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Modigliani and Miller famously argued that all other factors being equal, capital structure is irrelevant. In the real world, however, things are not equal. So the different assumptions that underlie the core of MM, as the theory is known, do not exist in real life. The implication of this for businesses, then, is that they need to examine the different factors that can affect their choice of capital structure and then make a decision about how they want to finance their business. This paper will analyze these factors in relation to Starbucks, and then make a determination about the optimal capital structure for the company.
Modigliani and Miller
Villamil (n.d.) outlines the different assumptions in the MM theorem that should be evaluated. These assumptions are neutral taxes, no capital market frictions, symmetric access to credit markets, and that firm financial policy reveals no information. By ruling out all of these different factors, Modigliani and Miller were able to successfully argue that a firm's choice of capital structure is important to the long-run ability of the firm to increase shareholder wealth. We know that in the real world, none of these factors can be ignored. All firms face taxation, and governments often set tax policies to provide incentives for firms to act in one manner or another. So a firm's taxation environment will almost always play a role in its optimal capital structure.
The absence of market frictions, as Villamil notes, refers to the absence of transaction costs (such as the costs associated with underwriting an IPO), no asset trade restrictions and no bankruptcy costs. Firms must have symmetric access to credit markets for MM to hold, but we know that there is no such thing as symmetric access to credit markets. Financial intermediaries take spreads on credit transactions, so there are always going to be differences between the cost to borrow and the cost to lend. Lastly, we know that financial policy does reveal information to the markets. A firm with a very high debt load is either in trouble, or in the case of a company like Clorox, does not see its business as a growth business and is therefore seeking strictly to lower its cost of capital. Firms with all equity -- and especially ones that have no long-term debt but do not pay dividends -- send a signal to the markets that they are strictly a growth company. Apple, up until it announced a dividend this week, would fall into that category.
Optimal Capital Structure
The optimal capital structure, ultimately, for any firm, is determined by the firm itself. There are theories about the best structures for certain types of firms and certain industries, but there are no definitively "correct" answers to the question. Thus, evaluating a firm's capital structure is strictly a judgment call. It is worth noting, however, that it goes beyond MM. Because firm management is involved in the determination, the risk aversion of management is an important consideration. In MM, firms are purely rational, but the majority of people have a tendency to risk aversion. Indeed in the wake of MM, it was assumed that the corporate tax structure in the U.S., which favors debt financing, would cause companies to maximize debt in their capital structure. This was not the case, however. Kim (1978) showed that risk aversion plays a role in this. Investors are risk averse, and leverage increases risk. Companies seeking to maximize their share values therefore must maintain moderate debt levels. They cannot maximize their debt levels for fear that investors will flee the stock, eroding its value. Thus, risk aversion among investors, and management's estimation of that risk aversion, are significant factors in capital structure decisions.
One of the major drivers of risk aversion is the nature of the firm, particularly its risk, and the nature of the industry, again most especially concerned with risk. A company with stable revenues, operating cash flows and profits can carry more debt than a company with a highly volatile business, at the same level of comfort for its risk-averse managers and investors. Highly cyclical businesses where firms have limited control over key inputs -- airlines, for example -- are clearly going to be riskier than producers of consumer staples, as the aforementioned Clorox is. Firms in high growth industries might be risk averse because their current stage of the product cycle means that their future cash flows are less certain. There is even a case to be made for a company like Google or Apple, both of which have billions in cash on their balance sheets, to avoid debt financing. These firms, especially Apple, operate in industries characterized by a rapid pace of innovation and short product cycles. Consider how in the past five years, Research in Motion dominated smartphones, only to lose much of its share to Apple, only for Apple to have its share eroded by Android. In an industry were a firm can move from dominance to irrelevance in a few short years, risk-averse investors would naturally prefer to keep debt to a minimum. For a company like Wal-Mart, the situation would be entirely different. In addition, firms with high exits (liquidation) costs have shown to be more risk averse than other firms, and therefore to carry less debt (Titman & Wessels, 1988). Again, this points to a role that the business the firm is in matters in the choice of capital structure.
Among the MM factors, taxation is probably the most important. Tax policy has a direct impact on the cost of capital. In the United States, interest expense on debt is a before-tax deduction on income. Dividends are not; they come out of the after-tax net income, and then are taxed again as income for the shareholder. This double-taxation of dividends combined with the tax-reduction that comes from interest expense makes debt financing more attractive. Thus, tax policy encourages the use of debt financing over equity. Indeed, Llewellen and Llewellen (2006) argue that there is also a differentiation in the cost of internal equity (retained earnings) and external equity (an IPO, for example). There are naturally more transaction costs associated with external equity (underwriting fees, for example) but if some of the additional costs comes from tax policy, this is another issue that the company would need to consider.
As of the end of Q1 of fiscal 2012 (end of January 1, 2012), the capital structure of Starbucks was 39% debt and 61% equity. The company has held $550 million in long-term debt on its books for at least the past five years, and reduced its total liabilities over that span of time. Its equities, meanwhile, have increased significantly over the same time period. The intent, it can be inferred, is to reduce the total debt in the company's capital structure.
To analyze the merits of this decision, the factors that contribute to capital structure choices should be analyzed. Starbucks is an American company, and U.S. taxation laws favor debt. The impact of tax deductible interest, lower debt costs, and the double taxation on dividends implies that American firms should increase their debt in order to lower their cost of capital. Clearly, Starbucks is choosing to reduce its total debt, moving in the opposite direction.
Risk aversion is an interesting proposition. The Starbucks business has been shown to be relatively volatile. The company made several strategic missteps in the mid-2000s and suffered revenue declines during the latter part of the decade, ostensibly a function of increased competition and the economic downturn. The company could, therefore, be risk averse because it saw the downside risk of its business increase during those years. Starbucks did not have much downside risk for most of its existence, but the downturn could well have given the company notice of its own potential mortality. It is worth noting that this downturn also should have increased the risk aversion of the company's shareholders. The company's stock price declined sharply during the middle of the 2000s, so during the economic downturn the company decided against increasing debt financing, even though interest rates are very low.
Further to this, the company has not increased debt even though its performance and stock price have recovered in the past few years. The prospect of restricted cash flows may have instilled risk aversion in senior management. The company had been able to pull itself out of its doldrums with investment, precisely at a time when the company was facing recession and diminished cash flows. Higher debt levels could well rule out such a tactic in the future, as cash flows would go to debt service rather than to improving the company. For this reason, senior management could have seen its risk aversion increase, along with the risk aversion of the company's shareholders.
It is also worth noting that the company may simply have a preference for equity financing. Firms tend to make adjustments to their capital structure slowly (Huang & Ritter, 2009). Starbucks took out debt under the…[continue]
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