Capital Structure and Firm Performance

Arvin Ghosh

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351530163
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Capital structure theory is one of the most dynamic areas of finance and forms the basis for modern thinking on the capital structure of firms. Much controversy has resulted from comparisons of the theory of capital structure originally developed by Franco Modigliani and Merton Miller to real-world situations. Two competing theories have emerged over the years, the optimal capital structure theory and the pecking order theory.Arvin Ghosh begins with an overview of the controversies regarding capital structure theories, and then statistically tests both the optimal capital structure and pecking order theories. Using the binomial approach he analyzes the determinants of capital structure while discussing the role of market power in determining capital structure decisions. Ghosh probes the questions of new stock offerings and stockholders' returns, and analyzes capital structure and executive compensation. He then looks into debt financing ownership structure, and the controversal relationship between capital structure and firm profitability. Finally, he discusses the latest developments in the field of capital structure.A concise overview of a major issue in business economics and finance, this volume provides a fuller understanding of capital structure influence on the financial performance of firms, and will certainly stimulate further debate. While hundreds of scholarly articles have been written on the subject this is the first book to test competing theories against measurements of firms' performance and their underlying capital structure.

1 Introduction Capital Structure Theory: An Overview

Modern capital structure theory began with the path-breaking article of Professors Modigliani and Miller in 1958. Before that we had some vague ideas about the effects of debt and equity issues on capital structure, but no systematic and analytical framework on the subject. Shortly after the Modigliani-Miller article, David Durant had published the costs of debt and equity funds for business in Ezra Solomon’s The Management of Corporate Capital (ed., 1959). There he introduced two approaches: the Net Income approach and the Net Operating Income approach. In the Net Income approach he showed that a firm can lower its cost of capital and increase its valuation continually with the use of debt funds. But his critical assumption that debt does not become increasingly risky in the minds of investors and creditors as the degree of leverage is increased is a rather unrealistic assumption, to say the least.

Similarly, in his Net Operating Income approach, Durant has assumed that the overall capitalization rate of the firm is constant for all degrees of leverage—an increase in the use of supposedly “cheaper” debt is exactly offset by the increase in the equity-capitalization rate. Thus the weighted average cost of capital composed of debt and equity remain unchanged for all degrees of leverage. According to the Net Operating Income approach, the real cost of debt and the real cost of equity are the same, and there is no optimal capital structure.

Durant’s approaches to capital structure theory had been purely definitional and had no behavioral significance. That was provided by Modigliani and Miller’s 1958 article which gave a rigorous proof of the independence of firm valuation and the cost of capital in a firm’s capital structure.

Modigliani-Miller Theorems

In their seminal article, Modigliani and Miller (henceforth MM) proposed that changes in capital structure has no long-term effect on the value of the firm and that the value of the firm is independent of its bond/stock financing mix. MM built their model on the following main assumptions: (1) the capital market is perfect; (2) there are no taxes; (3) there are no bankruptcy and transaction costs; (4) investors can borrow at the same rate as corporations, and (5) all investors have the same information as management have about the firm’s future investment opportunities.

Modigliani and Miller posited their arguments as Proposition I and Proposition II. Simply stated:

Proposition I:

Vj=Dj+Ej=Xj/Pk..............................⁢(1A)

or, alternatively:

Pk=Xj/Vkforanyfirmjinclassk..............................⁢(1B)

Where Vj measures the value of firm j (j = 1,2 ...), D stands for the value of debt, E stands for the value of equity capital, X is the net return of firm J before interest payments (i.e., EBIT), and P is the cost of equity capital for an all-equity firm (i.e., the rate of capitalization), which is constant for all firms in the given class. Proposition I means “the market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate P appropriate to its class.”

Modigliani and Miller’s Proposition II states:

Proposition II:

ij−=P+(P−r)Dj/Ej..............................⁢(2)

where r is the interest rate on debt. Proposition II simply means, “the market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate P appropriate to its class, plus a premium related to financial risk equal to the debt-to-equity ratio times the spread between P and r.”

The two MM “invariance” propositions state that the increase in debt in capital structure will not enhance the value of the firm because the advantage of cheaper debt will be exactly offset by the increase in the cost of equity. Thus, according to Modigliani and Miller, in a world without taxes, both the value of a firm and its cost of capital are unaffected by its capital structure. As proof, MM provided an arbitrage proof to support their propositions. Simply stated, they showed that, under their assumptions, if the two companies differ principally (1) in the way they are financed, and (2) in their total market value, then investors would sell their shares to the overvalued firms, and with those proceeds buy shares of the undervalued firms, and would continue the process until the two companies would have exactly the same market value.

It is to be noted that V_j = X_j/P_k rests on the fact that the net return X_j is a perpetually constant value. In his criticism, Durant (1959) has observed, “indeed, MM’s approach to the cost of capital, as the ratio of current earnings to market price, is essentially static,” and he had further observed that, “the concept of an equilibrium return class, derived from the notion of static equilibrium, is not adequate to a highly dynamic economy.” It is to be noted that in their correction paper (1963), MM had alluded that X can be perpetually constant in a steady-state equilibrium, and therefore, this criticism is moot.

Stiglitz (1969) and Altman (1984) posited that more debt would increase stockholders’ and creditors’ risk in a firm. Both effects would put an effective limit to a firm’s debt-to-equity ratio. But the main criticisms of the MM theorems were their unrealistic assumptions. Realizing this, MM in their 1963 article relaxed the most important objection, i.e., lack of income taxes, particularly corporate taxes. With corporate income taxes, MM concluded that leverage will increase a firm’s value because interest payment is tax-deductible, while the dividend income from owning stocks is not. To them, the difference between the levered firm and unlevered firm is that for the former, we have to include any “side effects,” such as tax shield:

VL=VU+TD..............................⁢(3)

Here Magginson (1997 explained the situation with a simple example of two firms, U and L, with a market value of assets worth $100,000, where firm U financed its assets fully with equity and firm L used 50 percent equity and 50 percent debt, comprising a debt-to-total capital ratio of 50 percent. Each firm generates $1000,000 in net operating income each year, all of which goes to the shareholders of firm U. Firm L, however, must pay $30,000 in interest on its debt ($500,000 with a 6 percent interest rate), leaving $70,000 for firm L’s shareholders. Now, if we introduce a tax on corporate profit at a rate of 35 percent (T = 0.35), this will reduce $350,000 in the market value of the all-equity company, firm U. For firm L, we can compute the present value of the interest tax shields to be 0.35 x $500,000 = $175,000 (this is equal to the tax rate times the amount of interest paid T x rD). Hence, if a 50 percent debt-to-capital ratio firm increases its value by $175,000 over that of an otherwise equivalent unlevered firm, and each additional $1 debt increases firm value by 35 cents (corporate tax rate), then the optimal debt-asset ratio should be 100 percent! This is the conclusion we can deduce from the MM 1963 article, which initially made the acceptance of their position less appealing.

The Miller Model

Fourteen years after their correction paper (1963), Professor Miller (1977) alone had introduced the personal income tax to the MM theorems, along with the corporate income tax added earlier. He provided the following formula for the gains from using leverage, G_L, for the stockholders, in a firm holding real assets.

Miller has argued that firms in the aggregate would issue debt and equity in such a way that the before-tax returns on corporate securities and the personal tax rates of the investors would adjust continuously until an equilibrium is obtained. At the equilibrium, (1 ‒ T_PS) would be equal to (1 ‒ T_C)(1 ‒ T_PS), and therefore, the tax advantage of issuing debt would be exactly offset by personal taxation. Thus, capital structure is again irrelevant to a firm’s value or its cost of capital. Any situation in which the owners of corporations could increase their wealth by substituting debt for equity (or vice versa) would be incompatible with market equilibrium.

Some of the criticisms of both the MM theorems and the Miller model are that they assume corporate and personal leverage to be perfect substitutes. But in reality they are not, because if a person invests in corporate stocks, he or she will have limited liability while for personal investments he or she will face unlimited liability, even using the “homemade” leverage. This additional risk may retard individuals from using arbitrage activities, so that the equilibrium conditions MM have posited would be different in reality. Also, institutional investors face many governmental restrictions that would inhibit their ability to use homemade leverage.

Second, if an unlevered firm faces financial losses, it would cut dividends, rather than taking the shelter of the bankruptcy court. If the dividend is cut, then the individuals using homemade leverage will have less money. This will put them in greater financial distress than the stockholders of levered firms.

Third, MM argue that both corporations and individuals may borrow at the same rate. But in reality, corporations generally borrow at a “privilaged” (i.e. lower) rate, while most of the individuals pay a higher rate than corporations.

Fourth, Miller assumes that the tax benefits from corporate debt would be the same for firms of all sizes. But again, in reality larger firms gain more from increased leverage than smaller, financially burdened firms. Also, larger firms may have other non-debt tax shields such as depletion allowances, higher depreciation, and larger pension plan contributions, that smaller firms may not have.

Finally, MM, and Miller especially, do not take into account the effect of brokerage fees and transaction costs that in reality, most of the individuals as well as corporations have to face. They do not discuss the costs of financial distress, agency costs, costs associated with information asymmetry and so forth. While the Modigliani-Miller model is the first step toward constructing a capital structure theory, other factors have to be taken into account to make it a guide to corporate decision making.

Optimal Capital Structure Theory

The introduction of corporate and personal income taxes to the Modigliani-Miller theorems still leaves out other imperfections in the capital market such as bankruptcy costs and financial distress. The famous article by DeAngelo and Masulis (1980) on optimal capital structure, incorporates such bankruptcy costs explicitly. In their model, regardless of whether default costs are large or small, the market’s relative prices of debt and equity will adjust in such a way that the net (corporate and marginal personal) tax advantage of debt is of the same magnitude as expected marginal default costs. The relative prices will equilibrate in this way to induce firms to supply the proper quantities of debt and equity to satisfy the demand of investors. In particular, the presence of non-debt tax shields and/or default costs implies optimum leverage ratio for each firm.

The bankruptcy costs of firms with increasing leverage can better be expressed by the costs associated with increasing financial distress. But as Gilson, John, and Lang (1990) have pointed out, costs associated with bankruptcy and financial distress will discourage the use of financial leverage only if (1) financial distress would reduce market demand for a firm’s products or increase its cost of production; (2) financial distress would give the firm’s managers operating or financial incentives to act in such a way as to reduce the value of the firm; or (3) entering bankruptcy would impose deadweight costs to the firm involved.

A firm’s asset characteristics also will influence its use of the degree of leverage in its capital structure, i.e., costs of distress vary with types of assets. Companies whose assets are mostly tangible and have a well-developed secondary market will have less fear of fina...

Table of contents

• Cover Page
• Half title
• Title Page
• copyright
• Dedication
• Contents
• Preface
• 1 Introduction Capital Structure Theory: An Overview
• 2 Capital Structure: Tests of Optimality vs. Pecking Order Theory
• 3 Tests of Capital Structure Theory: A Binomial Approach
• 4 The Determinants of Capital Structure
• 5 Capital Structure and Market Power
• 6 New Stock Offerings and Stockholders’ Returns
• 7 Capital Structure and Executive Compensation
• 8 Debt Financing and Ownership Structure
• 9 Capital Structure and Firm Profitability: NYSE and NASDAQ Firms
• 10 Capital Structure and Firm Profitability: NYSE and AMEX Firms
• 11 Summary and Conclusions
• Bibliography
• Index