Capital Structure Theories: Debt, Equity, and Firm Value

Introduction to Capital Structure

The capital structure of a company is broadly influenced by practical considerations such as managerial shareholdings, corporate strategy, and taxation. The investment strategies firms pursue require managers to explore methods of financing new investment. Managers generally exercise three main preferences: the utilization of retained earnings, borrowing through debt instruments, or the issuance of new shares. Retained earnings, debt, and equity therefore constitute the three primary ingredients of a firm's capital structure. The first and third ingredients represent ownership by shareholders, while the second represents ownership by debt holders.

The financing policy, capital structure, and firm ownership are inextricably linked. Together, they represent the ways in which economic agents form and alter their asset acquisition behavior through firms and capital markets, and how they influence their income levels and returns to asset holdings in the form of capital gains, dividends, or direct remuneration (Prasad, Green, and Murinde, 2001).

Capital structure indicates the relative mix of long-term debt and equity in a company's capital. Most theories striving to explain capital structure movements concentrate on the value of debt as a source of tax shield for firms. Unlike dividend payments, the interest paid on long-term debt is normally deductible for corporation tax purposes. The presence of long-term debt on the balance sheet therefore generates a valuable interest-tax shield for the company. The firm-specific importance of such a tax shield increases with the firm's marginal tax rate, the interest payable on long-term debt, and the stimulation levels inherent in the firm. Since interest rates and marginal tax rates are exogenous elements, the most direct method of adding to the value of the tax shield is to increase gearing. However, this strategy also exposes the firm to enhanced levels of financial risk and the agency costs of debt. The three primary theories that attempt to explain capital structure in this direction are the static trade-off, pecking order, and signaling theories (O'Sullivan, n.d.).

The Modigliani and Miller Theorem

The basis of modern discussions on corporate capital structure stems from Modigliani and Miller. Their analysis challenged the traditional view of corporate finance, which concerns itself with the relationship between the weighted average cost of capital — the weighted sum of debt and equity costs — and the minimum overall return required on existing operations to satisfy all stakeholders. The traditional view begins with the hypothesis that debt is normally cheaper than equity as a means of investment finance. A firm therefore strives to increase its debt relative to equity in order to reduce its average cost of capital. However, this process cannot continue indefinitely, since higher levels of debt increase the probability of default, prompting both debt holders and shareholders to demand greater returns on their capital (Prasad, Green, and Murinde, 2001).

Contrary to the traditional view, the Modigliani and Miller theorem begins with the hypothesis of a perfect capital market and employs a simple arbitrage mechanism to explore three propositions relating to the value of the firm, the behavior of the equity cost of capital, and the cutoff rate for new investment. Proposition I states that the market value of any firm is independent of its capital structure, and the same holds for the average cost of capital. Proposition II states that the rate of return required by shareholders increases proportionately with the increase of a firm's debt-equity ratio — meaning the cost of equity rises so as to exactly counteract any benefit derived from the use of cheaper debt. Proposition III indicates that a firm will only undertake investments whose returns are at least equal to the firm's weighted average cost of capital, which is the minimum overall return required on existing operations to meet the demands of all stakeholders.

Two major differences exist between the traditional view and the Modigliani and Miller theory. First, in the traditional view the value and cost of capital of a firm are interrelated with its capital structure, while Modigliani and Miller represent them as independent of one another. Second, Proposition II of the Modigliani and Miller theorem indicates a linear relationship between shareholder rate of return and firm leverage. As a result, at low levels of debt the cost of equity increases faster under the Modigliani and Miller theorem than under the traditional view. At higher levels of debt, the default risk increases and the cost of equity rises at a faster rate under the traditional view than under Proposition II of the Modigliani and Miller theorem (Prasad, Green, and Murinde, 2001).

Modigliani and Miller, assuming an efficient market environment with no taxes and no bankruptcy costs, conclude that the value of a firm is invariant to its capital structure. This theory of irrelevance has since been modified and expanded so that capital structure is shown to be affected by deviations from perfect markets — such as taxes and bankruptcy costs — as well as the real-world costs connected to agency problems, asymmetric information, and moral hazard. Modern theories of capital structure therefore account for such real-world costs and frictions, incorporating the trade-off theory, agency cost theory, pecking order theory, and asymmetric information theory. Empirical analyses by Titman and Wessels, Harris and Raviv, and Frank and Goyal affirm the significance of firm-level determinants of capital structure. General evidence indicates that a firm's leverage level is linked to its size, investment opportunities, profitability, fixed assets, tax rates, bankruptcy probability, dividend policy, and industry average leverage (Aggarwal and Kyaw, 2004).

Trade-Off Theory and Pecking Order Theory

The trade-off theory of capital structure envisages the achievement of an optimal debt ratio through a trade-off between the costs and benefits of debt financing. Firms regard this ratio as a target debt ratio, since achieving it is expected to maximize the market value of the corporation. Myers's formulation of this theory holds that firms must adapt their capital structure over time to attain the target ratio. However, such adaptation requires both time and money. It is therefore possible that the present debt ratio temporarily differs from the target ratio. Accordingly, the trade-off theory envisions firms striving to maximize their market value through this process (Pauwels, 2001).

Contrary to this, the free cash flow theory presumes that there exist widely divergent interests between shareholders and managers. This implies that managerial decisions do not always maximize the market value of the firm. Free cash flow refers to the balance of money remaining after all projects with positive net present values have been financed. Debt reduces the agency costs of free cash flow by decreasing the cash available for spending at managers' discretionary authority. Debt also constrains managerial decision-making, since a firm is obliged to pay interest and repay principal on schedule. There is always a risk that a firm may be unable to meet these obligations, and this risk provides managers with an incentive to lead and organize the firm more effectively (Pauwels, 2001).

Myers also propounded the pecking order theory alongside the static trade-off theory. This theory holds that firms prefer to select a financing mode in a specific order when funding projects. The order of investment resources is shaped by difficulties arising from asymmetric information between managers and prospective investors. The theory rests on several key assumptions: firms prefer internal modes of financing projects; firms adapt their target dividend payout ratio to prevailing investment opportunities; a firm's internal resources vary as a result of unforeseen fluctuations in profits; and when a firm requires additional resources, it prefers secured modes of obtaining funds — meaning firms prefer debt over convertible stocks and common stocks.

The conclusions of the pecking order theory are that a firm does not require a specific target debt ratio. The target ratio is instead influenced by how a firm has financed its projects in the past. The theory also attributes significant importance to the costs of asymmetric information and the costs of bankruptcy. While these costs exist, a firm does not always choose to finance projects with a positive net present value. The decision about how to finance a project is not determined solely by whether the net present value is positive, but by the mode in which the firm is able to access financing (Pauwels, 2001).

Conclusion: Capital Structure as an Ongoing Puzzle

The studies made in the sphere of the relationship between taxes and corporate financing decisions — particularly with reference to the Italian Tax Reform of 1997 — reveal a close relationship between corporate income tax and corporate financing decisions. During the period of the reform, companies appear to have increased their equity as intended by the Tax Reforms. Furthermore, variation in taxes paid by companies is statistically significant in explaining debt variation even before the Tax Reform took effect, while it is not significant in explaining debt policy after the Tax Reform.