Capital Structure

The capital structure of a company is the way a company finances its assets. A company can finance its operations by either debt or equity or different combinations of these two sources. The capital structure of a company can have a majority of debt component or majority of equity, only one of the 2 components or an equal mix of both debt and equity. Each approach has its own set of advantages and disadvantages. There are various capital structure theories, trying to establish a relationship between the financial leverage of a company (the proportion of debt in the company’s capital structure) with its market value. One such approach is the Modigliani and Miller Approach.

This approach was devised by Modigliani and Miller during 1950s. The fundamentals of Modigliani and Miller Approach resemble that of Net Operating Income Approach. Modigliani and Miller advocate capital structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has lower debt component in the financing mix, it has no bearing on the value of a firm.

Modigliani and Miller Approach further states that the market value of a firm is affected by its future growth prospect apart from the risk involved in the investment. The theory stated that value of the firm is not dependent on the choice of capital structure or financing decision of the firm. If a company has high growth prospect, its market value is higher and hence its stock prices would be high. If investors do not see attractive growth prospects in a firm, the market value of that firm would not be that great.

ASSUMPTIONS OF MODIGLIANI AND MILLER APPROACH

• No taxes.
• Zero Cost for Buying and selling securities as well bankruptcy.
• Investor will have access to same information that a corporate would
• Investors would behave rationally.
• Same cost of borrowing for investors and companies.
• Debt financing does not affect companies EBIT.

Modigliani and Miller Approach indicates that value of a firm which has a mix of debt and equity is the same as the value of a firm which is wholly financed by equity if the operating profits and future prospects are same. That is, if an investor purchases shares of a leveraged firm, it would cost him the same as buying the shares of an unleveraged firm. Although this showed the theory introduced by the two M’s, they created a number of propositions. The two key propositions being that there is no taxation and there are no costs as we have seen above, thing that does make the theory irrelevant to the reality which in my opinion is a negative characteristic of their theory as it does not take into account real world’s elements.

Based on their “irrelevant” theory, further studies were conducted between them based on incorporated tax replacing some of their past theories, in line with the tax benefits resulting from loss, contrasting to equity, a rise in the level of gearing will affect WACC to drop leading to add up in the value of the firm.

The Trade-Off model, by Kraus & Litzenberger (1973) with an update on 2011 by Frank & Goyal (2011), claimed that the overlooked market limitations are tough or even impossible to overlook.The trade-off theory assumes that there are benefits to leverage within a capital structure up until the optimal capital structure is reached. The theory recognizes the tax benefit from interest payments. Studies suggest, however, that most companies have less leverage than this theory would suggest is optimal.

All in all, by comparing the two theories, the main difference between them is the potential benefit from debt in a capital structure. This benefit comes from tax benefit of the interest payments. Since the MM capital-structure irrelevance theory assumes no taxes, this benefit is not recognized, unlike the trade-off theory of leverage, where taxes and thus the tax benefit of interest payments are recognized. Generally I rely that an optimal level of gearing can be attained but this level is reliant on what industry an organisation operates. When the gearing is high will cause a financial distress costs, a rise in WACC and a reduction of the company’s value, leading to the company to lose a high level of power over the competitors, not in a position to invest and take financial steps in favour of their value.