Capital Structure and the Value of the Firm - Finance Essay Sample

A firm funds its general operations as well as growth (assets) via diverse sources of equity, debt, and hybrid securities finances like debentures, borrowings and bonds which create its capital structure (Saad, 2010). Some firms consider all-equity funds without debt whereas others would consider little equity with high debt. The choice that concerns with the mix of equity along with debt is known as financing decision.

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A company's financing mix of equity, debt or hybrid securities directly impacts its WACC. WACC aligns with the market value (MV) of equity and debt and thus variations in equity and debt causes variations in the WACC. Hence, change in the working structure (debt and equity) of a firm changes its WACC.

There exists a relation between the financing decision and the objective of maximizing the shareholders' wealth. This is because wealth presents the present value (PV) of forthcoming cash flows which have been calculated at the investors' needed profit making the market value to equalize the PV of the forthcoming cash flows which is calculated by its weighted average cost of capital.

MV = Future cash flows/WACC

A low WACC implies a high market value as demonstrated by the example below. When the WACC is 30%, the MV is 333 and when the WACC is 20%, the MV rises to 500. Thus, changing the capital structure to decrease weighted average cost of capital implies a progress in the MV and hence an increase in the shareholders' wealth

MV=100/0.3= 333, 100/0.2 = 500.

The pursuit for an optimum capital structure causes the pursuit for the minimal WACC. This is owed to the fact that a minimized WACC implies a maximized value or the firm as well as shareholders' wealth. Finance managers therefore have a duty to establish an optimum capital structure that shall realize the minimal WACC.

Equity-to-Debt Ratio and WACC

WACC is the weightings between the cost of equity as well as debt. All managers consider the cheaper of the two elements and to integrate more of the cheaper element and less of the expensive component to lower their average. Obviously, the debt's cost represents the cheapest compared to equity's cost. This is because, debt presents less risk compared to equity as the return desired to pay the debt is lower than that of equity shareholders. Additionally, debt is less risky as interest is always fixed and necessary in scope and it is paid before dividends as they are discretionary in nature. Also, debt has low risk considering liquidation as debtors are compensated in priority to shareholders (King & Santor, 2008). Further, debt is cheaper owing to the diverse company tax treatment of interest as well as dividends. Interest is derived prior to tax calculations meaning firms get tax reliefs on interest. Dividends on the other hand are derived following tax calculations implying lack of tax reliefs on dividends. Therefore, if the interest payment of a firm is $10m and the tax is 30 percent, the firm's cost is $7m.

Lowering the expensive equity and increasing the cheaper debt will lower WACC. But using more debt increases gearing whereby the interest paid out of profits shall increase prior to the paying of dividends to shareholders. This implies increased volatility of dividends since poor performance means the increased interest payments must be made. This also increases the financial risk to the shareholders who requires increased return to cover the advanced risk thereby increasing equity's cost and an increased WACC. Thus, the lowest WACC requires the replacement of the expensive equity with more debt. However, much debt causes WACC to increase since the financial risk, beta equity, gearing level and keg WACC increases. Finding which of the two components have a significant impact, whether it is the decline in the WACC owing to low-cost debt or increased WACC owing to increased financial risk requires the use capital structure theories.

Capital Structure Theories

Financing decisions are very difficult and present theories try to explain certain diversities as well as complexities of the financing alternatives. This paper shall integrate the traditional, Modigliani and Miller's no-tax and with-tax, and the Pecking Order theories.

Traditional Theory

The traditional theory states leverage is important and that through leverage, a company grows its returns on equity. Thus, increased leverage led to lower WACC since increase equity's cost is not in proportion to the growth in leverage. Thus, this perspective means the return on equity does not grow with the growth of a company's borrowing. Also, the WACC decreases first as the debt to equity ratio grows and then increase. This is owed to the fact that debt capital is cheaper compared to equity capital considering certain limits of debt. An optimum debt to equity ratio exists where the cost of capita is it at its lowest. Hence, this optimum ratio lowers the general capital's cost and increases an enterprise's value as demonstrated by figure 1 below.

Figure 1: Traditional View

Initially, WACC declines owing to the benefits of cheaper debt which outweighs the benefits of the increase in the cost of equity owing to the growing financial risk. The WACC goes on declining to the minimum point at the optimum capital structure which is represented by letter X. a continuation in gearing up implies a rise in WACC as the growth in financial risk /Keg is heavier than low-cost debt. At increased gearing, the risk of bankruptcy triggers the increase in the equity's cost curve to reach a sharper rate causing the debt's cost to rise. Any changed in gearing impacts the shareholders' wealth. An optimum gearing minimizes WACC and the general value of the firm becomes maximized. Thus, financial managers have a huge role to play by maintaining this level of gearing. As WACC is possibly U-shaped, the best gearing level does not exist thus diversity in optimal levels for different firms since it can only be estimated through trial and error.

Modigliani and Miller Theory

In 1958, Modigliani and Miller theorized capital structure by stating that without taxation, the costs of bankruptcy and systematic information, a company's WACC is not impacted at all gearing levels making the MV of a firm also static (Modigliani & Miller, 1958). Gearing up caused by increased cheaper debt is offset by increased WACC brought about by increased cost of capital owing to financial risk. Therefore, a firm can lower its WACC by changing its WACC as shown by figure 2 below.

Figure 2: no-tax model

Source: Modigliani & Miller (1958)

When leverage D/E grows, the K0 remains static. Equity's cost directly impacts the gearing. Increase in gearing increases the shareholders' financial risk thereby increasing Ke. Thus, the WACC, market value and shareholders' wealth remain static and not impacted by gearing since there is no optimum capital structure (Titman, 2002).

In 1963, Modigliani and Miller integrated taxation into their model thereby altering their earlier conclusion. They stated that debt grew cheaper owing to tax relies to cause debt's cost to decline from Kd to Kd(1-t) (Modigliani & Miller, 1963). This led to the decline in WACC which became significant compared to the growth in the WACC owing to the growth in the financial risk Ke. Therefore, WACC declines as gearing grows and firms should finance using debt as much as possible as the capital structure in this model is 99.99% (Fernandes, 2014) as shown by figure 3 below.

Figure 3: with-tax model

Source: Modigliani & Miller (1963)

Pecking Order Theory

This theory requires that firms follow a determined pecking order to allow them generate funds in the most suitable manner as there is no pursuit for an optimum capital structure. The order is that firms should utilize all their retained earnings available, and then debt follows and lastly the issue equity. This is because firms seek to lower issuing costs, lower the time as well as expenses of persuading investors to invest and the presence of asymmetrical as well as supposed information transmission that occurs as a consequence of management activities (Myers 1984).

Conclusion

Firms should minimize their WACC to maximize their shareholders' wealth by incorporating debt in the capital structure as it is low-cost compared to equity whereas preventing low gearing or increased gearing since it can experience bankruptcy agency as well as tax exhaustion. Firms should therefore, seek average gearing.

References

Fernandes, N. (2014). Finance for Executives: A Practical Guide for Managers. NPV Publishing.

King, M. R., & Santor, E. (2008). Family Values: Ownership Structure, Performance and Capital Structure of Canadian Firms. Journal of Banking and Financial, 32,2423-2432

Modigliani, F. & Miller, M. (1958). "The Cost of Capital, Corporation Finance and the Theory of Investment". American Economic Review, 48 (3): 261-297.

Modigliani, F. & Miller, M. (1963). "Corporate income taxes and the cost of capital: a correction". American Economic Review, 53 (3): 433-443.

Saad, N. M. (2010). Corporate Governance Compliance and the Effects to Capital Structure. International Journal of Economics and Financial, 2(1),105-114.

Titman, S. (2002). "The Modigliani and Miller Theorem and the Integration of Financial Markets". Financial Management, 31 (1): 101-115.