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Optimal Capital Structure

Optimal Capital Structure

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Critique the analysis of the traditional views on capital structure in light of the competing

views offered by Modigliani and Miller along with their assumptions.

Capital structure refers to the way a corporation finances its assets through some combination of

equity, debt, or hybrid securities. Stewart C. Myers argues that there is “no magic” in leverage

and there is nothing supporting a presumption that more debt is better. He adds that debt maybe

better than equity in some cases, worse in others or it may be no better and no worse. Thus, all

financing choices are equally good. A firm's capital structure is then the composition or 'structure'

of its liabilities. For example, a firm that sells $20bn dollars in equity and $80bn in debt is said to

be 20% equity financed and 80% debt financed. The firm's ratio of debt to total financing, 80%

in this example, is referred to as the firm's leverage. There are many views on capital structure

including the traditional views as well as the competing views offered by Modigliani and

Miller.

Traditional views on capital structure point to the existence of an optimal capital structure. An

optimal capital structure is simply a mix of debt and equity which maximizes the value of the

firm or minimizes the cost of capital. According to the traditional views on capital structure,

changes in capital structure benefit the stockholders if and only if the value of the firm

increases. Conversely, these changes hurt the stock holders if and only if the value of the firm

decreases. This result holds true for capital structure changes of many different types. Thus,

managers should choose the capital structure that they believe will have the highest firm value

because the capital structure will be most beneficial to the firm’s stockholders. Apart from that, a

change in the debt–equity ratio affects the value of the firm because it would change the risk

shareholders bear. Under the traditional views, the fundamental principle is that individuals

require higher returns in compensation if the risk they bear rises. If a rise in the debt–equity

ratio increases risk, firms should offer shareholders higher return and it is important to realize

that an increase in the debt–equity ratio increase the firm’s cost of capital. Thus, all corporations

should determine their capital structure bearing that in mind. In the article by Stewart C. Myers,

the author points out that the search for optimal capital structure is like the search for Truth or

Wisdom and that it is impossible to completely attain either goal but progress has been seen in

the past few years.

Apart from the traditional views on capital structure, there are competing views offered by

Modigliani and Miller along with their assumptions. The Modigliani-Miller(MM) 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 assumes

away many important factors in the capital structure decision. Modigliani and Miller (1958)

demonstrated that the firms overall cost of capital cannot be reduced as debt is substituted for

equity, even though debt appears to be cheaper than equity. The reason for this is that as the firm

adds debts, the remaining equity becomes more risky. As this risk rises, the cost of equity capital

also rises as a result. The increase in the cost of the remaining equity capital offsets the higher

proportion of the firm finance by low-cost debt. Infact, MM prove that the two effects exactly

offset each other, so that both the value of the firm and the firm’s overall cost of capital are

invariant to leverage. In addition, MM say that there is no “optimal” debt-equity ratio and the

amount of debt issued by the firm is irrelevant.

There are two propositions that MM have pointed out. MM Proposition 1 states that the value

of the levered firm is the same as the value of the unlevered firm. Basically, the market value

of any firm is independent of its capital structure and is given by capitalizing its expected return

at the rate appropriate to its risk class. Thus, each firm’s cost of capital is constant regardless of

the debt equity ratio. Before MM, the effect of leverage on the value of the firm was considered

complex and convoluted. MM showed a blindingly simple result: If levered firms are priced

too high, rational investors will simply borrow on their personal accounts to buy shares in

unlevered firms. This substitution is called homemade leverage. As long as individuals borrow

(and lend) on the same terms as the firms, they can duplicate the effects of corporate leverage on

their own and can earn a higher return on equity without changing his/her risk profile. Apart

from the first MM proposition, MM Proposition 2 states that the expected return on equity is

positively related to leverage because the risk to equity holders increases with leverage.

Thus, a higher debt-to-equity ratio leads to a higher required return on equity, because of the

higher risk involved for equity-holders in a company with debt. These propositions are true

assuming the following assumptions: no taxes exist, no transactions costs exist and

individuals and corporations borrow at the same rate. Propositions 1 and 2 are based on a

number of simplifying assumptions and in the real world, those assumptions are not valid.

However, the theorem is still taught and studied because it tells us something very important.

That is, if capital structure matters, it is precisely because one or more of the assumptions is

violated. It tells us where to look for determinants of optimal capital structure and how those

factors might affect optimal capital structure.

On the other hand, MM conclusions are changed when real world conditions differ from their

assumptions. One important real world phenomenon is the existence of corporate and personal

taxes which treat different forms of income differently. In this situation, MM Proposition 1 states

that because corporations can deduct interest payments but not dividend payments,

corporate leverage lowers tax payments and the firm’s value increases with leverage. The

key concept for understanding the impact of corporate taxation is the ‘present value of the

interest tax shield’ or, in other words, the present value of the tax saving that is obtained

through the firm having to make interest payments to its debt-holders. Apart from the first MM

proposition, MM Proposition 2 states that the cost of equity rises with leverage because the

risk to equity rises with leverage. If we consider the impact of corporate taxes alone, the

conclusion would be to observe 100% debt in the capital structure of firms.

According to the above information, it is clear that the choice of capital structure boils down to

taxes, risks and asset type. These three factors give managers a framework for thinking about

optimal capital structure and will enable managers to make good decisions that will improve the

long run performance of the company. In the article “The Search for optimal capital

structure”, Stewart C. Myers, argues that there is no presumption that borrowing is a good

thing, even if debt is kept to “moderate” levels. He adds that there is a moderate tax advantage

to corporate borrowing for companies that are reasonably sure they can use the interest tax

shields. However, the costs of possible financial distress may limit borrowing. These costs are

particularly valid for risky firms and for firms whose value depends on intangible assets. In

addition, growth firms should borrow less, other things equal.

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