Capital Structure Theory, Lecture notes of Financial Management

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Capital Structure Theory

By: Muhammad Afraz Abdur Rahman

Capital Structure Theory

• (^) Business risk is an important determinant of the optimal capital structure. Moreover, firms in different industries have different business risks. Therefore, we would expect capital structures to vary considerably across industries, and this is the case.
• (^) For example, biotechnology companies generally have very different capital structures than food processors.
• (^) What factors can explain these differences? In an attempt to answer that question, academics and practitioners have developed a number of theories: - (^) Modigliani & Miller’s Irrelevance Theory - (^) Trade-Off Theory / Static Theory - (^) Signaling Theory - (^) Pecking Order Theory

Modigliani & Miller’s Irrelevance Theory

• (^) A partial listing of MM’s assumptions are:
  • (^) There are no brokerage costs
  • (^) There are no taxes
  • (^) There are no bankruptcy costs
  • (^) Investors can borrow at the same rate as corporations
  • (^) All investors have the same information as management about the firm’s future investment opportunities
  • (^) EBIT is not affected by the use of debt
• (^) Despite the fact that some of these assumptions are unrealistic, MM’s irrelevance result is extremely important.

The Trade-Off Theory

• (^) This theory poses that firms trade-off the tax benefits of debt financing against problems caused by potential bankruptcy.
• (^) The fact that interest paid is interest paid is a deductible expense makes debt less expensive than common or preferred stock. In effect, the government pays part of the cost of debt. In other words, debt provides tax shelter benefits.
• (^) As a result, using more debt reduces taxes and thus allows more of the firm’s operating income (EBIT) to flow through to investors. This factor, on which MM focused, tends to raise the stock price.
• (^) However, in the real world, firms have target debt ratios that calls for less than 100% debt to limit the adverse effects of potential bankruptcy.

Signaling Theory

• (^) MM assumed that everyone – investors and managers alike – has the same information about a firm’s prospects.
• (^) Symmetric vs. Asymmetric information
• (^) The announcement of a stock offering is generally taken as a signal that the firm’s prospects as seen by its management are not bright.
• (^) Even if a company’s prospects are bright, it should, in normal times, maintain a reserve borrowing capacity that can be used in the event that some especially good investment opportunity comes along.
• (^) In such cases, firms are expected to use less debt than specified by the MM optimal capital structure in “normal” times to ensure that they can obtain debt capital later if necessary.

Pecking Order Theory

• (^) Another factor that may influence capital structures is the idea that managers have a preferred pecking order when it comes to raising capital and that this pecking order affects capital structure decisions.
• (^) Firms often finance in the following order: first spontaneous credit, then retained earnings, then debt, and finally new common stock.
• (^) Therefore, this sequence affects the capital structure of a firm.