Undoubtedly, the low cost of borrowing and the tax shield provided by the debt sources makes it a lucrative option for the company, and even the eminent finance professors, Modigliani and Miller has postulated that cost of capital is minimized at 100% debt level. In their study, MM Proposition II (With Taxes), the professors proposed that the tax shield provided by the debt funding causes Weighted Average Cost of Capital (WACC) to decline as the leverage increases. Therefore, the value of the firm is minimized at the point where WACC is minimized, which is 100% debt. The figure below shows that the tax shield provided by debt causes WACC to decrease as the firm acquire more debt funding. Therefore, the value of the firm is maximized at the point where WACC is minimized and this is achieved at 100% debt level.
However, I express my strong disagreement that a firm should adopt 100% debt structure because though the tax shield is indeed a core advantage of debt financing, but an entity must understand that at the higher level of debt financing, the risk of bankruptcy and cost of financial distress also increases. Important to note, cost of financial distress is the increased costs a might company face when it is not able to honor its debt commitments at the time of bearish earning trends. The cost of financial distress includes costs related to legal fees, administrative cost and indirect costs such as loss of customers and creditworthiness. Therefore, amid higher probability of financial distress associated with higher leverage, it is not a prudent position for any entity to operate with 100% debt structure.
In contrast, rather than adopting high leverage in its financial structure, a firm should look for an optimal capital structure that has optimal proportion of debt, as proposed by Kraus and Litzenberger in their Static Trade-Off Theory. This capital structure theory recognizes that indeed there are tax benefits associated with issuing debt because interest expenses is tax deductible, but increasing the use of debt also increases the cost of financial distress, and at some point of time, the costs of financial distress will exceed the tax benefits of debt. Therefore, an entity should always seek to balance the costs of financial distress with the tax shield benefit from using debt financing.
Optimal Capital Structure % of debt in capital structure
The figure above indicates an upward slope for the after-tax cost of debt due to increasing cost of financial distress associated with higher leverage position. In addition, as the firms acquires more debt funds, cost of equity also increases because the cost of increases financial distress is also borne by the shareholders. Therefore, the optimal proportion of debt is reached at the point when the marginal benefit provided by the tax shield of acquiring more debt is equal to the costs of financial distress incurred from the additional debt. This is the point of optimal capital structure of a firm as at this point, WACC is optimally minimized and value of the firm is maximized.
Therefore, after a meticulous observation of both the theories, i express my consent with Static Trade Off Theory, and propose that rather than adopting for high leverage position that my push an entity under the environment of high financial distress, a firm should look for an optimal capital structure that defines an optimal level of debt capital for the firm seeking balance between tax shield and financial distress.
References
"Capital Structure." Schweser, Kaplan. Scheser Notes for CFA Exam. USA: Kaplan Inc, 2012. 279-280. Print.
"Capital Structure." Schweser, Kaplan. Scheser Notes for CFA Exam. USA: Kaplan Inc, 2012. 281. Print.
Corporate Finance - The MM Capital Structure vs. The Tradeoff Theory of Leverage. n.d. http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/mm-capital-structure-versus-tradeoff-leverage.asp. 3 July 2015.
Martin, Kent Baker and Gerald. "Factors affecting capital structure decisions." Capital Structure and Corporate Financing Decisions: Thoery and Evidence. Wiley Publishers, n.d. Web.
Modigliani-Miller and Capital Structure Theory. n.d. http://financetrain.com/modigliani-miller-and-capital-structure-theory/. 3 July 2015.
Static Trade Off Theory. n.d. http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91339646. 3 July 2015.
