CAPITAL STRUCTURE OF A COMPANY
CAPITAL STRUCTURE OF A COMPANY
Before making an investment, investors assess different companies to determine the ones that are financially stable, and performing optimally to invest in. A majority of the investors will make their decision based on the overall working capital, asset performance, and capital structure of the company to determine the strength of the company’s balance sheet, and its investment quality (Dimitrov, 2011). Organizations that have a healthy capital structure, are the ones that have a low level of debt, and a high amount of equity. Such metrics are an indication of the investment quality of a company. The capital structure of a company is considered as a permanent type of funding, which contributes to the overall company’s growth and its overall assets.
Over the years, there has been arguments in line, and against the relevance of the capital structure on the overall valuation of the company. There are theories such as the Modigliani and Miller’s theory of capital structure, which states that the valuation of a firm is irrelevant to its capital structure (Habimana, 2015). In this study, the researcher is interested in determining whether, the capital structure of a company has a significant impact on its overall value. This will be determined by evaluating the prominent theories that are related to the capital structure (Tifow, & Sayilir, 2015). These are: the Modigliani and Miller’s theory of capital structure, the trade-off theory, and the pecking order theory.
The Modigliani and Miller’s Theory of Capital Structure
According to the Modigliani and Miller’s approach to the capital theory, there is the indication that the valuation of a firm is considered to be irrelevant to the capital structure of a company. This means that, whether a company is considered to be highly leveraged, or it has a lower debt component, it will have no impact on its overall market value. In this theory, there is the suggestion that the overall market value of a firm is dependent on its operating profits (Cheremushkin, 2011). To put it into perspective, according to the Modigliani-Miller theory, the overall market value of a firm is calculated based on the present value, and the future earnings of a firm, together with its underlying assets. It is an indication that when conducting the valuation of a firm, potential investors and businesses should not use the capital structure.
The logic of the Modigliani-Miller theory is based on the existing approaches that companies have in relation to financing their operations. Companies utilize only three strategies when they are raising the money to finance their operations, and to engage in the growth and expansion activities. These strategies are borrowing money by issuing bonds to the public, issue new stocks shares to their investors, and obtain loans from financial institutions (Cheremushkin, 2011). According to this theory, the option that a company selects to finance its operations and objectives will have no real effect on its overall market value.
Utilizing the Modigliani and Miller’s approach provides the indication that the overall value of a leveraged firm i.e. a company has a mix of debt and equity possesses the same value as an unleveraged company, which is a firm that has only used one financial funding option i.e. it has been financed by equity, if they have similar operating profits and future financial prospects (Nugroho, 2013). This means that in the event that an investor will purchase the shares of a leveraged firm, the cost will be similar as purchasing shares of an unleveraged firm.
An important point to note is that, when using the Modigliani and Miller approach, there are various assumptions that are made such as, in this situation, there are no taxes. Second, the overall transaction costs for purchasing, and selling the securities are nil. In addition to that, there is the need to have a symmetry of information. The investor in the two scenarios will have access to the same information as that of the corporation, which will ensure that the investor will behave in a rational manner (Welch, 2004). Other assumptions that will be made are: the overall cost of borrowing will be similar for both the investors and the companies, there are no flotation costs such as the underwriting of the commission, and no corporate dividend tax.
As has been stated, in the Modigliani and Miller approach, the assumption that is made is that there are no taxes. However, in reality, a majority of countries, tax companies. In this theory, there is the recognition that there are different tax benefits that are achieved, or accrued when by the overall interest payments. While the interest that is paid on the borrowed funds is considered to be tax deductible, this is not the case for the dividends that are paid on equity. The approach that is used in relation to the corporate taxes in this theory indicates that there are tax savings, and a change on the debt-equity ratio will have an overall effect on the Weighted Average Cost of Capital (WACC).
The Trade-Off Theory of Capital Structure
One of the primary assumptions that exists in the Modigliani and Miller theorem is that there are no taxes. To put it into perspective, the trade-off theory was built on the knowledge of the MM theoretical approach, but it takes into consideration, some of the cost effects of some of the assumptions such as the affects of the taxes, and the bankruptcy costs. An important point to note is that, while the M&M theorem can be used to indicate, or describe how a variety of the firms use their taxation to manipulate their overall profitability, and select their optimum debt level. However, it is important to point out that as the debt level of a company increases, there is the increased risk of a company being susceptible to bankruptcy.
In the trade-off theory, there is the recommendation that the optimal level of debt of a company is a situation in which its marginal benefits of the debt finance are equal to its marginal costs. This means that a company is in a better position of achieving its optimal capital structure by adjusting its debt and equity level, and balancing the overall tax shield and the financial distress cost. For the supporters of this theory such as, Myers (1977), there is the suggestion that the utilization of debt up to a specific level to offset the cost of the financial distress and interest tax shield. Fama and French (2002) pointed out that the ideal capital structure will be identified by the benefits of the debt tax deductibility of its overall interests, and the overall bankruptcy and agency costs.
Arnold (2008) provided an ideal explanation of how the increase in the debt capital in the relation to its capital structure has an impact on the overall valuation of a firm. In this case, as the debt capital of a company increases, the WACC of the firm will experience a decline until the point whereby a company will reach its optimal gearing level, and the overall cost of its financial distress increases in line with its overall debt level. This line of argument is supported by an earlier study that was conducted by Miller (1988) in relation to the optimal debt top the equity ratio of a company, which highlighted the highest possible tax shield that a company can be in a position to enjoy. An important point to note is that, according to Miller (1988), companies risk bankruptcy by because of an increased debt capital in its overall capital structure. The reason for this is that, in this theory, the cost of the debt of the company is associated with the direct and indirect costs of bankruptcy. The costs of bankruptcy include costs such as the legal and the administrative costs, as the direct costs, while the possibility of the company losing its valued customers, or clients is considered to be an indirect cost for the company.
Another important cost that is considered in this theory is the agency costs. There are direct and indirect costs that are associated with the agency costs that will mainly result from the principles and agents who are acting in their best interests. According to an earlier study that was conducted by Jenson (1986), the researcher argued that, the overall debt of a company can contribute to the reduction of its agency cost as the higher the debt capital, the greater the amount of money that will be used to service the debt. For the debt holders, they may instruct a company to engage in safe investments so that they can be able to recoup their debt. At this point, the debt holders are not concerned with the profitability of their investments in as much as they are considered with the ability of the company to pay its debts.
In the study by Brounen et al. (2005), it was argued that the presence of an optimal capital structure increases the overall shareholder wealth. In addition to that, the study findings by Brounen et al. (2005) provided an explanation that even with the maximization use of its debt capital to the full capacity, these companies face the risk of low probability of becoming bankrupt. In the study by Hovakimian et al. (2004), the study findings suggested that, the high profitability of the gearing indicated that when a firm’s tax shield is higher, then its possibility of becoming bankrupt decreases significantly.
The optimal capital structure selection of an organization should be designed in such a way that it would be easy to issue its debt capital, or its equity capital. The argument tat os provided in the trade-off theory suggests that all firms should have an optimal debt ratio, whereby the tax shield will be equal to the overall financial distress cost. The advantage of the use of this theory is that, it eliminates the impact of the overall information asymmetry.
The Pecking Order Theory
In a perfect capital market that was proposed in the M&M theorem, the management under the pecking order theorem prefer to utilize the internally generated funds, over the externally generated funds. In accordance with the pecking order theory, there is the belief that the management of a company will want to use the money that the company generates for investments that will promote its growth, as opposed to the use of finances, or funds that are obtained from loans, and other external funds. In line with this theory, in an ideal company, the management will first use its internal funds, and in case they are not enough, it will result in the issuance of debt, and as a final resort, it will issue equity capital for its business operations.
According to the Pecking order theory, a firm will most likely resort to borrowing funds, in the event that its internally generated funds are considered to be not sufficient to fulfil their current investment needs. This argument is supported by the study by Myers (2001) who noted that the debt ratio of a company normally reflects its cumulative figure in line with its external financing, and that companies that experience a higher profit and growth opportunities mainly use less, or significantly lower debt capital. In the event that a company does not have current investment opportunities, then its profits will be retained to avoid its future external financing.
In an earlier study that was conducted by Harris and Raviv (1991) they suggested that the capital structure decisions are meant to reduce, or eliminate the inefficiencies that are caused by the information asymmetry between the potential investors and the company. This was supported by Myers (2001) who suggested that the information asymmetry that exists between the insiders and the outsiders in a company setting, and its overall separation of the ownership of a company is one of the main reasons as to why a majority of the companies tend to avoid the capital markets. In another study that was conducted by Frydenberg (2004), the researcher provides the explanation that the debt issue of a company is an indication of its confidence in the market where it operates in such a manner that the management of the company is not afraid, or deterred in its ability to engage in debt financing. Frank and Goyal added that because of agency conflict between the management, the owners and the outside investors, the pecking order as proposed in this theory is highly likely to occur.
To put it into perspective, the overall studies in relation to the pecking order theory have failed to show the significance of the this theory in accurately determining a company’s overall capital structure. However, there are certain aspects of the study i.e. the capital structure that are best described by the use of the pecking order theory in comparison to the trade-off theory such as the preference of the company’s management to use internal funds for its investments and therefore reduce its likelihood to accumulate debts, that may increase the likelihood of the company stating that it is bankrupt. However, the short-comings of this theory have contributed to the formulation of other theories such as market timing theory.
All the three theories that have been discussed in this paper are meant to provide a better understanding of the capital structure decision of companies. In particular, the Modigliani and Miller theory indicates that the capital structure should be considered irrelevant when conducting the overall valuation of the company. It was developed to show the relationship between the debt and equity of a company. However, this theory was considered insufficient because of its assumptions, which cannot exist in the real world such as tax free companies. The trade off theory was developed to indicate the importance of the tax shield advantage and the value maximization through the engagement of the optimal debt to the equity mix. In addition to that, the pecking order theory shows the approach that the company uses to raise funds. The first approach is to use internal funds before proceeding to use external funds.
The differences in the capital structure theories is their approach on providing explanations on the significance of the taxes, information and agency costs on investments and overall valuation of the company. Although the three theories offers a unique insight of the capital structure and its impact on the valuation of the company, the theories are not perfect, or do not offer valid explanations that can be accepted by the economists and potential investors who want to assess the overall value of a company. This is an indication of the need to have a more comprehensive assessment on the impact of the capital’s structure on the overall value of the firm.
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