Capital structure refers to the combination of equity and debt a company uses to finance its assets and operations.
In this reading we will review some key factors affecting capital structure such as:
A company’s management seeks to find an optimal capital structure that balances the benefits of higher leverage with its costs. At this point, the company’s weighted average cost of capital (WACC) is minimized and shareholder value is maximized.
In this section we will look at the typical changes in a company’s capital structure as it evolves from a start-up, to a growth business, to a mature business.
2.1 Background
A company’s life cycle stage influences its cash flow characteristics, its ability to support debt; and is therefore a primary factor in determining capital structure. Any capital that is not sourced through borrowing must come from equity.
As companies mature and move from start-up, through growth, to maturity, their business risk typically declines, and their operating cash flows turn positive and become more predictable. This allows for greater use of leverage at more attractive terms. This is illustrated in Exhibit 1 from the curriculum.
2.2 Start-Ups
2.3 Growth Businesses
2.4 Mature Businesses
2.5 Unique Situations
In the preceding sections we established a general relationship between company maturity and capital structure. However, there are three important exceptions:
3.1 MM Proposition I without Taxes: Capital Structure Irrelevance
Economists Modigliani and Miller claimed the following proposition, given no taxes and a certain set of assumptions:
MM Proposition I: The market value of the company is not affected by the capital structure of the company.
V_{L }= V_{U}
where:
V_{L }= value of the levered firm
V_{u} = value of the unlevered firm
In other words, the value of a company is determined solely by its cash flows, not by the relative reliance on debt and equity capital.
The assumptions made were:
We can explain MM’s capital structure irrelevance proposition in terms of a pie. Suppose the total value of a company is represented by a pie. Slices represents how much of the total capital is contributed by debt and equity. Depending on the capital structure, the pie can be split in any number of ways, but the size of the pie will remain the same. This is illustrated in the figures below.
3.2 MM Proposition II without Taxes: Higher Financial Leverage Raises the Cost of Equity
Modigliani and Miller’s second proposition focuses on the cost of capital of the company.
MM Proposition II: The cost of equity is a linear function of the company’s debt-to-equity ratio.
where:
r_{0} is the cost of capital for a company financed only by equity and has zero debt
r_{d} is the cost of debt
r_{e} is the cost of equity
D/E = debt-to-equity ratio
As D/E rises, i.e. the company increases the use of debt, the cost of equity (r_{e}) rises. We know from MM Proposition I that the value of a company is unaffected by changes in D/E and the WACC remains constant. Proposition II then implies that the cost of equity increases in such a manner as to exactly offset the increased use of cheaper debt in order to maintain a constant WACC. Under this proposition, WACC is determined by the business risk of the company, and not by the capital structure.
MM Proposition II is illustrated in the figure below.
As leverage increases, the cost of equity increases, but WACC and the cost of debt remain constant.
Systematic Risk
The systematic risk or beta of a company’s assets is a weighted average of the systematic risks of its source of capital.
where:
β_{a} = asset beta
β_{d} = debt beta
β_{e }= equity beta
According to MM, as the use of debt rises the risk borne by equity holders rises, and therefore the equity beta rises.
3.3 MM Propositions with Taxes: Taxes, Cost of Capital, and Value of the Company
The discussion so far has ignored taxes. In this section, we will present MM propositions I and II with taxes. As interest paid is tax deductible, the use of debt provides a tax shield that increases the value of a company. If we ignore the costs of financial distress and bankruptcy, the value of the company increases as we take on more debt.
MM Proposition I with taxes: The value of a levered company is equal to the value of an unlevered company plus the value of the debt tax shield.
V_{L}=V_{U}+tD
where:
V_{L }= value of the levered firm
V_{u} = value of the unlevered firm
t = marginal tax rate
D = value of debt in the capital structure
The term tD is often referred to as the debt tax shield
MM Proposition II with taxes: The cost of equity is a linear function of the company’s debt-to-equity ratio with an adjustment for the tax rate.
The cost of equity increases as the company increases the amount of debt in its capital structure, but the cost of equity does not rise as fast as it does in the no tax case.
WACC for a leveraged company falls as debt increases, and therefore the overall company value increases. This is illustrated in the figure below:
The table below provides a summary of MM propositions.
Without Taxes | With Taxes | |
Proposition I | V_{L} = V_{U} | V_{L} = V_{U} + tD |
Proposition II |
3.4 Costs of Financial Distress
The disadvantage of operating and financial leverage is that earnings are magnified downward during economic slowdown. Lower or negative earnings put companies under stress, and this financial distress adds costs to a company.
The costs of financial distress can be classified into direct and indirect costs. Direct costs include the actual cash expenses associated with the bankruptcy process, such as legal and administrative fees. Indirect costs include forgone investment opportunities, impaired ability to conduct business, and agency costs associated with the debt during periods in which the company is near or in bankruptcy.
The costs of financial distress are lower for companies whose assets have a ready secondary market. For example, airlines, shipping companies etc.
The probability of financial distress and bankruptcy increases as the degree of leverage increases. The probability of bankruptcy depends, in part, on the company’s business risk. Other factors that affect the likelihood of bankruptcy include the company’s corporate governance structure and the management of the company.