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Capital Structure in A Perfect Market

Capital structure refers to how a company finances its assets through various combinations of equity, debt, and hybrid securities. A company's capital structure composition and ratios, such as leverage, impact its value. The Modigliani-Miller theorem formed the basis for thinking that in a perfect market, capital structure is irrelevant to a company's value. However, real world factors like taxes, bankruptcy costs, asymmetric information, and agency costs make capital structure relevant. Different theories try to explain capital structure decisions based on tradeoffs between costs and benefits of debt versus equity financing.

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Vaibhav Agrawal
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84 views3 pages

Capital Structure in A Perfect Market

Capital structure refers to how a company finances its assets through various combinations of equity, debt, and hybrid securities. A company's capital structure composition and ratios, such as leverage, impact its value. The Modigliani-Miller theorem formed the basis for thinking that in a perfect market, capital structure is irrelevant to a company's value. However, real world factors like taxes, bankruptcy costs, asymmetric information, and agency costs make capital structure relevant. Different theories try to explain capital structure decisions based on tradeoffs between costs and benefits of debt versus equity financing.

Uploaded by

Vaibhav Agrawal
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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In finance, capital structure refers to the way a corporation finances its assets through some

combination of equity, debt, or hybrid securities. A firm's capital structure is then the
composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity
and $80 billion 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. In
reality, capital structure may be highly complex and include dozens of sources. Gearing Ratio
is the proportion of the capital employed of the firm which come from outside of the business
finance, e.g. by taking a short term loan etc.

The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, 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, how a firm is financed is irrelevant to
its value. This result provides the base with which to examine real world reasons why capital
structure is relevant, that is, a company's value is affected by the capital structure it employs.
Some other reasons include bankruptcy costs, agency costs, taxes, and information
asymmetry. This analysis can then be extended to look at whether there is in fact an optimal
capital structure: the one which maximizes the value of the firm.

Capital structure in a perfect market


Assume a perfect capital market (no transaction or bankruptcy costs; perfect information);
firms and individuals can borrow at the same interest rate; no taxes; and investment decisions
aren't affected by financing decisions. Modigliani and Miller made two findings under these
conditions. Their first 'proposition' was that the value of a company is independent of its
capital structure. Their second 'proposition' stated that the cost of equity for a leveraged firm
is equal to the cost of equity for an unleveraged firm, plus an added premium for financial
risk. That is, as leverage increases, while the burden of individual risks is shifted between
different investor classes, total risk is conserved and hence no extra value created.

Their analysis was extended to include the effect of taxes and risky debt. Under a classical
tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of
capital decreases as the proportion of debt in the capital structure increases. The optimal
structure then would be to have virtually no equity at all.

Capital structure in the real world


If capital structure is irrelevant in a perfect market, then imperfections which exist in the real
world must be the cause of its relevance. The theories below try to address some of these
imperfections, by relaxing assumptions made in the M&M model.
Trade-off theory

Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to
financing with debt (namely, the tax benefit of debts) and that there is a cost of financing with
debt (the bankruptcy costs of debt). The marginal benefit of further increases in debt declines
as debt increases, while the marginal cost increases, so that a firm that is optimizing its
overall value will focus on this trade-off when choosing how much debt and equity to use for
financing. Empirically, this theory may explain differences in D/E ratios between industries,
but it doesn't explain differences within the same industry.

Pecking order theory

Pecking Order theory tries to capture the costs of asymmetric information. It states that
companies prioritize their sources of financing (from internal financing to equity) according
to the law of least effort, or of least resistance, preferring to raise equity as a financing means
“of last resort”. Hence: internal financing is used first; when that is depleted, then debt is
issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory
maintains that businesses adhere to a hierarchy of financing sources and prefer internal
financing when available, and debt is preferred over equity if external financing is required
(equity would mean issuring shares which meant 'bringing external ownership' into the
company. Thus, the form of debt a firm chooses can act as a signal of its need for external
finance. The pecking order theory is popularized by Myers (1984)[1] when he argues that
equity is a less preferred means to raise capital because when managers (who are assumed to
know better about true condition of the firm than investors) issue new equity, investors
believe that managers think that the firm is overvalued and managers are taking advantage of
this over-valuation. As a result, investors will place a lower value to the new equity issuance..

Agency Costs

There are three types of agency costs which can help explain the relevance of capital
structure.

 Asset substitution effect: As D/E increases, management has an increased incentive


to undertake risky (even negative NPV) projects. This is because if the project is
successful, share holders get all the upside, whereas if it is unsuccessful, debt holders
get all the downside. If the projects are undertaken, there is a chance of firm value
decreasing and a wealth transfer from debt holders to share holders.
 Underinvestment problem: If debt is risky (e.g., in a growth company), the gain
from the project will accrue to debtholders rather than shareholders. Thus,
management have an incentive to reject positive NPV projects, even though they have
the potential to increase firm value.
 Free cash flow: unless free cash flow is given back to investors, management has an
incentive to destroy firm value through empire building and perks etc. Increasing
leverage imposes financial discipline on management.

Other

 The neutral mutation hypothesis—firms fall into various habits of financing, which do
not impact on value.
 Market timing hypothesis—capital structure is the outcome of the historical
cumulative timing of the market by managers.
 Accelerated investment effect—even in absence of agency costs, levered firms use to
invest faster because of the existence of default risk.

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