1
Debt versus Equity
- In a low interest rate environment
Authors:
Johan Björkholm
Viktor Johansson
Examiner:
Fredrik Karlsson
Date:
Spring 2015
Level:
Master thesis
15 credits
Course code:
4FE08E
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Impact of Cost of Debt on Firms' Financing Decisions: A Study on Debt to Equity Ratios, Schemes and Mind Maps of Swedish
The relationship between the cost of debt and firms' financing decisions, specifically focusing on debt to equity ratios. The research indicates that firms as a group decrease their debt to equity ratios when the cost of debt is lower, making the result even more noteworthy given the current trend of debt becoming cheaper relative to equity. The document also explores the trade-off between tax advantages of debt and net present value of bankruptcy costs, and the role of corporate managers in making capital structure decisions.
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Debt versus Equity
- In a low interest rate environment
Authors: Johan Björkholm Viktor Johansson Examiner: Fredrik Karlsson Date: Spring 2015 Level: Master thesis 15 credits Course code: 4FE08E
Abstract
Background The long term downward trend in interest rates has brought us into new territory with negative interest rates. This should effect firms’ financing, and the choice between debt and equity. But how has the firms responded to the downward trend?
Purpose The purpose of this essay is to study the interest rate levels effect on decisions regarding capital structure. Existing theories give different answers when taking a lowered interest rate into account. The study aims to give empirical evidence from Swedish data.
Methodology By collecting financial data from 19 Swedish companies during 1998 until 2014, we will test the effect of the interest rate on the firms’ debt to equity ratio. This will be done by simple linear regressions.
Conclusions Our research show that our tested firms as a group decrease their debt to equity ratios when the cost of debt is lower. As we also show, debt has become cheaper relative the cost of equity, making the result even more noteworthy. Even though the results are in accordance with the Trade-off Theory, we argue that the theory needs to take more variables into account when determining financial distress.
- Introduction
- 1.1. Background
- 1.2. Problematization
- 1.3. Research question...............................................................................................
- 1.4. Purpose
- Theoretical framework
- 2.1. Modigliani and Miller’s theorem
- 2.2. Trade-off Theory
- 2.3. The Control Hypothesis
- 2.4. Pecking Order Theory
- 2.5. The Neutral Mutation Hypothesis
- 2.6. Formulation of hypotheses
- 2.6.1. Hypothesis I:
- 2.6.2. Hypothesis II:
- 2.6.3. Hypothesis III
- 2.6.4. Hypothesis IV
- Research method
- 3.1. Scientific approach
- 3.2. Quantitative study
- 3.3. Regression analysis
- 3.3.1. Significance level
- 3.3.2. Beta coefficient
- 3.3.3. Coefficient of determination
- 3.4. Selection of Companies....................................................................................
- 3.5. Gathering of data
- 3.6. Variables
- 3.6.1. Profitability
- 3.6.2. Leverage....................................................................................................
- 3.6.3. Cost of debt
- 3.6.4. General interest rate level
- 3.6.5. Cash flow
- 3.7. Statistical models
- 3.8. Reliability and Validity
- Empirical tests
- 4.1. Hypothesis I
- 4.2. Hypothesis II
- 4.3. Hypothesis III
- 4.4. Hypothesis IV...................................................................................................
- 4.5. Summary of test results
- Analysis
- 5.1. Manufacturing
- 5.2. Materials
- 5.3. Construction
- 5.4. Real Estate
- 5.5. IT/Telecom
- 5.6. Final discussion
- Conclusion
- 6.1. Directions for future research...........................................................................
1. Introduction
In 2015, The Riksbank cut its repo rate to negative 0,25 percent, reaching a new record low. How will this extraordinary event, preceded by a long downward trend in interest rate levels, affects firms’ capital structure decisions?
1.1. Background
As central banks in the Western world are struggling to maintain inflation in their respective economies at target levels, official interest rates has recently reached record low levels (Lawton 2014, The Riksbank 2015b). Although low inflation or deflation is a more recent problem, the downward trend in interest rates has been ongoing for the last decades (The Riksbank 2015b).
The neoclassical theory of investments argue that interest rates, viewed as capital costs, will affect firm's investment decision. When interest rates decrease, investments will increase and vice versa (Haavelmo, 1960; Jorgenson, 1963). Miles and Ezzell (1980) explained that investment opportunities are evaluated by the net present value of future cash flows. If the return of an investment exceeds the weighted average cost of capital (WACC), it is considered as profitable. When the cost of debt decreases, while the cost of equity is unchanged, the weighted cost of capital decreases. Therefore cost of financing is important when making investment decisions. All other things equal, if the cost of debt is lower, more investments will be considered profitable.
According to Bordo and Wheelock (1998) many central banks made the inflation target their main objective during the 1990s. To keep inflation at preferred levels, many central banks tried to steer the economy by changing official rates of interest. In Sweden, The Riksbank has cut its repo rate several times, from 4,5 percent in 2008 to negative 0, percent in 2015 (The Riksbank 2015b). It is important to point out that the repo rate is a nominal interest rate, including inflation and a risk premium as opposed to a real interest rate (Ang, Bekaert & Wie 2008). This means that even though the nominal interest rate is negative, the real interest rate can still be positive if the economy suffers from deflation.
Diagram 2. Swedish 10-year bond, market risk premium and the spread.
As shown in the diagram above, the spread between the required return on equity (RROE) and the risk free rate has increased dramatically. The required return on equity consists of the market risk premium and the risk free rate, in this case SE10Y. Even though both the interest rate level, as well as the required return on equity, has decreased, the interest rate level has decreased more relative to the required return on equity (PWC 2015). The spread between them indicates that the cost of equity is higher relative the cost of debt.
The rationality of using expensive equity over cheap debt for financing investments can therefore be questioned. A modern day example is the CEO of the Swedish manufacturer Atlas Copco, saying that the firm’s balance sheet might be too conservative given the possibilities of cheap debt financing. The reason given is that he wants to be in control of the firm’s destiny and thereby not have to rely on the debtors (Östman 2014). According to Blundell-Wignall and Roulet (2013), this kind of thinking is an example of irrational behavior. If equity is preferred over debt, and thereby not regarding the total cost of capital, there must be explanations beyond pure capital cost rationality. It could possibly be found in theories of capital structure choices.
1.2. Problematization
Myers (1984) starts his article “The Capital Structure Puzzle” by asking the question what determines the way corporations finance their business and investments. The authors
0%
2%
4%
6%
8%
10%
12%
SE10Y RROE Spread
gives a direct answer: we don’t know. Even though he states that there is no direct answer, Myers (1984) lists several theories that gives possible explanations for decisions regarding corporate financing. These are some of the most original theories in finance, including Miller and Modigliani’s theorem, the Pecking Order Theory and the Trade-off Theory.
Modigliani and Miller’s (1958) article regarding the financing of corporations and their firm value was a big game-changer. Their first proposition was that, in a world without transaction costs and where citizens and corporations can borrow funds at the same interest rate, a firm’s value would be the same if it was leveraged as if it was unlevered. In the second proposition, Modigliani and Miller (1958) show that the required return on equity increases as the debt-to-equity relation increases. However, more leverage leads to more financial risk. According to the authors, the relationship between debt-to-equity and expected return is linear. This goes back to the Modern Portfolio Theory by Markovitz (1952), who states that investors are risk averse. Therefore they are only willing to take on more risk if that risk taking is compensated by a higher expected return. In Modigliani and Miller’s (1958) theorem this means that a firm with high leverage will increase its expected return to investors to compensate for the risk.
While Modigliani and Miller’s (1958) first and second theorem did not take taxes into account, they later published an article that did. Modigliani and Miller (1963) wrote that leveraged financing has an advantage through the tax shield. Interest on debt financing is paid before taxes, unlike dividend paid to shareholders. This tax advantage would therefore increase the expected after tax returns to investors when using debt financing. According to Kraus and Litzenberger (1973), Modigliani and Miller assumed that the corporation was able to pay interest to its debtors. Therefore, Kraus and Litzenberg (1973) developed this theory and laid the ground for the so-called Trade-off Theory. The trade- off is between the tax advantage of debt as a source of financing and the net present value of bankruptcy costs. Increased leverage makes for a greater tax shield, but the financial risk and thereby bankruptcy costs, increases as well. The amount of debt used for financing depends on the corporation’s individual situation and the trade-off is between tax advantages and financial distress (Kraus & Litzenberg 1973, Scott 1977, Kim 1978).
Both de Jong, Verbeek and Verwijmeren (2011) and Shyam-Sunder and Myers (1999) argue that scholars have to regard both the Trade-off Theory, as well as the Pecking Order Theory, while trying to predict financing decisions. There is a risk that the actual determinants are missed when only studying one theory, and instead blaming actions that does not fit in the model on irrational behavior. By doing this, de Jong et al. (2011) finds that the Pecking Order Theory has an advantage over the Trade-off Theory when predicting firms’ issuing of debt. On the other hand, the Trade-off Theory is better of predicting the decisions of under-levered firms.
Elsas, Flannery and Garfinkel (2014) studies large investment financing decisions by testing the Trade-off Theory, Pecking Order Theory and the Market Timing Hypothesis. They conclude that the leverage method is dependent on actual debt to equity ratio and the firms target ratio, meaning that over-levered firms tend to issue equity instead of debt. Frank and Goyal (2009) uses the same theories, but instead testing them on decisions regarding capital structure. The authors argue that the Pecking Order Theory gives a pleasing explanation to why profitable firms have a tendency towards lower leverage. However it does not explain the industry characteristics where some industries tend to have a higher amount of leverage than others. Frank and Goyal (2009) argue that the Trade-off Theory gives better explanation for such factors, but instead lacks an account for why profitable firms have a lower debt-to-equity ratio.
The previous research shows that there is no single theoretical explanation regarding firms’ financing and capital structure decisions. Fama and French (2005) argue that these ongoing empirical horse races between the Trade-off Theory and the Pecking Order Theory needs to stop and instead be viewed as complement to each other. On the other hand, Frank and Goyal (2009) points out that a unified theory explaining leverage decisions is not beyond reach, but it should probably be based on the Trade-off Theory.
According to Jensen (1986), the Control Hypothesis has more advantage in corporations with large cash flows, which is not consistent with Myers and Majluf’s (1984) statement that well-doing firms generally uses internal capital for financing. The Trade-off Theory advocates the use of debt for its tax advantages, while also taking the financial risks that come with the use of leverage into account (Kraus & Litzenberg 1973, Scott 1977, Kim
1978). Both the control hypothesis and Trade-off Theory is based on a promised return to debtors in the form of interest rate, but for different reasons.
In 2015, when nominal interest rate levels have reached new record lows (The Riksbank 2015b), one might wonder how these long term changes affect firms’ decisions on capital structure. Modigliani and Miller’s theorem was founded in the late 1950s and early 1960s, which later led to the Trade-off Theory in the 1970s. The Pecking Order Theory was formed in the mid-1980s, about the same time as Control Hypothesis. As shown earlier, the interest rates in the western world have been in a downward trend since the mid-1980s (The Riksbank 2015b). The reality that corporations act in today are completely different from the time when these theories were developed. Modigliani and Miller’s theorem, the Trade-off Theory and the Control Hypothesis all depend on interest being paid on debt. However, none of the theories directly take the interest rate level into account when predicting corporations’ choices of capital structure.
While reviewing earlier studies, we have noticed that not a single test has been done regarding potential effects of the interest rate. When paid interest decreases, so does the tax benefit in accordance with the Trade-off Theory. Therefore the leverage levels today should be lower and a preference for the use of internal capital, in accordance with the Pecking Order theory, would instead be the case. However, low interest rates make for cheap financing and therefore a lower required return on investments. When more investments are considered to be profitable through debt financing, the debt-to-equity ratio should be higher. If corporate managers should be disciplined by debt in accordance with the Control Hypothesis, leverage levels would be at record highs since interest rate levels are at record lows. This discrepancy is the foundation of our research question.
The downward trend in interest rate levels makes for a unique opportunity to study its potential effects. When moving past the theoretical importance of the question, there is also a practical usefulness of the results. Both corporations and the public might benefit of knowing how changes in, for example policy rates or market rates, affect corporations’ decisions when making investments or other changes regarding the capital structure.
2. Theoretical framework
Modigliani and Miller’s theorem is one of the earliest theories regarding firms’ financing decisions. The Trade-off Theory, on which we have based two of our hypotheses, is derived from Modigliani and Miller’s theorem. We will also use the Pecking Order Theory, as well as the Control Hypothesis, which focus on the relationship between management and the investors. Lastly, the Neutral Mutation Hypothesis provides an antithesis in the discourse on capital structures. To explain how the long term trend in interest rates has affected capital structures, we formed hypotheses based on this theoretical framework. These are derived in the final section of this chapter.
2.1. Modigliani and Miller’s theorem
Modigliani and Miller (1958) showed, through their first proposition, that a leveraged company should be valued exactly the same as an unleveraged ditto. This was based on the assumption of perfect capital markets, without taxes and that investors and corporations could borrow at exactly the same interest rate. Since both investors and corporations borrow at the same interest rate, an investor could buy levered firm A, which has 80 % equity and 20 % debt, for $100. There is also the alternative to buy unlevered firm B for $80 and then borrow $20 to buy more shares. Both alternatives will give exactly the same returns, with the same cost of capital. Only difference is whether the firm or the investor pays the interest. Therefore, their first proposition is that the capital structure of a corporation has no effect on the firm’s value.
In the second proposition, Modigliani and Miller (1958) argued that increased leverage leads to more financial risk, and thereby increasing the required return by shareholders. The assumptions made are the same as in the first proposition. By deriving the WACC- formula (Weighted Average Cost of Capital), the authors show:
𝑟𝐸(𝐿𝑒𝑣𝑒𝑟𝑒𝑑) = 𝑟𝐸 (𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑) + 𝐷 𝐸 (𝑟𝐸 (𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑) − 𝑟𝐷) 𝑟𝐸 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝐷 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡
𝐷 𝐸 =^ 𝑑𝑒𝑏𝑡^ 𝑡𝑜^ 𝑒𝑞𝑢𝑖𝑡𝑦^ 𝑟𝑎𝑡𝑖𝑜
Modigliani and Miller (1958) argue that the source of financing is irrelevant, when the question regards whether an investment is profitable or not. Due to the assumptions made, and what is shown in Proposition II, the cost of capital is constant at every leverage level. However, if corporations were able to borrow funds at lower interest, the weighted average cost of capital would decrease slightly and the average leverage ratio would increase.
A few year later, Modigliani and Miller (1963) published a correction regarding the effects of corporate taxes. In the original article from 1958, the authors assumed a tax- free environment in Proposition I and II. However, they did write shortly about a gain to be made from leverage due to taxation. The follow-up article from 1963 concluded that the advantage of debt financing for corporations, due to taxes, was quite large.
Modigliani and Miller (1963) argue that the firm value should be greater for a leveraged firm, than an unlevered ditto, since interest on borrowed funds are paid before the profit is taxed. The result is different valuations depending on the expected after-tax return, leverage ratio and tax rate. The authors assumed that the corporation always was able to pay the interest on its debt, an assumption that was later criticized by Kraus and Litzenberg (1973). However, Modigliani and Miller (1963) wrote that even though the tax advantage of debt is substantial, firms should not seek to maximize their leverage ratios. The argument is that other financing options may be cheaper, for example retained earnings. In additions, lenders should limit the amount of debt a firm can issue in relation to the amount of equity in the firm.
2.2. Trade-off Theory
The critique by Kraus and Litzenberg (1973), regarding the firm’s ability to pay interest on its debt, led to the forming of a more developed version of the theory, the Trade-off Theory. Modigliani and Miller (1958) assumed perfect capital markets and therefore the firm’s market value was independent of its capital structure. However, Kraus and Litzenberg (1973) concluded that bankruptcy penalties and the taxation on corporate profits are an example of imperfect markets.
Figure 1. Trade-off Theory of capital structure (Myers 1984, p. 577)
The optimal capital structure can be found where the net present value of the tax advantage equals the increased costs of financial distress. It may seem as there is one optimal capital structure, given that all firms have the same costs of debt and tax ratio. However, the theory also states two factors causing firms to have different capital structures. The first is the level of risk in the firm’s assets. When the amount of risky assets increase, the leverage ratio decreases. Secondly, there is a time lag in the capital structure since optimizing the structure takes time. The second factor is why two companies with equivalent assets may have different capital structures (Brealey et al. 2008).
It is not only the balance sheet that matter in the Trade-off Theory. According to Frank and Goyal (2009), firms with greater profit value tax deductions higher. Since the Trade- off Theory is partly based on tax advantages of debt, profitable firms should maximize the tax shield until the point where marginal costs for financial distress just offset the marginal benefits.
2.3. The Control Hypothesis
The Control Hypothesis is based on Agency Theory (Jensen 1986), a theory primarily developed by Alchian and Demsetz (1972) and Jensen and Meckling (1976). According
to Fama and Jensen (1983), the Agency Theory is the reason why firms can separate ownership and control. The owners of the firm are the principals and they are also the carriers of risk. The managers are agents, given the responsibility to manage the company on the behalf of its owners. Fama (1980) argue that managers are always maximizing their utility and this may lead to consumption at the cost of the shareholder. This conflict of interest is minimized through two markets: the market for corporate takeovers and the labor market for managers. When the firm’s value increases, the market value of the managers do the same leading to increased compensation. This is the incentive for managers to act on the behalf of the firm’s owners.
According to Jensen (1986), there is an agency problem resulting from large free cash flows. Managers have incentives to make the firm grow. Murphy (1985) show that management compensation is positively related to a growth in turnover. Jensen (1986) therefore argue that managers may use cash flow to expand the firm more than necessary.
Managers may use substantial free cash flows to repurchase stock or increase the dividend, and thereby returning profits to the firm’s owners. However, the managers are in control of these cash flows and not even a promised future dividend is legally binding. Therefore, Jensen (1986) suggests the Control Hypothesis, using debt for motivating and disciplining managers. Debt reduces the free cash flow available to managers and failures to make payments on the debt motivates the firm and its managers to act more efficient. When issuing new debt, the firm and its managers also has to face the capital markets on a regular basis. This gives opportunities for the market to evaluate both the firm and its future investment projects. Such activities help reduce agency costs due to increased monitoring by the market.
Jensen (1986) continue with the agency costs of debt, which includes bankruptcy costs. Similar to the Trade-off Theory (Brealey et al. 2008, Ross et al. 2013), there is an optimal amount of leverage where the firm’s value is maximized. This can be found where the debt’s marginal costs offset the marginal benefits (Jensen 1986).
of new equity is interpreted as if the firm’s value is overpriced. New investors will not be part of the issue unless the firm’s risk-free debt opportunity is exhausted. In other words, investors will force managers to follow the pecking order of first using retained earnings and if external financing is the only option, debt is preferred over equity.
The asymmetric information between investors and managers will also affect managers when deciding on adjustments toward optimal capital structure according to Myers (1984). If the firm will exchange debt with equity it is considered as bad news. But if the firm instead exchange equity with debt it is considered as good news. This even though both actions are taken with the same objective, to maintain or move towards an optimal amount of leverage.
2.5. The Neutral Mutation Hypothesis
Miller (1977) argue that firm managers may fall into a pattern or a habit, regarding financing of the firm. This is based on a theory that the choice of financing does not affect the firm’s value, and therefore the decision is harmless. When managers do no harm, habits make them feel better and since no one is affected by their choices, no one cares to stop or change them.
Myers (1984) opposes the Neutral Mutation Hypothesis, saying that we already know investors’ interest for capital structure since stock prices react as news of a change in the capital structure reaches the market.
2.6. Formulation of hypotheses
This thesis is hypothetico-deductive, which means that our hypotheses are based on the logical rationality of our theoretical framework and set out to enable answering the research question by testing the theories empirically (Wallén 1996, Bryman & Bell 2005, Alvesson & Sköldberg 2008).
As mentioned in our theoretical framework, differences between industries should be expected. This is mainly due to the fact that companies in the same sector usually have
similar types of assets and therefore the risk level of the balance sheet should be approximately at the same level. Especially within the Trade-off Theory, there are empirical support for large differences between industries. When the risk level of the assets differ, the financial risk changes. This leads to different financing opportunities, since both shareholders as well as debtors consider the financial risk when evaluating an investment opportunity (Brealey et al. 2008, Ross et al. 2008, Frank & Goyal 2009, Ross et al. 2013). Due to this we performed all tests of the hypotheses on both the whole sample of companies, as well as for each individual sector. By doing this, we were able to discover differences between sectors which enhanced the utility of the results.
2.6.1. Hypothesis I: According to Brealey et al. (2008) and Ross et al. (2013), the Trade-off Theory states that there is an optimal capital structure for each corporation, and it is up to the managers to find it. The tax advantage comes from the fact that interest on debt is paid before taxes. With high leverage comes financial distress which causes bankruptcy cost. The trade-off is between these two factors and will determine a corporation's optimal capital structure.
According to the theory, if interest rates decline the debt to equity ratio should decline as well if the corporation wish to remain at the optimal point in the capital structure. Not changing the debt to equity ratio would result in less tax advantages, while the financial distress remains at the same level. This is because the theory assumes that the level of financial distress is solely based on the debt to equity ratio. When interest rates decline, the amount that will be tax deductible decreases and therefore the expected return after taxes will be lower. The trade-off is therefore altered and the optimal amount of leverage is changed, therefore:
Hypothesis I:
𝐻 0 : 𝐴 𝑓𝑖𝑟𝑚′𝑠 𝑑𝑒𝑏𝑡 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 𝑑𝑜𝑒𝑠 𝑛𝑜𝑡 𝑑𝑒𝑝𝑒𝑛𝑑 𝑜𝑛 𝑖𝑡𝑠 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 (𝛽 = 0)
𝐻 1 : 𝐴 𝑓𝑖𝑟𝑚′𝑠 𝑑𝑒𝑏𝑡 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 𝑑𝑒𝑝𝑒𝑛𝑑𝑠 𝑜𝑛 𝑖𝑡𝑠 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 (𝛽 ≠ 0)