Optimal Capital Structure: Thoery and Practice

Optimal capital structure refers to the mix of debt and equity financing that maximizes a company’s overall value while minimizing its cost of capital.

Management can try to evaluate whether there is a capital structure that maximizes the value of the company. This capital structure, if it exists, is referred to as the optimal capital structure. However, even if the company’s optimal capital structure cannot be determined precisely, management should understand that there is an economic benefit from the tax deductibility of taxes, but eventually this benefit may be reduced by the costs of financial distress.

Looking at the financing behavior of companies in conjunction with their dividend and investment opportunities, we can make several observations:

• Companies prefer using internally generated capital (retained earnings) to externally raised funds (issuing equity or debt).
• Companies try to avoid sudden changes in dividends.
• When internally generated funds are greater than needed for investment opportunities, companies pay off debt or invest in marketable securities.
• When internally generated funds are less than needed for investment opportunities, companies use existing cash balances or sell off marketable securities.
• If companies need to raise capital externally, they issue the safest security first; for example, debt is issued before preferred stock, which is issued before common equity.

The trade-off among taxes and the costs of financial distress leads to the belief that there is some optimal capital structure, such that the value of the company is maximized. Yet it is difficult to reconcile this with some observations in practice. Why?

One possible explanation is that the trade-off analysis is incomplete. We didn’t consider the relative costs of raising funds from debt and equity. Because there are no out-of-pocket costs to raising internally generated funds (retained earnings), it may be preferred to debt and to externally raised funds. Because the cost of issuing debt is less than the cost of raising a similar amount from issuing common stock (typically flotation costs of 2.2% versus 7.1%), debt may be preferred to issuing stock.

Another explanation for the differences between what we observe and what we believe should exist is that companies may wish to build up financial slack, in the form of cash, marketable securities, or unused debt capacity, to avoid the high cost of issuing new equity.

Still another explanation is that management may be concerned about the signal given to investors when equity is issued. It has been observed that the announcement of a new common stock issue is viewed as a negative signal, since the announcement is accompanied by a drop in the value of the equity of the company.

It is also observed that the announcement of the issuance of debt does not affect the market value of equity. Therefore, management must consider the effect that the new security announcement may have on the value of equity and therefore may shy away from issuing new equity.

The concern over the relative costs of debt and equity and the concern over the interpretation by investors of the announcement of equity financing leads to a preferred ordering, or pecking order, of sources of capital: first internal equity, then debt, then preferred stock, then external equity (new common stock).

A result of this preferred ordering is that companies prefer to build up funds, in the form of cash and marketable securities, so as not to be forced to issue equity at times when internal equity (that is, retained earnings) is inadequate to meet new profitable investment opportunities.

Modigliani-Miller Theory of Capital Structure

Franco Modigliani and Merton Miller provide a theory of capital structure that is a framework for the discussion of the factors most important in a company’s capital structure decision: taxes, financial distress, and risk. Though this theory does not give a prescription for capital structure decisions, it does offer a method of examining the role of these important factors that provide the financial manager with the basic decision-making tools in analyzing the capital structure decision. Within their theory, Modigliani and Miller demonstrate that without taxes and costs of financial distress, the capital structure decision is irrelevant to the value of the company.

The capital structure decision becomes value-relevant when taxes are introduced into the situation, such that an interest tax shield from the tax deductibility of interest on debt obligations encourages the use of debt because this shield becomes a source of value.

Financial distress becomes relevant because costs associated distress mitigate the benefits of debt in the capital structure, offsetting or partially offsetting the benefit from interest deductibility.

The value of a company-meaning the value of all its assets-is equal to the sum of its liabilities and its equity (the ownership interest). Does the way we finance the company’s assets affect the value of the company and hence the value of its owner’s equity? Yes. How does it affect the value of the company?

M&M Irrelevance Proposition

Franco Modigliani and Merton Miller developed the basic framework for the analysis of capital structure and how taxes affect the value of the company. The essence of this framework is that what matters in the value of the company is the company’s operating cash flows and the uncertainty associated with these cash flows.

Modigliani and Miller (M&M) reasoned that if the following conditions hold, the value of the company is not affected by its capital structure:

• Condition 1: Individuals and corporations can borrow and lend at the same terms (referred to as equal access).
• Condition 2: There is no tax advantage associated with debt financing vis-a-vis to equity financing. `
• Condition 3: Debt and equity trade in a market where assets that are substitutes for one another, they trade at the same price.

Under the first condition, individuals can borrow and lend on the same terms as the business entities.

Therefore, if individuals are seeking a given level of risk they can either:

1. Borrow or lend on their own, or
2. Invest in a business that borrows or lends.

In other words, if an individual investor wants to increase the risk of the investment, the investor could choose to invest in a company that uses debt to finance its assets. Or the individual could invest in a company with no financial leverage and take out a personal loan-increasing the investor’s own financial leverage.

The second condition isolates the effect of financial leverage. If deducting interest from earnings is allowed in the analysis, it would be difficult to figure out what effect financial leverage itself has on the value of the company. M&M relax this later, but at this point assume no tax advantage exists between debt or equity securities-either for the company or the investor.

The third condition ensures that assets are priced according to their risk and return characteristics. This condition establishes what is referred to as a perfect capital market: If assets are traded in a perfect market, the value of assets with the same risk and return characteristics trade for the same price.

Under these conditions, the value of a company is the same, no matter how it chooses to finance itself. The total cash flow to owners and creditors is the same and the value of the company is the present value of the company’s operating cash flows in perpetuity.

M&M with Tax Deductibility of Interest Paid on Debt

M&M’s second proposition is that when interest on debt is deducted in determining taxable income, but dividends are not, the value of the company is enhanced because of this tax deductibility of interest.

When Modigliani and Miller introduce the tax deductibility of interest into the framework, the use of debt has a distinct advantage over financing with stock. The deductibility of interest represents a form of a government subsidy of financing activities; the government is sharing the company’s cost of debt. We refer to the benefit from interest deductibility as the interest tax shield because the interest expense shields income from taxation. The tax shield from interest deductibility is the amount by which taxes are reduced by the deduction for interest.

If there are no costs associated with financial distress, then the value of the company increases with ever-increasing use of debt financing because of the value enhancement from the use of the interest tax shield. Further, if there are no costs to financial distress, the cost of capital for the company decreases with ever-increasing use of debt financing because the after-tax cost of debt affects the cost of capital for the company as a whole such that the increased use of the debt reduces the cost of capital.

Is there a limit to how much debt a company can take on? As long as there are no costs to financial distress, the only limit is the existence of at least a small percentage of equity in the capital structure.

Capital Structure Theory and Costs to Financial Distress

If the debt burden is too much, the company may experience financial distress, resulting in an increasing cost of capital: At some point, the value of the company declines and the cost of capital increases with increasing use of debt financing.

Financial distress results in both direct and indirect costs including legal costs, opportunity costs for projects, and the effect of distress on the relationship with customers and suppliers.

At some capital structure, these costs begin to offset the benefit of the interest deductibility of debt. The optimal capital structure is the point at which the value of the company is maximized. Up until the optimal capital structure, the benefits from the tax deductibility of interest outweigh the cost of financial distress.

When the amount of financial leverage exceeds the optimal capital structure, the benefits from the tax deductibility of interest are outweighed by the cost of financial distress. Because of the relation between the value of the company and the cost of capital, the capital structure that maximizes the value of the company is the same capital structure that minimizes the cost of capital.

The optimal capital structure depends, in large part, on the business risk of the company: the greater the business risk of the company, the sooner this optimal capital structure is reached.

So what good is the theory of capital structure if financial managers cannot determine the optimal capital structure?

The M&M theory, along with subsequent, related theories and evidence, provides a framework for decision making:

• There is a benefit to taking on debt-to a point.
• The cost of capital of a company decreases with ever-increasing use of debt financing-to a point.
• The optimal capital structure depends on the risk associated with the company’s operating cash flows.

Current Capital Structure Theory and Practice

The M&M theory offers a trade-off model of capital structure: some balance exists between the present value of the interest tax shields and the present value of the costs of financial distress. We simply cannot determine, based on this theory, where this point is for a given company

Since M&M introduced their theory of capital structure in a series of articles, there have been many other considerations offered by researchers, including:

• Agency costs that may complicate the maximization of shareholder’s wealth.
• Asymmetric information and signaling that result in a pecking order of financing choices.
• Nonfinancial stakeholder issues that may affect the costs of financial distress.