For a firm, the most significant everlasting theme is getting the maximum profit is by minimising cost and taking the least risk. Capital Structure refers to the mix of sources from where the long term funds required in a business may be raised, i. e.
, what should be the proportions of equity share capital, preference share capital, internal sources, debentures, and other sources of funds in the total amount of capital which an undertaking may raise for establishing its business.A bad financing decision may result in many forms of higher direct or indirect costs, such as lowering stock price, higher cost of capital and lost growth opportunities, increased probability of bankruptcy, higher agency cost and possible wealth transfers from one group of investors to another. Therefore how a manager finances a firm becomes a key concept to a firm. The founderstone of this theory is the Modigliani –Miller theory (MM).
MM was developed by two economists, Franco Modigliani, a professor at Massachusetts Institute of Technology, and Merton Miller, a professor at University of Chicago Graduate School of Business. By this main contribution, Modigliani won the Nobel Prize in Economics in 1985 and Miller won the Nobel Prize in Economics in 1990. MM postulate in his interview that “we should not try to make our shareholders wealthy by adjusting debt levels, because at least in the somewhat idealized world in which economists operate, and sometimes in practice it will not work.Instead, MM further argues, the company’s best capital structure is one that supports the operations and investments of the business.
The concept of Modigliani-Miller Theorem holds that a fim’s market value is calculated by the risk associated with the underlying assets of the firm and also on the earnings capacity of the firm. This theory is based on some assumptions that there is a control aspects of shares which are ignored, there are no taxes and that there exist a perfect market where shareholders can lend and borrrow at the same interest rate and there is no bankruptcy .However the MM theory also gives us a second proposition whereby there is the existence of tax, this proposition states that a levered firm expected returns will be given by a linear function of the ratio of debt and equity. He also postulates that all investors have the same expectations from a firm’s net operating income (EBIT) which are necessary to evaluate the value of a firm and the divident payment ratio is 100%.
In other words, there are no retaines earnings.MM agree that while companies in different industries face different risks which will result in their earnings being capitalized at different rates, it is not possible for these companies to affect their market values, and therefore their overall capitalization rate by use of leverage. That is for a company in a particular risk class, the total market value must be same irrespective of porportion of debt in company’s capital structure. The supprt for this hypothesis lies in the presence of arbitrage in the capital market.
They contend arbitrage will substitute personal leverage for corporate leverage. This can be illustrated in the example : Suppose there are two companies X ; Y in the same risk class. Company X is financed by equity and company Y has a capital structure which includes debt. If market price of share of company Y is higher than company X, market participants would take advantage of difference by selling equity shares of company Y, borrowing money to equate their personal leverage to the degree of corporate leverage in company Y, and use these funds to invest in company X.
The sale of Company Y share will bring down its price until the market value of company Y debt and equity equals the market value of the company financed only by equity capital. However these assumptions have been criticized by numerous authorities. Mostly criticism is about perfect market assumption and the arbitrage assumption. The assumption of a perfect market is unrealistics.
Practically there are taxes, floatation cost and transaction cost. Informations are not obtained freely. Eventually the concept of perfectly market cannot be applied in this realistics world.The meaning of perfect market mean customers and investors has pefect knowledge of the business but in Mauritius for instance the company falsify the information and published it in the newspaper.
Is it the way people will get all information? Again the assumption of availability of free and up to date information is not true as everything has a cost, investors need to pay for obtaining certain informations on a particular business before investing. A high leverage tends to improve the efficiency of the managers. So investors tend to consider the issue of new debt in a favourable way. But, later on, the anagers may decide to actuate riskier projects.
To try to avoid this outcome, the equity holders favours bank indebtment because they think that the banks have powerful means to control the managers. Bank can in fact threaten the managers with the request of debts repayment. Managers could consider the issue of new shares. But they could also consider the risk of being overthrown.
Still more important is the risk coming from the possible market reactions. In fact, the would-be stock investors tend to think that the managers, acting in the interest of existing stockholders, would never issue new shares at an undervalued price.They would instead try to sell the stock at an overvalued price. Hence the market would react in an unfavourable way, i.
e. by marking-down the stock price. The managers then prefer not to issue new shares even if this decisions has the effect of rejecting some profitable investment programs. Hence the form of finance the managers mostly prefer is undistributed profits.
But they have to consider that it is difficult to cut dividends in order to have more internal finance. In all likelihood, the market would react badly.In fact, an announcement of lower dividends is considered by investors as an information that the firm is not in good health: the market value of the firm declines . The pecking order theory also recognize that the internal resources and the external ones are not perfect substitutes in a world of asymmetric information between investors and managers.
The formers ask for a premium in order to be compensated for the risk that the information given them by managers is not quite candid. The required premium is higher for the equity investors and lower for the debt investors.The theory then maintains that the forms of finance preferred by managers have a definite order: 1. Undistributed profits; 2.
Debt; 3. Equity. This fact has a relevant impact on the firms’ investment decisions: insufficient internal resources and difficulties in obtaining bank loans may result in the curtailment of investments, in particular those of the small and medium size firms. Conflicts between debtholders and stockholders only arise when there is a risk of default or of financial distress.
In the absence of this risk, debtholders have no interest in the firm’s value.But, when the risk is significant, they have to consider all the costs that would reduce the value of the debt: Firstly the costs of lawyers and accountants, judiciary expenses, costs of the financial experts of the court, and so on;and the loss of reputation and customers. Hence, the existence of the conflict of interests means that the mere threat of default can influence a firm’s investment decisions in an unfavourable way. Since investors understand this risk, the market price of both the debt and the stock decline.
This is another good reason for managers to operate at relatively low debt ratios.The Conflicts between managers and stockholders as said above can also critics the theory of modigliani miller. The latter favour debt because, by forcing the managers to pay interest, force them to avoid inefficiencies, overinvestment and excessive utilization of the firm’s resources to the managers’ benefit. The free cash flow theory that maintains that high debt ratios increase firms’ value, not with standing the threat of financial distress, is useful to explain the behaviour of mature (cash-cow) firms that are prone to over invest.
Moreover Moon points to another reason that capital structure matters in the real world : information asymmetries. This awkward-sounding term is used to describe the rather pedestrian notion that investors can be somewhat suspicious of equity offerings managers may not be willing or able to tell all they know and drive down a company’s stock price. While investor suspicion can affect the value of a company’s securities, so can another “information problem”: many investors just don’t have the resources to get to know small companies.As a result, these companies have to pay a higher price for financing.
Another market place reality that, like information problems, can hurt the value of a firm is bankruptcy. The risk of bankruptcy also explains why companies with a lot of intangible assets and growth opportunities tend not to use debt. “Myers says putting such companies through financial distress is like “putting a wedding cake through a car wash. There’s not a lot left at the end.
” The assumption also talked about taxes but the analysis of the implications of taxation for corporate financial policy turned out to be far more omplicated than they had originally envisioned. One needed to look simultaneously at corporate and individual taxes; and one needed to recogise that there were tax implication of adjusting the debt equity ratio; that is, if a firm for instance has a low debt equity ratio, say because it had receives some windfall profits, even if debt received favorable tax treatment, distributing the earnings to shareholders had tax implications which might more than offset the advantages that would come from a higher debt equity ratio.Firms that had had large windfall profits might wind up with a low debt equity ratio, while other firms which had not had these windfall profits might have a high debt equity ratio. Although everyone seems to have a favorite bone to pick with MM, there seems to be a little disagreement about one more thing, while well-designed capital structures might creat some value, most value comes from the decision making done by managers.
The MM propositions remind us that it is a corporate strategy that produces value as said Cheryl Francis.The challenge on the right-hand side of the balance sheet is to find the capital structure that can support the business strategy. What MM did was to help us cut though the “smoke and mirrors”, the marketing pitches, and find the true value-creating opportunity. In a slow-growth business like printing,one might expect o conservative balance sheet.
But what about a fast-growing company? The MM hypothesis further argue that through personnel arbitrage investors would quickly eliminate any inequalities between the value of leverages firms and value of unleveraged firms in the same risk class.The basic-argument here is that individuals arbitragers, through the use of personal leverage can alter corporate leverage. Again this argument is not valid in the practical world, for it is extremely doubtful that personnel investors would substitute personal leverage for corporate leverage, since they do not have the same risk characteristics. To conclude, one may say that the controversy between the traditionalists and the supporters of Modigliani and Miller approach cannot be resolved due to lack of empirical research.
Traditionalists argue that the cost of capital of a firm can be lowered and the market value of the shares can be increased by a careful use of financial leverage. However after certain stage as the company becomes highly geared, it becomes too risky for investors and lenders. Hence, beyond a point overall cost of capital begins to rise. This point indicates the optimal capital structure.
MM argue that in the absence of corporate income taxes, overall cost of capital is independent of the capital structure of the firm.