Analyse the Development of Capital Structuring Theory - Free Essay Example

Sample details Pages: 7 Words: 2237 Downloads: 3 Date added: 2017/06/26 Category Finance Essay Type Analytical essay Level High school Did you like this example? Introduction The essay intends to cover the development of capital structuring theory over the course of the 20th Century. It will highlight the different theories put forth by researchers, primarily Franco Modigliani and Merton Miller and their work during the 1950s and 1960s, and describe the differences in the theories and their implications and impact in the world of business and finance. Background of Theory In 1952, David Durand produced an article titled Cost of Debt and Equity Funds for Business: Trends and Problems of Measurement (Durand, 1952), for the National Bureau of Economic Research. Within this publication he created what is now known as a Traditional View of capital structuring which according to this view, the value of the firm can be increased or the cost of capital can be reduced by the judicious mix of debt and equity capital (Chand, 2015). This implies that the market valuation of a corporation can be altered depending on the capital structure used to finance the organisation. The Traditional View assumes that as debt capital increases the overall cost of capital decreases and thus the market valuation of a company can be increased through the benefit of a Tax-shield of Debt that is apparent when a company decides to finance through debt (FT Lexicon, 2015). This is due to the fact that interest payments on debt capital are treated as tax-deductable therefore a comp any will obtain more profit and shareholders are more inclined to accept a certain amount of debt finance. However, as leverage begins to increase beyond a certain amount à ¢Ã¢â€š ¬Ã¢â‚¬Å" an optimal point à ¢Ã¢â€š ¬Ã¢â‚¬Å" then shareholders are aware of bankruptcy risks, resulting in an increased cost of capital to compensate an increase in risk, lowering company market valuation. Furthermore, as you increase debt capital you are at the whim of some macro-economic factors, such as the setting of interest base-rates by the countrys central bank which of course would increase debt payments, perhaps beyond an efficient level, again increasing risk. However, in 1958 Franco Modigliani and Merton Miller published a conflicting article in The American Economic Review titled The Cost of Capital, Corporation Finance and the Theory of Investment (Modigliani and Miller, 1958). Within this article they put forth different propositions in relation to how capital structuring affects the mar ket value of a corporation and they criticised David Durands assumption that the cost of equity remains unaffected by leverage up to some reasonable limit as in their view the cost of equity is an increasing function of debt capital (Chand, 2015). This is likely to be because as bankruptcy risks are increasing shareholders are more inclined to request an increasing amount of returns to compensate, therefore the cost of equity will increase. Within the 1958 article Modigliani and Miller had the view that an organisations weighted average cost of capital is not affected by changes in its capital structure. Modigliani and Miller also published an article in 1963 titled Corporate Income Taxes and the Cost of Capital: A Correction for the American Economic Association (Modigliani and Miller, 1963). Within this article they had back-tracked on statements made within their first article published in 1958 and now were stating that among other things, that the tax advantages of debt finan cing are somewhat greater than we originally suggest and, to this extent, the quantitative difference between the valuations implied by our position and by the traditional view is narrowed (Modigliani and Miller, 1963, pp.434). This modification leads Modigliani and Miller to admit that tax relief on interest payments does lower the weighted average cost of capital.(ACCA, 2012, pp.314) Don’t waste time! Our writers will create an original "Analyse the Development of Capital Structuring Theory" essay for you Create order Development of Theory As we have stated, David Durands theory à ¢Ã¢â€š ¬Ã¢â‚¬Å" the traditional view à ¢Ã¢â€š ¬Ã¢â‚¬Å" is of the belief that a company can alter its market valuation by finding an optimal capital structure point which in turn would lower the Weighted Average Cost of Capital (WACC) and thus increase market valuation. This theory has been created on the basis of certain assumptions which are as follows; The company pays out all its earnings as dividends The gearing of the company can be changed immediately by issuing debt to repurchase shares or by issues shares to repurchase debt. There are no transaction costs for issues. The earnings of the company are expected to remain constant in perpetuity and all investors share the same expectations about these future earnings Business risk is also constant, regardless of how the company invests its funds Taxation, for the time being, is ignored (ACCA, 2012, pp.310-311) This theory was used as a basic backdrop to the issues of debt and equity costing and finance. Durand had put forth a Net Income (NI) and Net Operating Income (NOI) in his article Cost of Debt and Equity Funds for Business: Trends and Problems of Measurement (Durand, 1952). The combination of these ideas formed the basis of the Traditional View. That was until the creation of a publication in 1958, Modigliani and Miller put forth propositions which had built upon the theory created by David Durand in 1952 which assumed certain initial assumptions. The assumptions for the first proposition are as follows; A world without taxation A world without transaction costs A world without bankruptcy costs A world without growth opportunities A world without asymmetric information between insider and outsider investors i.e. a perfect capital market exists A world where there are differences in risk between different firms and individuals (Frentzel, 2013, pp.13) Within this theory Modigliani and Miller had rejected the idea put forth within the Traditional View and they had believed that the firms overall weighted average cost of capital is not influenced by changes in its capital structure (ACCA, 2012, pp.310). This is likely to be because, in the absence of taxation, an organisations market value is determined by only two factors; i) The total earnings of a company and ii) the level of business risk attached to those earnings. The WACC would then be determined by discounting the total earnings at a rate that is appropriate to the level of operating risk (ACCA, 2012, pp.312). Therefore capital structuring would be deemed to be of irrelevance, thus the name of this theory was deemed Irrelevance Theory. However, after receiving large amount of criticism due to the unreasonable assumptions, mainly that of an omission of taxation, Modigliani and Miller had to produce a correction paper in 1963 à ¢Ã¢â€š ¬Ã¢â‚¬ Å" as mentioned earlier. This theory à ¢Ã¢â€š ¬Ã¢â‚¬Å" a second proposition à ¢Ã¢â€š ¬Ã¢â‚¬Å" had included corporation tax in their model and they had then concluded that capital structuring does affect WACC and therefore market valuation. The reason for their conclusion arises after they [had] identified taxation as the primary reason why the combination of financing sources does matter because interests on debt may be deducted from the firms income and thereby reduces the net taxable earnings. As a result, this tax saving that constitutes an additional advantage to using debt capital lowers the effective cost of debt capital (Frentzel, 2013, pp. 15-16), this is known as the Tax Shield. This would suggest a firm would benefit from funding their organisation entirely out of debt as they would lower their tax liability due to the savings incurred from interest payments that are tax-deductable. This notion of a firm funding itself entirely out of debt in practice seems illogical considering; a) shareholders would deem the company a risky investment should it be completely funded by debt and would request a higher return to compensate and b) the bankruptcy costs and increased likelihood of insolvency should a company fund itself entirely out of debt even though the model rejects the idea of bankruptcy costs, in reality we know there are such costs. This then brings us onto the next theory which has been named Trade-Off Theory. This theory arose out of the controversy surrounding the second proposition put forth by Modigliani and Miller which implied a company can and should fund itself entirely out of debt due to the benefits of the Tax Shield. This of course does not make sense and sounds extreme due to the reality of bankruptcy costs and therefore an off-setting mechanism is needed which comes in the form of the tax advantages of borrowed money and the costs of financial distress when the firm finds it has borrowed too much (Shyam-Sunder and Myers,1998, pp. 210). This seems to make more sense in that an optimal point between equity and debt financing can be reached as well as including assumptions previously omitted from earlier theory such as the effects of corporation tax and that of bankruptcy. The final theory highlighted in this essay is named Pecking-Order Theory and it has been developed as an alternative to Traditional Theory. It made an appearance in an article titled The Capital Structure Puzzle (Myers, 1984) within the Journal of Finance and suggested that there exists a particular pecking order of funding which, put one way, is that Firms prefer internal finance [retained earnings]If external finance is required, firms issue the safest security first. That is, they start with debt, then possibly hybrid securities such as convertible bonds, then perhaps equity as a last resort. In this story, there is no well-defined target debt-equity mix, because there are two kinds of equity, internal and external, one at the t op of the pecking order and one at the bottom (Myers, 1984, pp. 581). Put in simpler terms, adverse selection implies that retained earnings are better than debt and debt is better than equity (Murray and Vidhan, 2005, pp.19). The Pecking-Order Theory is an explanation of what businesses actually do, rather than what they should do (ACCA, 2012, pp.315). This theory does not provide us with an optimal mix of finance but does provide us with a preferred method of funding for numerous reasons, for example, it is easier to use retained earnings as you have no external expectations set upon the company, there are also no issuing costs with retained earnings, issuing debt provides a signalling effect which is better than issuing equities. This final reason is because should a company start to issue equity, it could be sign that the managers believe that their equities are overvalued and are trying to cash in on the equities before they return to fundamental value, there is also a fixed income in regard to issuing debt whilst having a priority on liquidation. Conclusion In conclusion, there have been some productive developments concerning the area of capital structuring. In just over half a century various different hypothesis have developed which have contributed largely to the field, from an initial period where capital structuring was questioned to have any relevance at all to a view-point where a mix of debt and equity finance can achieve an optimal point of capital structuring. The importance of this cannot be underestimated as achieving an optimal point can lower the Weighted Average Cost of Capital so that a discount factor used in investment appraisals can lead a company to increase or decrease its market valuation. Reaching the optimal point is a case of trial and error for a company however once a company has reached this point the benefits can be profound, should a company increase its market valuation it may attract a different kind of investor or increase the possibility of a merger or an acquisition. Achieving the optimal point will allow a company to have a greater understanding of its Weighted Average Cost of Capital and therefore a discount factor; once this is achieved certain investment opportunities that may once have been out of reach may now be an acceptable possible idea to pool company resources or capital. This in turn may allow a company to enter into investment opportunities that it once thought it couldnt, perhaps leading to the entrance into new markets, the development of new technology, or an avenue to achieve re-engineered growth, all leading the company to a position to move forward and most importantly keeping the current and possibility new shareholders content with the current business model and situation. Bibliography Chand, S. (2015). Theories of Capital Structure (explained with examples). Available at: https://www.yourarticlelibrary.com/financial-management/theories-of-capital-structure-explained-with-examples-financial-management/29398/ Durand, D. (1952). Cost of Debt and Equity Funds for Business: Trends and Problems of Measurement, National Bureau of Economic Research, pp.215 à ¢Ã¢â€š ¬Ã¢â‚¬Å" 262, [PDF]. Available at: https://www.nber.org/chapters/c4790.pdf FT Lexicon. (2015). Definition of the Tax Shield. [Online] Financial Times. Available at: https://lexicon.ft.com/Term?term=tax-shield Modigliani, F. And Miller, M. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment, The American Economic Review, 48(3), pp. 261-298, [PDF]. Available at: https://www.aeaweb.org/aer/top20/48.3.261-297.pdf Modigliani, F. And Miller, M. (1963). Corporate Income Taxes and the Cost of Capital: A Correction, The American Economic Review, 53(3), pp. 433-443 [PDF] Available at: https://www2.bc.edu/~chemmanu/phdfincorp/MF891%20papers/MM1963.pdf ACCA. (2012). Paper F9, Financial Management, Study Text. London: BPP Learning Media Ltd Frentzel, B. (2013). Capital Structure Theory since Modigliani-Miller. Bachelor of Arts Thesis (BA). Berlin School of Economics and Law. Available at: https://opus4.kobv.de/opus4-hwr/files/166/Frentzel,Bennet_BA_2013.pdf Shyam-Sunder, L. And Myers, S. (1998). Testing Static Tradeoff against Pecking Order Models of Capital Structure, Journal of Financial Economics, 51, pp. 219-244 [PDF] Available at: https://pages.stern.nyu.edu/~eofek/PhD/papers/SM_Testing_JFE.pdf Myers, S. (1984). The Capital Structure Puzzle, The Journal of Finance, 39(3) , pp. 575-592 [PDF] Available at: https://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1984.tb03646.x/pdf Murray, F. And Vidhan, G. (2005). Tradeoff and Pecking Order Theories of Debt, (Working Paper) Tuck School of Business at Dartmouth. Available at: https://www.tc.umn.edu/~murra280/WorkingPapers/Survey.pdf