Capital Structure Theory

Summaries

MM1 Proposition I (without tax)

-          value of a firm is unaffected by it’s choice of capital structure, assuming

-          market is efficient: no tax, no bankruptcy cost, no transaction cost, and

-          investors have homogeneous expectation

MM1 Proposition II (without tax)

-          cost of equity increasing linearly with the % use of debt

-          As debt increases, r_e is increased also. The result is that WACC is constant.

-          r_e = WACC + (WACC – r_d)*(debt/equity)

-          WACC = r_e (when 100% equity) = constant > cost of debt

MM1 Proposition I (with tax)

-          100% debt maximize the value of the company due to tax shield

-          Value_of_unleveled_company + debt x tax_rate= Value_of_leveled_company

-          WACC is minimized in 100% debt case

-          WACC = r_d (when 100% debt after tax), WACC = r_e (when 100% equity), but r_d (when 100% debt after tax) < r_e (when 100% equity)

Cost of Financial Distress – increased costs when earnings decline and the firm cannot pay interest on debt

-          direct cost in dealing with bankruptcy etc.

-          indirect cost due to forgone opportunities

Agency costs of equity – conflicting interest between managers and owners

Net agency cost of equity (to prevent conflict of interests)

-          monitoring cost

-          Bonding costs

-          Residue loss – the loss even monitoring and bonding are implemented

Costs of asymmetric information – managers have more information than owners and creditors, thus required rate of return is higher as it is less transparent

Static Trade-off Theory

-          When cost of financial stress is taken into account, there is a point the marginal cost of stress exceeds the marginal benefit of tax shield. So there is optimal point in capital structure or the company value

-          Value_leveled = Value_unleveled + tax_rate x debt – PV of cost of stress

Pecking Order Theory: Managers try to make choices sending least signals to investors

1. Internal generated funds
2. Debts
3. External Equity (send strongest signal that the firm is not at very good position)

Variation of Capital Structure Targets

1)      To exploit opportunities (e.g. unusually low interest rate)

2)      Since Capital structure is calculated based on market value, it can fluctuate with market price

Spread from AAA to BBB bonds is about 100 basis points

Leverage in different countries:

1)      France, Japan use more debts than US and UK

2)      Japan use shorter maturity debts than US

3)      Developed countries use more debt and longer maturity debts then emerging markets

Good Legal system: less agency cost, use less but longer debt

Less information asymmetric: Use more equity as transparency is high

High tax shield: use more debt

High liquidity of capital market: longer debt

Reliance on Banking system: more debt

Reliance on investor: less debt, longer debt

High inflation: less and shorter debt

High GDP growth: longer debt