Capital structure and its impact on firm value

Capital structure theories and basic concepts

Duong NguyenSchool of Economics

I. Introduction:

The relationship between capital structure and firm value has been the subject for researching for long time, both theoretical and empirical. However, so far, there is no certainty about the overall effects of debt on firm value. This paper aims to explain the basic concepts of firm capital structure such as leverage, debt, equity, cost of capital, and impacts on firm value. Due to the limit of understanding about theories and empirical evidences, for now, the paper will only provide the concepts and two theories about capital structure that are most prominently examined including the traditional theories and M&M theorem of capital structure. However, that does not mean only these two theories will be used for research in the updated version of the paper. In the updated version of the paper, there will be more theories explained. The main objective of the paper is to explain the capital structure of the firm and present theories about capital structure that could have some impacts on firm value.

II. Basic terminology

Before going into further explaining the capital structure concepts of the firm, the paper will discuss briefly about the basic terminology in terms of risk and return such as cost of capital (WACC), cost of debts, cost of equity, leverage, financial ratios.

Market value of the firm (V) is equal to the market value of equity (E) plus the market value of debts (D).

Financial leverage: the ratio between debts and equity

A firm’s basic resource is the stream of cash flows produced by its assets. When the firm is financed entirely by common stock, all those cash flows belong to stockholders. When the firm issues both debt and equity securities, it splits the cash flows into two streams, a relatively safe stream that goes to the debtholders and a riskier stream goes to shareholders (Allen, 2011). Therefore, it leads to the concept of cost of equity, cost debts.

Cost of Equity – also called Capital Asset Pricing Model. Usually, there are three main sources of investing including government bonds, stock market, and corporations bonds. For example, from the point of view of investors, they can buy government bonds and get a risk free rate of 2% a year, they can either invest in the general stock market of the country which has the systematic risk. The stock market with systematic risk has to offer a higher rate of return –such as 5%, since the general stock market possesses higher risks in business compared to government bonds, the stock market has to offer a higher rate of return in order to have the equal level of attractiveness with the government. Similar rules applied to corporate shares, in order to attract the investors’ attention, the firms have to offer a certain amount of rate of return for the shares so that investors will put money into the firms’ business. And the CAPM model is used to calculate the percentage which the firm will set:

• Re= Rf + β(Rm –Rf )

Rm: the rate of return of medium risk investment

Rf rate of return of risk-free investment such as government bonds

Β: the number to describe the volatility of the investment compared to a commonly used system. The higher the volatility of the firm, the higher risks and higher profits in return. For example, if the Google.Inc shares are said to be 20% more volatile than the common stock, it means that Β = 1.2; and when the general price of stock market goes up/down by 10%, the Google.Inc shares will go up/down by 12%.

Cost of debts is the cost of borrowing money to run the business. Company can benefit from tax reductions from interest expenses which will be deduced from net iincome. The net cost of debt is the interest paid less the tax savings:

• Cost of debts = (Rd) (1-Tc)

Cost of debt is calculated by using the market rate that the company is currently paying on its debts. There are tax deductions available on interest paid which benefits the company tax shield. Because of this, the net cost of companies’ debt is the amount of interest they are paying, minus the amount they have saved taxes due to the tax-deductible interest payment.

Weighted Average Cost of Capital: Capital can either get from owner’s money (equity) or from borrowing bank (debt). Therefore, the cost of capital depends on where the money comes from. If the money is raised only from the bank, then the cost of capital is the same as the interest rate of borrowing money from banks or the cost of debts, if the money only comes from investors then the cost of capital is viewed equally same as the expected return of investors – or cost of equity. What if the capital is combination of both debts and equity, will the cost of capital be equal to loan interest rate or the average expected return of investors? The WACC is used to calculate the exact cost of capital percentage. In other words, WACC represents the overall cost of capital for a company, incorporating the cost equity, debt and preference share capital, weighted according to the proportions of each source of finance.

WACC=

= DV (Rd) (1-Tc) +

EV (Re)

– V= D+E

– D/V: percentage of capital by Debt

– E/V: percentage of capital by Equity

– Rd: interest rate of debts

– Re: expected rate of return for shareholders

Tc: tax rate

D/V: leverage ratio

This equation is very important in terms of explaining different theories of capital structure.

III. What is capital structure of a firm?

Capital structure is the way a company finances itself by combining long term debt, specific short term debt, and equity. It shows how a company finances overall operations by using different source of funds. Capital structure of firms varies with the sizes, type, and some other characteristics such as age of the company, asset structure, profitability, growth, risk and liquidity.

The purpose of managing capital structure is to mix the financial sources in order to maximize the wealth of shareholders and minimize the company cost of capital – both of the terms will be explained later in the essay. Therefore, one of the financial manager’s responsibility is to manage and decide the optimal capital structure. The decision on capital structure is very critical because it may affect the company values and it involves the tradeoff between risks and returns. The finance source of firms, as it was mentioned above, comes from equity and debts. Too much debts will increase the company’s risk and lead to a decrease in stock price and increase in the expected return of stock price (Source).

What are the available theories for capital structure? There are several theories explaining the decision on capital structure of the firm, including the following ones.

IV. Literature review:

The traditional approach:

According to Ehrhardt and Bringham (Ehrhardt, 2003), the value of the firm based on present value of all expected future cash flows to be generated by assets, discounted at the company’s weighted average cost of capital (WACC). From this, it can be seen that the WACC has a direct impact on the value of a business (We & Dhanraj). The choice between debt and equity is to find the optimal structure that will maximize the shareholders wealth. WACC is used to define the firm’s value by discounting future cash flows. Minimizing WACC of any firm will maximize the value of the firm (Messbacher, 2004). That led to the traditional approach of economist about capital structure.

The traditional approach has several assumptions as following:

1. The rate of interest on debt remains constant for a certain period and thereafter with increase in leverage, it increases

2. The expected rate of return by equity shareholders remains constant or increase gradually. As the debt level increases, the shareholders perceive financial risks and then posed a higher expected rate of returns

3. As a result of the combination of debt and equity, the WACC first decreases and then increases. The lowest point on the WACC curve is optimal capital structure.

The traditional theory states there is a certain level of combination between equity and debt at which the market value of the company is maximized. Considering that debt level should exist only up to a specific point that the firm value of firm is highest, beyond such level of debt, any increase in leverage ratio will cause a reduction in firm’s value. To be more specific, since the firm’s capital is raised by both equity and debt, there is an optimum value of debt to equity ratio that the WACC is minimized and the value of the firm is highest. Once the firm crosses that value of debt to equity ratio, the WACC will increase and the market value of firm will start going downwards.

The below graph will visually illustrates the traditional theory of capital structure.

To be clearer, let’s consider an example about a company with following data: (Efinancemanagement, n.d.)

Proportion of debt 20%Proportion of equity 80%

Cost of debt 10%Cost of equity 13%WACC D

V (Rd) (1-Tc) + EV (Re) = (20%*10%) +(80%*13*)

= 12.4%

Re

WACC

Rd

Cost of capital

Optimal capital structure

Debt to equity ratio

Now, assume the company increases its financial leverage and as a result, the debt is 30% and equity is 70%. The cost of debt and equity also rise because of the higher exposure to financial risks. And the new WACC is calculated as following:

Proportion of debt 30%Proportion of equity 70%Cost of debt 11%Cost of equity 14%WACC D

V (Rd) (1-Tc) + EV (Re)

= (30% x 11%) + (70 x14%)= 11.9%

As it could be seen, the increase in debt to equity ratio, the weighted average cost of capital is reduced even though the cost of debt and cost of equity increase. The reason behind this result is that debt is a cheaper source of finance comparing to equity.

Now assume that the firm increases its financial leverage further to debt 50% and equity 50%, the cost of debt and the cost of equity raises further.

Proportion of debt 50Proportion of equity 50Cost of debt 12%Cost of equity 15%WACC

= DV (Rd) (1-Tc) +

EV (Re)

= 13.5%

As observed, with the increase in the financial leverage of the company to the current level, the average cost of capital increases. It illustrates that increasing the debt reduces WACC, but only to a certain level. After that level is crossed, the higher debt level increases WACC and reduces the market value of the firm. However, the problem with traditional theory of capital structure is that there is no scientific base to provide how much the cost of equity or cost of debt should increase to reach the optimum point

Modigliani and Miller theorem: Franco Modigliani and Merton Miller developed a theory that helps to understand how taxes and financial distress affect a company’s capital structure decision. The M&M theorem proposes examination about leverage, taxes, financial distress, agency costs, and asymmetric information’s impact on firm cost of equity, cost of capital, and optimal capital structure.

Modigliani and Miller (Modigliani&Miller, 1958) released their first conclusion about the relevance between capital structure of the firm and its value.

Under the assumption that

1. Investors agree on the expected cash flows from a given investment. This means that all investors have same expectations from future cash flows.

2. There is no corporate taxes applied. 3. Bonds and shares of stock are traded in perfect capital market. This means that there are no

transaction costs, no taxes, and no bankruptcy costs and everyone has the same information. 4. Investors can borrow and lend at the risk-free rate, which means that it does not matter whether the

firm or investors borrow or lend, it is all done with the same rate5. Managers always act to maximize the shareholder wealth, there is no waste funds, all funds are put

to productive use.

Under the perfect market, MM argues that the firms have same opportunities of investment, therefore, the firm should have the same expected EBIT every year. The net present value of a firm should be based on the net present value of the expected cash flows, not based on the capital structure. In other words, the market value of the firm is independent of the capital structure. Thus, it could be drawn from here that if the firms have same EBIT and same market value, they will have the same WACC in any degree of financial leverage.

Re

WACC

Rd

Cost of capital

D/E

In 1963, Modigliani and Miller releaser another theorem, regarding the imperfect market and corporate taxes included. They argued that the use of financial leverage would increase the firm’s value. Since the interest payment is deducted from the EBIT, thus, the debt will provide firm with tax shields. And the value of levered firm will equal the value of unlevered firm plus the tax shields. VL= VU + Tc . D

VL: value of levered firm

Vu: value of unlevered firm

Tc: corporate tax rate

D: amount of debt

TcD: tax shield.

Thus, in general, according to the M&M theorem in 1963, the capital structure could have some impacts on firm value. The higher amount of debt firm has, the higher value of firm can be. And the optimal point for firm value is when firm is 100% levered.

V. Conclusion:

Throughout the paper, there are explanations for cost of capital and other cost associated. It provides the overview of the concepts and how these strands come together to create the cost of capital. It is clear that WACC lies at the heart of every firm decision, linking together the key areas of finance decisions to measure how much a business/firm is worth. What is not clear is how the WACC is affected for changes in business, and how the changes in WACC create the change in firm value. Minimum WACC will create the maximum values for firm. Such uncertainties are partly covered by traditional theory which says that the WACC is at minimum at some point of ratio between debt and equity, the M&M theorem say that the higher amount of debt firm has, the higher value of firm can be. This paper is only the starting point of further research, more examinations and explanations will be provided.

Works CitedAllen. (2011). Does Debt Policy Matter. In Allen, Principles of Corporate Finance, 10th e (p. 418). McGrill.

Efinancemanagement. (n.d.). EFinanceManagement. Retrieved from Capital Structure Theory-Traditional Approach.

Ehrhardt, B. (2003). Corporate Finance, A focused approach. Thomson.

Messbacher. (2004). Does capital structure influence firms value? University of Ulster.

Modigliani&Miller. (1958). The cost of capital, corporate finance, and the theory of investment. American Economics Review 48, 261-297.

We, J. v., & Dhanraj, K. (n.d.). Unlocking shareholder value by moving closer to the optimal capital. Accountancy SA, Accounting and Tax Predictions, 28-32.