Capital Structure Theory

Capital Structure Theory

        A firm must choose its mixture of debt and equity financing. This will be their capital structure. The firm will strive to be as close to their target capital structure as possible so the intrinsic value of the firm can be maximized. Different levels of the debt and equity measure pose different risk problems and different ROEs. One industry can be very different from another; these differences are attempted to be explained through the capital structure theories.
        The first theory, by Modigliani and Miller, makes many assumptions to explain capital structure. The assumptions are as follows: No brokerage costs, no taxes, no bankruptcy costs, investors borrow at the same rate as corporations, investors have the same information as management, and EBIT is not affected using debt. M&M discovered that if one had two identical portfolios, except one has all the equity of firms that don’t require debt, and the other has the same firms but require debt financing and a person owns both the debt and the equity of these firms. Both portfolios will earn EBIT entirely paid out as dividends if you assume there is no growth and all the other assumptions above. Because they are the same, the capital structure of the firm irrelevant. This is a fine theory; however, the assumptions do not reflect the real world.
        Modigliani and Miller created a new theory with the effect of corporate taxes in mind. The tax code allows business to deduct interest payments as an expense from debt financing but it does not allow that for dividends paid out to shareholders. So, if a firm pays less to the government, it has more money left over for both itself and the shareholders. The best capital structure according to this theory is 100% debt. But we know this is not how most businesses structure themselves because debt is riskier than equity.
        The next theory, conducted by Miller alone considered the effect of both the corporate tax and personal tax. This theory concludes that the perfect capital structure is less than complete debt financing but still close to it. The income from bonds is generally interest, which is taxed as a personal income, the tax rate can go up to 39.6%. Income from stocks are partly from dividends and partly from capital gains, which has a rate of 20%. So, returns on stock are lower on average than returns on debt. Because stocks have a more favorable tax treatment, lower returns are required, which favors the use of equity financing.
        Trade-Off theory includes the bankruptcy costs when debt is used. Firms whose earnings are more volatile should use less debt because they are at greater risk, while a company with stable earnings can take on more debt because it can predict its income and secure a level of debt that it knows it can pay off without going bankrupt. The more debt one uses, the riskier it becomes, so a firm must lower its debt level and gain less of a tax shield to offset the costs of bankruptcy.
        The Signaling theory considers the actions of managers and how investors perceive it. If management has information that the firm will do better in the future because of new developments, then they will want to issue debt so the gains are not distributed to more stockholders. If the outlook is not good, firms will want to issue stock so they can sell it at a higher price, raise funds to compete better, and share the losses by distributing them to more shareholders. They will not raise funds through debt because that would increase their chances of bankruptcy.