Capital structure is the mixture of securities issued by a company to finance its operations. Companies need real assets in order to operate. These can be tangible assets, such as buildings and machinery, or intangible assets, such as brand names and expertise. To pay for the assets, companies raise cash not only vi a their trading activities but also by selling financial assets, called securities, financial instruments or contingent claims. These securities may be classified broadly as either equity or debt (though it is possible to create securities with elements of both). Equity is held as shares of stock in the company, whereby the company’s stock holders are its owners. If the company’s trading activities are sufficiently successful, the value of its owners’ equity increases. Debt may be arranged such that repayments are made only to the original holder of the debt, or a “bond” may be created which can be sold on, thus transferring ownership of future repayments to new bondholders.
Capital structure can be changed by issuing more debt and using the proceeds to buy back shares, or by issuing more equity and using the proceeds to buy back debt. The question then arises: is there an optimal capital structure for a company? The solution to this question, for the restricted case of “perfect markets,” was given by Franco Modigliani and Merton Miller (1958), whose fame is now such that they are referred to in finance text topics simply as “MM!” A perfect market is one in which there are neither taxes nor brokerage fees and the numbers of buyers and sellers are sufficiently large, and all participants are financially sufficiently small relative to the size of the market that trading by a single participant cannot affect the market prices of securities. MM’s “fi rst proposition” states that the market value of any firm is independent of its capital structure. This may be considered as a law of conservation of value: the value of a company’s assets is unchanged by the claims against them. It means that in a perfect and rational market a company would not be able to gain value simply by recombining claims against it s assets and offering them in different forms. Modigliani and Miller (1961) likewise deduced that whether or not cash was disbursed as dividends was irrelevant in a perfect market.
MM’s first proposition relies on investors being able to borrow at the same interest rate as companies; if they cannot, then companies can increase their values by borrowing. If they can, then there is no advantage to investors if a company borrows more money, since the investors could, if they wished, borrow money themselves and use the money to buy extra shares of stock in the company. The investors would then have to pay interest on the cash borrowed, as would the company, but will benefit from holding more equity in the company, resulting in the same overall benefit to the investor.
An analogy which has been used for this pro position is the sale of milk and its derivative products (see Ross et al., 1988). Milk can be sold whole or it can be split into cream and low cream milk. Suppose that splitting (or recombining) the milk costs virtually nothing and that you buy and sell all three products through a broker at no cost. Cream can be sold at a high price in the market and so by splitting off the cream from your milk you might appear to be able to gain wealth. However, the low cream milk remaining will be less valuable than the original, full cream milk – a buyer has a choice in the market between full cream milk and milk with its cream removed; offered both at the same price, he would do best to buy full cream milk, remove its cream and sell it himself. Trading in the perfect market would act so as to make the combined price of cream and low cream milk in the perfect market the same as the price of full cream milk (conservation of value). If, for example, the combined price dropped below the full cream price then trader s could recombine the derivative products and sell them at a profit as full cream milk.
What was considered perplexing, before Modigliani-Miller, is now replaced by a strong and simple statement about capital structure. This is very convenient because any supposed deviations can be considered in terms of th e weakening of the assumptions behind the proposition. Obvious topics for consideration are the payment of brokers’ fees, taxes, the costs of financial distress and new financial instruments (which may stimulate or benefit from a temporarily imperfect market). New financial instruments may create value if they offer a service not previously available but required by investors. This is becoming progressively harder to achieve; but even if successful, the product will soon be copied and the advantage in the market will be removed. Charging of brokers’ fees simply removes a portion of the value and (as long as the portion is small!) this is not a major consideration, since we are concerned with the merits of different capital structures rather than the costs of conversion. Taxes, however, can change the result significantly: interest payments reduce the amount of corporation tax paid and so there is a tax advantage, or “shield,” given to debt compared with equity. When modified to include corporate taxes, MM’s proposition shows the value of a company increasing linearly as the amount of debt is increased (Brealey and Myers, 1991). This would suggest that companies should try to operate with as much debt as possible. The fact that very many companies do not do th is motivates further modifications to theory: inclusion of the effect of personal tax on share holders and inclusion of the costs of financial distress. Miller (1977) has argued that the increase in value caused by the corporate tax shield is reduced by the effect of personal taxes on investors. In addition, the costs of financial distress increase with added debt, so that the value of the company is represented by the following equation, in which PV denotes present value: value of company = value if all equity-financed +PV (tax shield) – PV (costs of financial distress)
As debt is increased, the corporate tax shield increases in value but the probability of financial distress increases, thus increasing the present value of the costs of financial distress. The value of the company is maximized when the present value of tax savings on additional borrowing only just compensates for increases in the present value of the costs of financial distress.
One element of financial distress can be bankruptcy. It is generally the case throughout the world’s democracies that shareholders have limited liability. Although shareholders may seem to fare badly by receiving nothing when a company is declared bankrupt, their right simply to walk away from the company with nothing is actually valuable, since they are not liable personally for the company’s unpaid debts. Short of bankruptcy there are other costs, including those caused by unwillingness to invest and shifts in value engineered between bondholders and shareholders, which increase with the level of debt. Holders of corporate debt, as bonds, stand to receive a maximum of the repayments owed; shareholders have limited liability, suffer nothing if the bondholders are not repaid and benefit from all gains in value above the amount owed to bondholders. Therefore, if a company has a large amount of outstanding debt it can be to the shareholders’ advantage to take on risky projects which may give large returns, since this is essentially a gamble using bondholders’ money! Conversely, shareholders may be unwilling to provide extra equity capital, even for sound projects. Thus a company in financial distress may suffer from a lack of capital expenditure to renew its machinery and underinvestment in research and development. Even if a company is not in financial distress, it can be put into that position by management issuing large amounts of debt. This devalues the debt already outstanding, thus transferring value from bondholders to shareholders. Interesting examples of this are to be found in leveraged buyouts (LBOs), perhaps the most famous being the attempted management buyout of R. J. R. Nabisco in the 1980s (Burrough and Helyar, 1990). Top man agement in R. J. R. Nabisco were, of course, trying to become richer by their actions – an extreme example of so-called agency costs, whereby managers do not act in the shareholders’ interest but seek extra benefits for themselves.
There is, finally, no simple formula for the optimum capital structure of a company. A balance has to be struck between the tax advantages of corporate borrowing (adjusted for the effect of personal taxation on investors) and the costs of financial distress. This suggests that companies with strong, taxable profits and valuable tangible assets should look towards high debt levels, but that currently unprofitable companies with intangible and risky assets should prefer equity financing. This approach is compatible with differences in debt levels between different industries but fails to explain why the most successful companies within a particular industry are often those with low debt. An attempt at an explanation for this is a “pecking order” theory (Myers, 1984). Profitable companies generate sufficient cash to finance the best projects available to management. These internal funds are preferred to external financing since issue costs are thus avoided, financial slack is created, in the form of cash, marketable securities, and unused debt capacity, which gives valuable options on future investment, and the possibly adverse signal of an equity issue is avoided.
