Capital Budgeting & Capital Structure

Corporate finance – Case study

Capital budgeting & Capital Structure

Question 3

The theory that the teacher in the OLD School of Business and Economics was most likely referring to the Capital Structure theory, invented by Modigliani and Miller. This theory states that in a situation where there are perfect capital markets, the capital structure of a firm does not influence its value. This value should instead be determined by the cash flows generated by the firm. The only thing that will be influenced by any changes in the capital structure is how much of the total cash flows (which can also be envisioned as a pie) goes to debt holders and how much goes to shareholders. In other words, the way the pie is divided changes but the size of the pie remains the same.

We should remark here that this theory only works when we assume that we are in a situation of perfect capital markets. This situation only manifests itself if the following conditions are satisfied:

• Market prices are equal to the present value of the future cash flows of the securities, and are equal for all investors, no matter their kind.
• There are no obstructions present in security trading. In other words, there are no transaction costs, no issuance costs and no taxes of any kind.
• Cash flows resulting from investments of a firm, are not influenced by the financial decisions of that firm. Those decisions also don’t reveal new information about the investments or their cash flows.

It should now be clear that there are several things present in the real world, that are missing from the world of Modigliani and Miller. Things such as corporate or personal taxes, costs of financial distress, transaction costs and the presence of asymmetric information about a firm’s investments (meaning that the management of a firm will know more about its investment than an investor will).

In an effort to move closer to reality we can relax the “no tax” condition. This will give debt an advantage over equity because interest payments are tax exempt whereas dividends and retained earnings are not. Therefore in this situation value is created if a firm finances its investments with more debt relative to equity because the more debt is used, the less value of the firm goes to the government and the more goes to the debt holders and the equity holders. Again the value of the pie or organization does not change but the division of it does. The value that debt creates is the reduction in the tax burden of an organization or otherwise called the tax shield. This is why the teacher in the OLD School of Business and Economics stated that the more debt is used in the financing of the firm, the more value is created.

If this were true however, all firms would be 100% financed with debt and this is not the case in the real world. This is because the other assumptions and conditions of the Modigliani and Miller theory are not yet relaxed and are not realistic. Take the financial costs of distress for example. These costs are created when a firm can no longer pay back its debt holders and therefore finds itself in a situation of financial distress. This costs range from direct bankruptcy costs (such as lost time, advisory fees, legal expenses, etc.) to indirect costs of financial distress (like an inability to raise funds to undertake new investments, taking inefficient investment decisions in an effort to save the firm, etc). It should be clear that the more debt a firm holds, the bigger the probability is that a situation of financial distress occurs and the more likely it is that the firm incurs these costs. There are other factors that increase the probability of financial distress: a high volatility of cash flows and a potential for this volatility to increase further, a high need for external funds for investments, a high probability of competitive threats if the organization is short on cash, the fact that customers care about the organization being in distress and finally the high difficult in selling the assets of the firm. In any of these situations a firm will likely choose to finance with equity over debt in an effort to avoid the costs of financial distress.