Capital Structure is defined as the way a company finances itself through the combination of equities or borrowings or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells 20bn pounds in equity and 80bn pounds 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.
As the common goal of all financial managers is to maximise the firm value, they seek optimum capital structure that yields lowest cost of capital. Initially all views that try to explain the relationship between capital structure and company value have been categorised into two main groups as Net Income approach (NI) and Net Operating Income approach (NOI). The NI approach states that cost of debt and the cost of equity do not change with a change in the leverage, which results in a decline in weighted average cost of capital (WACC) as leverage increases. The NOI advocates that as debt increases, stockholders will expect higher return as the the risk rises. This rise actually neutralises the overall cost of capital resulting a fixed value on all leverage levels. In the 1957 Modigliani-Miller presented their ground breaking theory by showing that the value of a firm is in fact irrelevant to the capital structure, supporting NOI approach.
Modigliani-Miller Theorem
The Modigliani-Miller theorem (1957), 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. But, had very restrictive assumptions:
- no taxes
- no growth
- no transaction costs
- all debt is risk-free
- debt is perpetual
- all debt issued is used to repurchase stock
- no bankruptcy costs
Then, in 1963, M&M showed that when corporate taxes are included, a firm’s value is increased by adding debt. In fact, the firm’s value is maximized at 100% debt!.
Later, in 1977, Miller showed that even when personal taxes (on both debt and equity) are added to the equation the firm’s value is still maximized at 100% debt!
Trade-off Theory
Static Trade-off Theory claims that there is an optimal debt ratio, which balances the costs and the benefits of borrowing. Debt is viewed as a tax shield and forces the managers greater financial discipline. On the other hand it is also financial distress and there is a risk of bankruptcy. Thus, finding a balance between the costs against the benefits of debt is regarded as a trade-off, and leads to the idea that there is an optimal capital structure for a firm, which maximises its market value.
Pecking Order Theory
Pecking Order theory says that when internal cash flow of a company is not enough for its new investments and dividend payments, company issues debt. Financial managers usually prefer internal funding to external, and debt to equity. Literally they prefer to finance new investment, first internally with retained earnings, then with debt, and finally with an issue of new equity. This implies that companies do not have a target debt ratio and debt ratio changes when there is an imbalance of internal cash flow. Therefore if a profitable company which does not have new investment opportunities will keep its debt ratio low. If investment opportunities exceed the internally generated cash companies will prefer borrowing. Thus, changes in debt ratio are related to the need for external cash rather than meeting optimal debt ratio target.
Signaling Theory
This model also assumes asymmetric information. Managers will not want to issue equity because of the signal it sends – that managers are issuing stock because they feel it is overpriced, since they would not rationally issue equity when the stock was undervalued.
Managerial Opportunism Hypothesis
The managerial opportunism hypothesis says that rational managers, armed with superior information, choose to sell shares when the public valuation of the company's shares exceeds management's valuation estimate. Managers time the market by issuing equity when the stock market is high. This can have lasting effects on a firm’s capital structure
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