Capital Structure Notes

Executive Summary:
In a perfect world, capital structure does not matter.  (See MM).  However, as we relax the assumptions capital structre seems to matter.  However, to say that we have a sound grasp on what an optimal capital structure looks like is overly optimistic.

Nobel prize winners:  Modigliani and Miller  (MM)  (Note: while some beleive that Eminem named himself after MM, there has yet to be proof)

MM: in a perfect world, nothing in finance matters.  

If we ignore costs of issuing securities and if no transaction costs, then what we issue does not matter….reason?  Investors can undo anything we do.

    Modigliani and Miller (MM)  Prop 1:

 pizza analogy…size of pie is what matters!  (See Yogi Berra!)

Suppose you own 1% equity in an Unleveraged firm, the firm then leverages up…(suppose stock buyback financed with Debt)…what can you do to get back to original position?)

Thus, if there are no transactions costs (and therefore no informational advantages, no taxes, and no impact from financing on operations)
    then any capital structure is as good as any other.  Therefore, for capital structre to matter, one or more of teh assumptions must not hold.


The world is not a perfect place, and there are various transactions costs etc.  So what does capital structure decision depend on?

We will now relax the assumptions of the MM model, one at a time and see its impact on an optimal capital structure.


CETERIS PARIBUS:    

firm value =  discounted cash flows....where the discount rate is the WACC.  So the capital structure that minimizes WACC will maximize value of the firm.


But in reality we don’t hold everything else constant.  (but be patient)

MM I:  as you increase debt, required return on equity increases.
(1958)

First lets relax debt assumption.  SPecifically we will allow firms to deduct interest.

 
            MM prop 2
(1963)
Value of a levered firm = value of unlevered firm + TD


However, as we will see, this overstates the true benefit of debt for a number of reasons.  

Miller 1976 proposed that the 1963 paper overstated benefits of debt.  Why?  
•    Equity returns are preferred by shareholders on a tax basis.
•    Why?  Investors can "time" returns to avoid taxes, capital gains rate lower, etc.  
•    Thus debt while having tax advantages to the firm, has tax disadvantages to the investor.  This lowers the benefit of debt.


Insert formulaRelative advantage of debt )


Maybe easier to understand  Easiest to understand is that as debt levels grow, the costs of financial distress rise.  That is, the capital structure of a firm begins to impact the operations of the firm.  (the RHS effects the LHS of balance sheet)

    so value of a firm = value of unlevered firm + tax benefits -Fin Distress costs

        thus we have to look at where this risk (cost of financial distress) is great....for these firms, they will be worth more with less debt
What are financial distress costs? Bankruptcy Costs
•    A subset of Financial distress costs
•    Those costs stemming from Bankruptcy
•    Direct and Indirect
•    Warner (1977) suggests the Direct Costs are low
•    Generally direct costs are not high enough to explain low debt levels
•    Indirect Bankruptcy costs are higher
Where is the cost of financial distress greatest?

•    Credence goods
•    Specialized assets
•    High information asymmetries
•    Intangible assets

Thus predictions on capital structure
Assets in place vs. growth options
•    We expect more debt for firms with assets in place. (Smith-Barclay)  
•    Why?   Assets make better collateral, less opportunity for taking advantage of BH, less risk of passing up positive growth opportunities, etc.
•    Lower debt at high growth firms
With debt the firm may pass up positive NPV projects, assets make better collateral, etc.  
Further types of assets matter.  More specialized assets (those that are only valuable to your firm) make poor collateral.  Thus if you have highly specialized assets you would likely have lower debt.  

Intanglible assets:
More intanglibel assets : lower debt
What is often firm's most valuable asset?  People.
  Using people as collateral illegal (1863).  So firms with high percentage of value tied up in people assets, will have lower debt.

Taxes
    Internationally it does appear to matter.  That is firms do issue more debt in countries with higher taxes.  However, itis often hard to determine looking domestically.  Some newer reseach (GAlpin 2003) in fact finds the reverse to be true.  


One can definitely see this relationship in an industry analysis. Some industries have high debt/equity levels (steel) others (software manufacturers etc) have very low levels of debt.  However, there is often a great deal of firm specific variation.

Publicly traded  vs. Privately held firms
While all of this is true for both private and public firms, there are some differences:

•    Closely held firms have great variability in the capital structures.  As the owners (often managers as well) have undiversified portfolios, they tend to be more risk averse which would lead to less debt, BUT also may not want equity issue (for control reasons) thus they often finance extensively with debt.
•    Smaller firms do not have same financing options available (example Commercial Paper)

Conclusion
Overall there is little evidence of a single "optimal" capital structure.  More similarities within an industry, but even then great differences can exist.  Firms with lower financial distress costs will have more debt.