs remain constant, amplifying the impact on operating income. However, during periods of declining sales, these firms also face greater losses due to the burden of high fixed costs.
A higher degree of operating leverage indicates that a small change in sales can lead to a larger change in operating income, increasing the risk for the company.
Financial Leverage:
Financial leverage refers to the use of debt in a companyās capital structure. A company with high financial leverage has a higher proportion of debt relative to equity.
The use of debt amplifies the returns to equity holders when times are good because interest payments are fixed, and any additional profits go to shareholders. However, in periods of poor performance, financial leverage can exacerbate losses, as interest payments must still be made, even if the company is not generating enough profit.
Higher financial leverage increases both the potential return and the risk to equity holders.
6.4 Leverage and Risk
Leverage, whether operating or financial, increases the risk profile of a company. The key risks associated with leverage are:
Business Risk:
Business risk arises from the companyās operations and is influenced by factors such as variability in sales, costs, and overall economic conditions. Companies with high operating leverage are particularly exposed to business risk because they must cover their fixed costs regardless of sales performance.
Business risk is independent of the firmās capital structure.
Financial Risk:
Financial risk is the additional risk placed on shareholders due to the use of debt financing. Companies with high financial leverage must meet their debt obligations regardless of their financial performance, which can lead to financial distress or bankruptcy if they are unable to generate sufficient cash flow.
The higher the proportion of debt in the capital structure, the greater the financial risk to shareholders.
Combined Leverage:
Combined leverage takes into account both operating and financial leverage. Companies with high combined leverage face amplified risks, as fluctuations in sales can lead to significant changes in earnings before interest and taxes (EBIT) and, consequently, in net income.
High combined leverage can lead to substantial rewards during periods of growth, but it also increases the likelihood of financial distress during downturns.
In summary, leverage can be a powerful tool for enhancing returns, but it also introduces significant risk. A companyās ability to manage both operating and financial leverage is critical to maintaining financial stability and maximizing shareholder value. Balancing leverage and risk is an essential aspect of determining the optimal capital structure.
