Optimal Capital Structure (Under the Trade-off View)

GLOSSARY Equity: For corporations, this is just another name for common stock. Equity is the amount of money that the stockholders or owners have invested in the company. Capital Structure: A company's ratio of long-term debt to equity. Optimal Capital Structure: A "best" debt/equity ratio for a company. This is the debt/equity ratio that will minimize the cost of capital, i.e., the cost of financing the company's operations. Trade-off Theory: The managers of a company should find a debt/equity ratio that balances the risk of bankruptcy (i.e., a high ratio) with the risk of using too little of the cheapest form of financing (i.e., a low ratio. The after-tax cost of debt will always be lower than the cost of financing with equity.) Following Modigliani and Miller's pioneering work on capital structure, we are left with the question, "Is there such a thing as an optimal capital structure for a company? In other words, is there a best way to finance the company: an optimal debt/equity ratio?" According to the trade-off theory, the answer is yes - in fact, you might even say that there is an optimal range. There is a specific debt/equity ratio that will minimize a company's cost of capital. (This is also the point at which the value of the company will be maximized.) However, because the cost of capital curve is fairly shallow (like the bottom of a bowl), you can deviate from this optimal debt/equity ratio without appreciably increasing the cost of capital. This creates a range in the bottom portion of the curve where the cost of capital is essentially the same throughout the range. There is a danger of getting outside of this range however. The cost of capital will increase rapidly once you get outside the range, as shown by the blue Average Cost of Capital line in the graph below. The Trade-off View of the Cost of Capital

A company's overall cost of capital is a weighted average of the cost of debt and the cost of equity. For example, if a company's debt/equity ratio is 30/70 and the after-tax cost of debt is 4% and the cost of equity is 10.5%, the company's overall cost of capital is 0.30 * 4% plus 0.70 * 10.5%, or 8.55%. Let's take a company from its inception: 1. When a company is new, it will likely be financed entirely with equity, so its average cost of capital is the same as its cost of equity (10% in the graph above for a 0/100 debt/equity ratio). 2. As the company grows, it establishes a track record and attracts the confidence of lenders. As the company increases its use of debt, the company's debt/equity ratio increases and the average cost of capital decreases. In essence, the company is substituting the cheaper debt for the more expensive equity, thereby decreasing its overall cost. (It might be useful to think of the company borrowing money, then using that borrowed money to buy back some of its common stock. The debt goes up, the equity goes down, and the company's average cost of capital decreases because the company has substituted the cheaper debt for the more expensive equity.) 3. Eventually, as the company's debt/equity ratio increases, the cost of debt and the cost of equity will increase. Lenders will become more concerned about the risk of the loan and will increase the interest rate on its loans. Common shareholders will become more concerned about default on the loans (and, in bankruptcy, losing all of their investment) and will insist on receiving a higher rate of return to

compensate them for the higher risk. Since both the cost of debt and equity increases, the average cost of capital will also increase. 4. This results in a minimum point on the cost of capital curve. However, the curve (for most industries) is relatively shallow. This means that the financial manager has considerable flexibility in choosing a debt/equity ratio. He or she wants to move to the shallow portion of the curve and, once there, remain there. However, there is a range of debt/equity ratios that will allow the company to stay in this shallow portion of the curve. Just remember that there is a danger in getting outside of this range.

If you move too far to the left-hand side of the curve, you are paying too much to raise money - you would be better off borrowing money (at a relatively low aftertax interest rate) and buying back some of the more expensive equity. (The cost of financing with debt is always considerably lower than financing with equity.) If you move too far to the right-hand side of the curve, you are paying too much to raise money - lenders and stockholders perceive your company as being too risky. You should either pay down the debt or issue new equity in the next round of financing in order to reduce the risk and to move back into the shallow portion of the curve.

Pecking Order Theory There is a competing theory to the trade-off view. It is based more on observations of how managers take short-cuts rather than a repudiation of the trade-off view. The pecking order theory says that companies tend to finance investments with internal funds when possible and also issue debt whenever possible. Since internal funds (profits that are retained in the company) are a form of equity and have a very high cost, managers are obviously not always following the recommendations of the trade-off view. The pecking order theory says that companies finance investments by raising funds in this order: (1) internal funds (retained earnings), (2) debt, and (3) sale of new common stock (the most expensive form of financing). Much of this may have to do with convenience - the pecking order corresponds to the easiest and most convenient ways to raise money. Although a bit dated, an excellent description of capital structure (and capital budgeting), as practiced by corporate managers, may be found in this Duke University article (in pdf format).

How Much Debt?

Modigliani and Miller's Capital Structure Theory (M & M Theory)

How Much Equity?

GLOSSARY Financial Structure: The ratio of short-term funds to long-term sources of financing for a company. Financial structure is concerned with how a company's assets are financed, with emphasis on whether the company is depending primarily on short-term or long-term financing. In short, financial structure looks at the entire right-hand side of a company's balance sheet. Capital Structure: The ratio of long-term debt to equity for a company. In other words, capital structure is concerned how a company's permanent assets are financed. Notice that short-term sources of funds are ignored; only long-term sources are analyzed. In other words, capital structure looks only at the lower portion of a company's balance sheet (i.e., the long-term financing portion). Optimal Capital Structure: The "best" debt-to-equity ratio that a company can have. The optimal capital structure is the debt/equity ratio that will minimize the financing costs of the company. it is also the ratio that will maximize the value of the company in the marketplace.

Franco Modigliani and Merton Miller (M & M) revolutionized the financial world in 1958 and set the cornerstone for thinking about a company's capital structure. Prior to their landmark study, the "traditional approach" to capital structure maintained that there was an optimal level of debt that a company should have. In other words, there was one "best" debt-to-equity ratio for a company. Managers should identify this point and not deviate from it. In a research study that has been named in many global surveys as the most important financial research paper ever published, Modigliani and Miller threw this view out the window. There are several levels of their theory, based on the simplifying assumptions. Let's take each in turn. Level I - A World Without Taxes: Assume a very simple world in which there is no such thing as taxes, bankruptcy costs, or unequal access to information. All financial markets are also assumed to be very efficient. In this type of world, M & M argued that the cost of debt is lower than the cost of equity, based upon its lower level of risk. When a company is first starting out, it is often financed entirely by the stockholders since the company does not have a history or proven ability to generate profits. This means that the company's overall cost of capital is the same as its cost of equity. For example, in the graph below, assume that a company's stockholders want a 15% rate of return at the time the company is formed (i.e., when the debt level is zero). So its overall cost of capital is also 15% since equity is the only source of funding used. However, as the company grows, it is able to borrow money at an interest rate of 10%.

As the company borrows more and more money, two forces begin to tug against one another:

The average cost of capital is pulled down as we use more and more of the cheaper source of financing (i.e., debt). For example, assuming that the costs of debt and equity don't change, moving from a debt /equity ratio of 0 (i.e., no debt) to a debt/equity ratio of 0.25 (i.e., 20% debt and 80% equity, or 20 / 80) might cause the cost of capital to decline from 15% to a new level of 14%, Cost =

Proportion *

Wt. Ave. 0.20 * 10% = 2.0% 0.80 * 15% = 12.0% Cost of Capital = 14.0% The average cost of capital is pulled up by the fact that higher debt levels increase the risk of the common stockholders and they will demand a higher rate of return (shown by the rising blue line below). In other words, in the previous bullet point, we assumed that the costs of debt and equity don't change, but the cost of equity does indeed change - it goes up.

Modigliani and Miller's research showed that, in a world without taxes, these two forces would exactly offset one another. In other words, the cost of capital curve will be a horizontal line. It doesn't matter how much debt a company uses! The cost of capital is the same, regardless of whether the company uses no debt or huge levels of debt there is no optimal capital structure. In other words, how a company finances itself it totally irrelevant to its success or failure. Corporate treasurers spend a lot of time worrying about how to finance the company - M & M is telling them, "Don't worry about it; it simply doesn't matter." (That's putting it politely; in a way, M & M were telling the treasurers: "You just don't matter; what you do in this regard doesn't affect the fortunes of the company in any way.")

Level II - A World With Taxes: Modigliani and Miller knew, of course, that taxes exist in the real world. In a follow-up article, they relaxed the assumption about taxes and asked the question, "So what happens when we introduce taxes into the analysis?" Since interest is tax-deductible and common stock dividends are not, this make debt even cheaper than before. The higher the tax rate, the more attractive debt financing becomes. In a round-about way, the government ends up paying part of the interest for the company. (It does this by making the entire interest amount tax-deductible, saving the company a lot of money in taxes if it uses quite a bit of debt.) How does this change our analysis? Adding taxes causes the green cost of debt line above to shift downward in a parallel manner. Assuming that the company is in the 40% tax bracket (total of federal, state, and local taxes), an interest rate of 10% becomes an after-tax cost of 6%. (To convert from a before-tax to an after-tax basis, multiply the pre-tax rate time [one minus the tax rate]. That is, 10% * (1 - 0.40) = 6%.) We can see from the graph below that this changes the tug between the two forces mentioned above. Since debt is now quite a bit cheaper, using more and more of it will cause the downward tug to be larger than the upward tug on the cost of capital line. The overall cost of capital line now turns downward!

How then should a company finance itself if the lowest point on the cost of capital curve is on the far right-hand side of the curve? With as much debt as possible - borrow, borrow, and then borrow some more! At some point, lenders will cut you off and refuse to lend you any more money. At this point, you have reached the optimal capital structure. As you can imagine, this upset the treasurers also. "Rubbish", "ridiculous", "insane" were a few of the kinder comments. The "borrow, borrow, borrow" suggestion seemed to fly in the face of reality and seemed fiscally irresponsible. And what about the debt line on the graph ... we've said very little about its shape or curvature. Surely there was more to the story.

We are going to leave M & M in order to go to Level III in a moment. But before we do, let's ask the question, "Were Modigliani and Miller right?" The answer is yes and no. Yes, given the simplifying assumptions that they made. And no, because their assumptions proved to be too simplifying to describe the real world. So, if Modigliani and Miller didn't have the final answer, why did they both win Nobel prizes for their work and why is their work considered among the finest in the financial literature, even today? The answer is that after M & M's research was published in 1958, financial researchers spent decades trying to disprove their work. In the process, we learned an awful lot about how companies should finance their operations and about the corporate financial world in general. Their work served as a catalyst and springboard for a number of advances in finance. Modigliani and Miller's greatest accomplishment may be their finding that the real value of a company comes from managing the asset side of the balance sheet, not the financing side. While later research showed that it does matter how a company is financed, it is a lot less important than managing the assets of the company. Now on to Level III ... Level III - A World With Bankruptcy Costs: Eventually, the weakest point of M & M's research proved to be their assumption of no bankruptcy costs. When we relax that assumption, the shape of the curves change. At higher and higher debt levels, the possibility of bankruptcy increases. This causes both the debt and equity lines to curve upward. It also causes the overall cost of capital line to curve also. These advances in knowledge were led by people other than Modigliani and Miller, but Level III's inclusion of bankruptcy costs led us to our present views about the cost of capital and the optimal capital structure of a firm. Most of these current beliefs are captured in another graph of capital structure. Let's go there now by studying the result of relaxing the restriction on bankruptcy costs. The current view of capital structure maintains that there is such a thing as the optimal capital structure. This is encapsulated in the Trade-off View of capital structure.

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