'Capital structure' refers to the way a
corporation finances itself through some combination of
equity,
debt, or
hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20bn dollars in equity and $80bn in debt is said to be 20% equity financed and 80% debt financed. The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's
leverage.
The
Modigliani-Miller theorem, proposed by
Franco Modigliani and
Merton Miller, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it assumes away many important factors in the capital structure decision. The theorem states that, in a perfect market, the value of a firm is unaffected by how that firm is financed. This result provides the base with which to examine real world reasons why capital structure ''is'' relevant, that is, a company's value is affected by the capital structure it employs. These other reasons include bankruptcy costs, agency costs and asymmetric information. This analysis can then be extended to look at whether there is in fact an 'optimal' capital structure: the one which maximizes the value of the firm.
Capital Structure in a Perfect Market
Main articles: Modigliani-Miller theorem
Assume a perfect capital market (no
transaction or
bankruptcy costs;
perfect information); firms and individuals can borrow at the same interest rate; no
taxes; and investment decisions aren't affected by financing decisions. Modigliani and Miller made two findings under these conditions. Their first 'proposition' was that the value of a company is independent of its capital structure. That is, you cannot change the size of a cake by cutting it into different sized pieces. Their second 'proposition' stated that the cost of equity for a levered firm is equal to the cost of equity for an unlevered firm, plus an added premium for financial risk. That is, as leverage increases, while the burden of individual risks is shifted between different investor classes, total risk is conserved and hence no extra value created.
Their analysis was extended to include the effect of taxes and risky debt. Under a
classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure, then would be to have virtually no equity at all.
Capital Structure in the real world
If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance. The theories below try to address some of these imperfections, by relaxing assumptions made in the M&M model.
Trade-off theory
Main articles: Trade-off theory of capital structure
Trade-off theory allows
bankruptcy costs to exist. It states that there is an advantage to financing with debt, the
tax benefit of debt and there is a cost of financing with debt, the bankruptcy costs of debt. The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Empirically, this theory may explain differences in D/E ratios between industries, however it doesn't explain differences within the same industry.
Pecking order theory
Main articles: Pecking Order Theory
Pecking Order theory tries to capture the costs of
asymmetric information. It states that companies prioritize their sources of financing (from internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing means “of last resort”. Hence internal funds are used first, and when that is depleted debt is issued, and when it is not sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required. Thus, the form of debt a firm chooses can act as a signal of its need for external finance.
Agency Costs
There are three types of
agency costs which can help explain the relevance of capital structure.
★ 'Asset substitution effect': As D/E increases, management has an increased incentive to undertake risky (even negative
NPV) projects. This is because if the project is successful, share holders get all the upside, whereas if it is unsuccessful, debt holders get all the downside. If the projects are undertaken, there is a chance of firm value decreasing and a wealth transfer from debt holders to share holders.
★ 'Underinvestment problem': If debt is risky (eg in a growth company), the gain from the project will accrue to debtholders rather than shareholders. Thus, management have an incentive to reject positive NPV projects, even though they have the potential to increase firm value.
★ 'Free cash flow': unless
free cash flow is given back to investors, management has an incentive to destroy firm value through empire building and perks etc. Increasing leverage imposes financial discipline on management.
Other
★ The neutral mutation hypothesis—firms fall into various habits of financing, which do not impact on value.
★ Market timing hypothesis—capital structure is the outcome of the historical cumulative timing of the market by managers (Baker and Wurlger).
Arbitrage
Similar questions are also the concern of a variety of speculator known as a capital-structure arbitrageur, see
arbitrage.
A capital-structure arbitrageur seeks opportunities created by differential pricing of various instruments issued by one corporation. Consider, for example, traditional bonds and
convertible bonds. The latter are bonds that are, under contracted-for conditions, convertible into shares of equity. The stock-option component of a convertible bond has a calculable value in itself. The value of the whole instrument ''should'' be the value of the traditional bonds ''plus'' the extra value of the option feature. If the spread, the difference between the convertible and the non-convertible bonds grows excessively, then the capital-structure arbitrageur will bet that it will converge.
See also
★
Financial economics
★
Corporate finance
References
External links
★ http://www.investopedia.com/terms/c/capitalstructure.asp
★ http://www.westga.edu/~bquest/2002/rethinking.htm
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