About the paper
Capital structure of the company represents the mix of debt and equity components used by an entity to finance its capital requirements. However, right from the beginning of the corporate era, the goal of the financial managers has always been the minimization of weighted average cost of capital and thereby maximizing the value of their entity. Ironically, the world of academicians is divided and postulates different opinion as under what conditions the WACC rate is minimized and how the additional funding affects the WACC rate of the company. While static trade-off theory stands as the most pragmatic theory relating to the capital structure till date, however, in order to understand the aspects of this theory, we will need to understand the theory proposed by Modigliani and Miller(MM) as the former theory(static-trade off) is built on the foundation provided by MM theory only.
Therefore, in this paper, we will discuss the MM theory(in the presence of taxes) and static-trade off theory and will try to learn about the relationship between capital structure and the value of the firm.
MM Theory
Modigliani and Miller, in 1958, published their first seminal work on the theory of capital structure as part of which they postulated their ‘theory of irrelevance’ under the restrictive set of assumptions such as:
Capital Markets are perfectly competitive and there is no cost of transactions or taxes or bankruptcy costs.
Investors share homogeneous expectations in regard to cash flow they expect from their investments
Investors can borrow or lend at the risk free rate
There is no conflict of interest between the shareholders and the management
However, following the criticism on their assumption of no taxes, the researchers relaxed their assumption and introduced the new theory as part of which they explained how the capital structure is affected by financing decisions in the presence of taxes.
It is considerable that under the tax provisions of most countries, interest paid on debt borrowings is a deductible expense while dividends are not facilitated with such provisions as the same are paid on after-tax basis. This differential treatment between debt borrowings and dividend payment, encourage the company to borrow more debt as additional borrowing means higher interest expense and eventually, lower taxable income. Therefore, it is the tax shield offered by the debt borrowings that provides the advantage to the company, and accordingly, this factor entice the company to borrow more debt and lower the cost of capital. Important to note, the tax shield here equals the marginal tax rate multiplied by the debt borrowings of the company. Stated otherwise, Modigliani and Miller proposed that the value of levered firm is equal to the value of unlevered firm multiplied by tax shield
VL = VU * Tax Shield
Therefore, upholding the assumption of no bankruptcy costs as in their first theory, Modigliani and Miller proposed that the value of the firm increases with higher leverage and the level of 100% debt financing represents the optimal capital structure of the firm. Highlighted below is the graph that represents the outcome of MM theory under the presence of taxes:
The above graph indicates that with the increase in the leverage position, the required rate of return on debt remains same, however, since the proportional benefit of tax shield exceeds the risk passed on to the equity holders because of additional leverage, the overall cost of capital gets reduced and the firm is able to maximize the value at 100% debt level. In other words, as the firm increased the level of debt financing in the capital structure, it assumes high risk because of which the equity holders start demanding additional premium and this increase the cost of equity of the firm. However, with additional level of debt funding, the level of tax shield also enhances and this neutralize the effect of increasing cost of equity and at the level of 100% debt, WACC turns minimum and the value of the firm is maximized. Stated otherwise, the WACC rate declines for every single unit increase in the debt amount as long as the firm earns taxable profits.
It is considerable that the assumptions and framework proposed by Modigliani and Miller were never accepted citing their imperfection and non-acceptance in real life.Still, the academic fraternity has cited the Modigliani and Miller’s contribution to the theory of capital structure as pathbreaking as even though the theory suffers from the limitation of realistic description,it did provided means of finding reasons as why the composition of capital structure matters for every organization and can be rated as the foundation of modern finance theories.
Static Trade-off theory
Right from the beginning of its introduction in the literature world, MM theory was widely criticized on the grounds of unrealistic assumptions. Even the author of the theory, Merton Miller later noted that ‘’ “in many ways this tax-adjusted MM proposition provoked even more controversy than the original invariance one’’. It was very much clear that the academicians were not ready to accept that the optimal level of gearing is achieved at the 100% debt level because of tax shield associated with debt financing.
Then, a significant improvement came in the form of static trade-off theory, which continues to dominate the literature on capital structure. The static trade-off theory states that every firm has an optimal level of capital structure and an optimal level of debt to support the capital structure. The theory is based on the realistic assumption that even though debt offers tax shield in the form of the interest rate deduction, but it also has bankruptcy costs associated with it. Therefore, the optimal level of the capital structure is not 100% debt, but a mix of equity financing and debt financing.
Stated otherwise, the static trade-off theory asserts that if we remove the assumption of no bankruptcy costs, there comes a point when the additional value added from the tax shield associated with debt financing is succumbed by the value reducing costs of additional borrowing. Therefore, the firm should borrow the additional debt only up to the point when the marginal benefit provided by the tax shield of the additional debt is equal to the marginal costs associated with bankruptcy related to the additional debt. This is the point of optimal capital structure as at this point, the cost of capital is minimized and value of the firm is maximized. Therefore, under the static trade-off theory, the value of levered firm becomes:
Value of Levered Firm= Value of unlevered firm+ tax shield- PV(Cost of financial distress)
As we can see in the above graph, as the firm keep on adding more debt in its capital structure, there comes a point when the cost of bankruptcy exceeds the benefit of tax shield and this increases the WACC level. Hence, the firm should only add up more debt to the optimal level and not beyond that. Therefore, the static trade-off theory plausibly substantiates the existence of optimal or target capital structure that the firms should try to achieve to increase the shareholder wealth.
Important to note, many academicians have derived their own trade-off model as they believe that the firm should not only consider the bankruptcy costs associated with debt funding, but also the additional factors must be included in a more general cost-benefit analysis of debt. One such factor, which is largely accepted amongst the academic fraternity is the agency costs model proposed by Jensen and Meckling. Agency cost is related to equity funding and is related to conflicts of interest between the principal (shareholders) and the agents(managers). The researchers argue that shareholders are always aware of the fact that managers, at some point, will consider their own interest rather than that of the shareholders and this give rise to agency cost of equity. Agency cost of equity has three components:
Monitoring Costs: These are the costs associated with supervising management
Bonding Costs: These are the costs assumed by the management to assure the shareholders that the managers are working in the interest of shareholders
Residual Losses: These are the losses related to monitoring and bonding provisions
However, unlike the original convention of trade-off theory, some researchers have disagreed with the inclusion of agency-costs in the trade-off model. For instance, Frank and Goyal has contended that Jensen and Meckling could not justify the true impact of agency costs on the capital structure. Similarly, Bradley asserted that since the original model already includes cost of financial distress, it already includes bankruptcy costs, agency costs and other costs. Therefore, separate consideration of agency costs is not justified.
It is noticeable that while the static trade-off theory was readily accepted on theoretical basis, researchers were predominantly interested in testing the theory framework unde real time circumstances. For instance, Schwartz and Aronson (1967) and Scott (1976) were able to study the impact of debt ratios on the industry participants and the need for keeping the debt ratio under optimal level. Similarly, Bradley, in his research paper confirmed the same outcome while he conducted the research on 851 firms from 25 different industries. More direct evidence is provided by Taggart and Auerbach, who used target-adjustment model to ascertain significant adjustment coefficients for optimized gearing level. However,one of the most well accepted empirical evidence came from Graham and Harvey,who used the method of qualitative surveys to study the impact of debt-ratio on the financing decisions of the firm. As part of their research, the researchers surveyed 392 Chief Financial Officers(CFO) and proved that 71% of them considers the target debt-equity ratio while making financing decisions. The study was rated exceptional by the academic fraternity because of its normative approach, which is intended to advise the practitioners on how to increase the value of the firm through leverage.
Conclusion
On the basis of the above discussion, we can assert that even though the assumptions of MM theory were never practical in real life, but still, it provided base to the fundamentals of static trade-off theory because it is only because the static trade-off theory relaxed assumptions of perfect markets such as taxes, bankruptcy and agency costs, it is still the widely accepted theory related to capital structure. Additionally, the concept of optimal capital structure and maximization of shareholder wealth at this level of funding, provides high credibility to the model. Moreover,the static trade-off theory finds high empirical support as large number of researchers have agreed on the fact that the capital structure of the firm does matter, but there is always an optimum level of debt, which the CFO and CEO’s always take into consideration while considering financing decisions as there is a particular range of gearing level that has an effect on shareholder wealth. Having said that, the researchers also agree that there is not one standard optimum capital structure as the same depends on the industry within which the company operates, operation risk, sales risk, corporate governance and many other factors.
Therefore, it is because of this reason that we cannot expect an all purpose theory of the capital structure that assimilates all the factors. Therefore, while MM theory taken individually, has no practical relevance, but it did provide a base for the static-trade off theory. On the other hand, static trade-off theory, which indeed gather practical relevance and widespread acceptance amongst the theory of capital structure, still has some flaws on the treatment of agency costs along with costs of financial distress. Therefore, we believe that it is important for anyone studying the theories of capital structure to follow a more comprehensive view in order to explain the actual gearing levels adopted by firms.
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