Does Capital Structure Matter

Introduction

The capital structure of the firm initially made up of debt and equity and thereafter augmented by retained earnings, debt enhancement and infusion of capital, is considered to be one of the most important elements of modern-day economic theory and business activity (Bevan & Danbolt, 2002). Organisational managements take care in designing their capital structure after considering various factors like the organisational need for long-term funds, potential tax savings and the implications of financial risk (Bevan & Danbolt, 2002). The importance of capital structure in modern business has attracted substantial academic, researcher and management practitioner interest and to the development of various theories on the subject (Brounen & Eichholtz, 2001). Such theories have not only enriched the area and added to knowledge on the subject but have also attracted extensive debate, discussion and criticism (Brounen & Eichholtz, 2001).

Overview of Capital Structure

The capital structure of a modern corporation is, at its rudimentary level, determined by the organisational need for long-term funds and its satisfaction through two specific long-term capital sources, i.e. shareholder-provided equity and long-term debt from diverse external agencies (Damodaran, 2004). These sources, with specific regard to joint stock companies, retain their identity but assume different shapes (Damodaran, 2004). Equity, for example, is available in the form of equity and preference shares, whereas long-term debt is obtained from banks and financial institutions, as well as raised through the issue of bonds and debentures (Harris & Raviv, 1990). Long-term funds, apart from these two sources also become available from retained earnings, when firms start making profits and retain some of it for internal uses (Harris & Raviv, 1990). The capital structure comprises internal funds (generated from equity and retained earnings) and external funds (obtained through external debt and the issues of bonds and debentures) (Harris & Raviv, 1990).

Organisational decisions on the quantum of capital structure are influenced by three specific considerations, i.e. the organisational need for long-term financing on account of both ongoing and future businesses, the comparative cost of debt and equity, and the financial risks associated with excessive use of long term debt (Beck & DeMarzo, 2014). The cost of debt is considered to be lower than the cost of equity because of the deductibility of interest from income for purposes of tax payment (Beck & DeMarzo, 2014). Whilst enhancement in the usage of debt theoretically results in a reduction of organisational costs and adds to post-tax organisational profitability, it also leads to organisational exposure to financial risks (Harris & Raviv, 1991). Both debt and the interest thereon have to mandatorily be repaid to debt providers; the failure to do so can result in punitive action from lenders, the takeover of the defaulting organisations, the liquidation of assets and the closure of business activities (Harris & Raviv, 1991). An overload of debt can thus result in significantly greater costs and severe consequences for business firms, despite its seeming attractiveness as an economic and effective source of long-term funds (Kraus & Litzenberger, 1973).

Organisational managements make their decisions on capital structure primarily based on these assumptions (Bradley et al., 1984). Such structuring decisions are however influenced by specific macro and micro environmental factors like the availability of external debt, the capacity of the organisation to raise capital through equity issues, the confidence of lenders in the organisation’s management and its future ability to satisfy debt obligations (Bradley et al., 1984). Notwithstanding such basic understanding of organisational decisions on the structuring of long-term capital, diverse researchers and experts have contributed at length to the role of capital structure and the imperatives that drive capital structuring decisions (Leary & Roberts, 2005).

Modigliani-Miller Theorem

Modigliani and Miller developed their theory on organisational capital in the 1950s, suggesting that the valuation of a firm was irrelevant to its capital structure (Adrian & Shin, 2010). Their theory also known as the Capital Structure Irrelevancy Theory posits that the valuation of a firm was irrelevant to its capital structure (Adrian & Shin, 2010). The element of debt used by organisational management in the capital of the firm did not have any bearing on its market value, which was dependent on the profits of the business (Levati et al., 2012).

The Modigliani and Miller (M&M) approach goes on to state that the market value of the firm was affected by its prospects for future growth and the risks that were involved in its investment (Levati et al., 2012). The value of the firm was not dependent upon the selection of capital structure or the financing decisions of the firm (Gordon, 1982). An organisation with high prospects for growth was bound to develop enhancement in market valuation, which would result in growth in stock prices (Gordon, 1982). The absence of such developments would on the other hand result in stagnation or even decline in share prices (Levati et al., 2012). M&M, however, added specific caveats, stating that (a) it was assumed that there were no taxes, (b) the transaction costs for the purchase and sale of securities, as well as the costs of bankruptcy, was nil, (c) information availability was symmetrical, i.e. investors and corporations had access to similar information, (d) investors were expected to behave rationally (e) the cost of borrowing was the same for companies and investors and (f) debt financing did not affect the EBIT (Earnings Before Interest and Tax) of companies (Brealey et al., 2014). The Modigliani and Miller approach posited that the value of a leveraged firm, with a mix of equity and debt was likely to be the same as the value of an unleveraged firm, which was completely financed by equity if the operating profits and the future growth prospects of the two businesses were the same (Brealey et al., 2014). The costs of shares to investors of both these firms were thus likely to be similar when shares were purchased from the market (Brealey et al., 2014).

Notwithstanding the seminal nature of the M&M theory and its contribution to the understanding of capital structure, it has been subjected to extensive debate, discussion and critique (Modigliani & Miller, 1958). The original proposition and the essential elements of the M&M theorem assumed the existence of a fully efficient market, free of taxes, transaction and bankruptcy costs (Baker & Wurgler, 2002). M&M further assumed that abundant information was available with all market participants (Bhole & Mahakud, 2009). They later included the impact of taxes on their model in 1963 to bring it closer to reality (Bhole & Mahakud, 2009).

Jordan and Miller (2008) stated that the advancement of the M&M model has resulted in two major contributions to the utilisation of a no-arbitrage argument and the structure of debt. Other experts have however strongly voiced their scepticism of the M&M propositions and their unrealistic nature (Jordan & Miller, 2008). Stiglitz (1969) stated that risk classes were crucial and M&M’s assumptions were based upon the analysis of partial, rather than general equilibrium. It was also incorrect to assume that individuals and firms could borrow at the same market rate and that bankruptcies did not exist (Modigliani & Miller, 1958). Individuals were subject to limitations in market rates in their borrowings, compared to the market rates available to firms (Modigliani & Miller, 1958).

Bankruptcies were also too violent to be ignored and could create significantly greater problems to firms than was considered by the M&M proposition (Bose, 2010). Several critics have also questioned M&M’s other assumptions, namely that organisations did not have to pay corporate taxes or that costs were not involved in the raising of capital (Bose, 2010). M&M’s critics also stated that the majority of corporations did not provide complete information to capital markets (Bose, 2010). The M&M theorem was thus considered to be faulty because it was based on unrealistic assumptions (Bose, 2010).

Bierman (2002) stated that M&M underestimated the tax benefits of debt, which stemmed from the deductibility of interest from profits for the calculation of taxable income. M&M have however conceded this point in their 1963 paper and showed that value could be created with debt, even though such value was not likely to be substantial (Modigliani & Miller, 1963).

Baker and Wurgler (2002) made the point that capital structure mattered in the real world because of the existence of information asymmetries. Organisational managers may be unwilling or unable to provide all the information available with them, which in turn could result in the “insider’s advantage” and lead to organisational decisions on debt or equity affecting the value of the firm (Baker & Wurgler, 2002).

Whilst the M&M theory has generated substantial critique and debate, there appears to be broad agreement on the fact that whilst well-designed capital structures could lead to the creation of some value, the overwhelming proportion of organisational value emerges from managerial decision-making processes and organisational growth prospects; the main conclusion of the M&M theorem (Masulis, 1980). Levati et al., (2012) stated that the M&M theorem established a standard on capital structure theory and created substantial alertness in the area.

Trade-Off Theory

M&M’s advancement of the Capital Structure Irrelevance Theory initiated significant debate and discussion in the area and led to the development of other theories, two of the more important of which are the static Trade-off Theory and the Pecking Order Theory (Fama & French, 2002).

The static trade-off theory concentrates on the diverse benefits and costs associated with debt issuance and subsequently posits that an optimal target/objective for the development of a financial debt ratio exists and its deliberate assumption can result in the maximisation of organisational value (Danso & Adomako, 2014). The best possible point for the debt/equity ratio is the one when the marginal value of the benefits that accrue from debt specifically and exactly offset and counterbalance the increment in the present value of the various expenses that occur with the issuance of greater debt (Danso & Adomako, 2014). Luigi and Sorin (2009) and several other experts have stated that debt was clearly associated with the significant organisational advantage that stemmed from the tax deductibility of interest payments; this made it a beneficial financing option.

De Jong et al., (2011) argued that organisational debt played an important role in the reduction of shareholder-manager agency conflicts. Agency theory states that the conflicting interests of principals and agents result in agents often pursuing their own interests to the detriment of their principals (De Jong et al., 2011). Corporate managers frequently tend to engage in inappropriate utilisation of additional and free cash flows on investments in inappropriate assets and projects, as well as in perquisites for their own benefits (Lemmon et al., 2008). The utilisation of debt financing should, at least in theory limit and reduce the availability to limit managerial access to free cash flows and thereby help in the control of agency problems and enhance corporate governance levels and outcomes (Lemmon et al., 2008). Jung et al., (1996) posited that the issuance of greater debt was associated with financial distress costs, along with agency costs that could develop on account of greater conflict between shareholders and debtors. Financial distress on account of high levels of organisational debt is likely to occur when organisations cannot satisfy their principal and interest payment obligations. The most optimal debt-equity ratio, as such takes place when firms with greater debt levels and more vulnerability to additional risks, because of financial distress and agency costs, lower their debt levels; firms with low debt levels on the other hand enhance their utilisation of debt to benefit from the cost savings that accrue on account of the tax deductibility on interest (Jonathan & Olivier, 2012).

Empirical studies, carried out by Titman and Wessels (1988) Booth et al., (2001) and Frank and Goyal (2009) confirmed the role of different factors used by the trade-off theory to explain the financial behaviour of firms. Evidence on the Trade-off Theory is however mixed because some studies have found that business firms often move comparatively quickly towards their target debt ratio, as found by Flannery and Rangan (2006), whereas other studies carried out by Fischer et al., (1989) and Fama and French (2002) found that such reversion occurs extremely slowly. Flannery and Rangan (2006) in fact argue that a typical company converges towards its long-term target at a speed of more than 30% per year, which is more than double of the speed suggested by past evaluations. Chang and Dasgupta (2009) have also criticised a significant portion of the evidence-based target adjustment models and have shown that it was possible to observe supposed target adjustment behaviour, even when samples were generated through simulations, wherein target behaviour was not assumed. M&M’s advancement of the Capital Structure Irrelevance Theory initiated significant debate and discussion in the area and led to the development of other theories, two of the more important of which are the static Trade-off Theory and the Pecking Order Theory (Fama & French, 2002).

Pecking Order Theory

The Pecking Order Theory, which is often, used to balance and counter the Trade-off Theory has also become accepted as an influential theory of corporate finance (Chen, 2011). The Trade-off theory was, in fact, the defining theory for the explanation of capital structure decisions, before Myers and Majluf (1984) developed the Pecking Order Theory. Quan (2002) stated that the Pecking Order Theory, which provides an important alternative approach to capital structure, posits that the capital structure of a company is primarily driven by the preference of the organisational management to engage in specific priorities in fund allocation. Organisational managements prefer to finance their businesses, including expansion with internally generated funds, rather than external funds (Quan, 2002). Whilst external funds are required in some circumstances, organisational managements appeared to prefer obtaining of debt, rather than equity for this purpose. Equity is in fact rarely issued for business requirements (Vasiliou et al., 2009).

Shyam Sunder and Myers (1999) refined these ideas into an important testable prediction stating that financing deficits should, in normal circumstances be matched, pound for pound, by an alteration in corporate borrowing. They stated that the adherence of business corporations to the tenets of the Pecking Order Theory should result in the generation of a slope coefficient of one in a regression of net debt issues on the financing deficit (Shyam Sunder & Myers, 1999). The experts found strong support for this prediction in their study of 157 business firms that had traded continuously from 1971 to 1989 (Shyam Sunder & Myers, 1999). The Pecking Order Theory has thus been offered as a parsimonious empirical model of business leverage that was also descriptively reasonable (Shyam Sunder & Myers, 1999).

The Pecking Order Theory has largely been explained from the perspective of asymmetric information and the definite existence of transaction costs (Riahi-Belkaoui, 1999). Desai et al., (2003) made the point that asymmetric information expenses are likely to be incurred when firms intentionally choose not to make use of external financing and thereby relinquish investments with positive Net Present Value (NPV). The theory of asymmetric information posits that organisational insiders, i.e. influential organisational managers are likely to have access to much more information than outsiders (Desai et al., 2003). The availability of such information motivates opportunistic managerial behaviour; securities are, for example, issued at times when the market prices of organisational securities are more than real firm values. The difference between the real firm value and the market price of securities comes about because investors tend to wrongly price equity because of their comparatively lower information and knowledge about the actual value of organisational assets (Swanson et al., 2003).

Padron et al., (2005) stated that the pecking order theory could furthermore be explained by making use of the role of transaction costs. Such transaction costs are associated with obtaining of financing for organisational purposes (Padron et al., 2005). Transaction costs are lowest for financing through internal sources, which are likely to result in internal funds being the first choice of funding (Quan, 2002). Organisations will tend to subsequently make use of external debt financing and lastly resort to external equity financing (Quan, 2002). MacKie-Mason (1990) stated that the transaction costs of debt were always lesser than those of equity issuance, which ensured that debt financing would be preferred to equity issues. Various research studies have revealed that the costs of equity issuance could be approximately 4 to 15 times those of the costs associated with rising of debt (MacKie-Mason, 1990). Such significant differences in transaction costs were likely to ensure that new equity would be issued only after making use of all other financing avenues.

Eriotis (2007) also suggested that agency issues were likely to increase organisational preference for internal funds because the use of external funds could result in the greater application of market discipline and lesser freedom of action of organisational managers. Organisational managers would be likely to be opposed to losing control over operations and would thus attempt to finance their operations with internal funds (Eriotis, 2007). They would be likely to choose external funds only in case of inadequacy of internal earnings and would first select short-term debt on account of the absence of a requirement for collateral or the imposition of covenants (Eriotis, 2007). The exhaustion of short-term debt options would result first in attempts to obtain long-term debt and thereafter to equity (Padron et al., 2005). Quan (2002) also suggested that firms resorted to external funds only for the satisfaction of residual financial needs.

Chen (2011) informed that the Pecking Order Theory, unlike the Trade-off Theory, did not predict any sort of long-term targeting of capital structure. It also did not stipulate an optimal mix of debt and equity because retained earnings and the issuance of new shares, both of which were forms of equity, occupied positions at the apex and the bottom of the Pecking Order (Chen, 2011). Firms should thus ideally attempt to achieve a debt-equity ratio of zero by ensuring that funding was obtained totally from internal sources, rather than debt (Desai et al., 2003). Whilst this could be achieved by mature companies over the long term, small and growing businesses were likely to continue to depend upon external financing, both through debt and equity (Desai et al., 2003).

Conclusions

Modigliani and Miller posited that the capital structure of a firm, comprising of debt and equity, was irrelevant to its market value. They stated that market value was actually determined by an organisational focus on growth and the adoption of strategies that would enhance it. The M&M theorem, despite its pioneering and seminal nature, has been questioned and critiqued by various experts for its unrealistic assumptions with specific regard to the ignoring of taxation and transaction costs, as well as the availability of complete information by all market participants. Whilst such criticism appears to be valid to a great extent and has even been accepted by Modigliani and Miller, who have subsequently incorporated the impact of taxation in their theory, there is little doubt that the M&M theorem has contributed to modern day understanding of the capital structure and has initiated an extensive debate on the subject. It has also shifted the priorities of investors and managements from profit maximisation to wealth maximisation through the adoption of appropriate organisational strategies.

The Trade-off Theory and the Pecking Order Theory, which were advanced in the wake of the interest generated by M&M on capital structure, approach the issue from different perspectives. The Trade-off Theory posits that organisations act to develop the most optimal debt-equity ratios, which serve their needs, in terms of funding availability, organisational costs, and organisational risk. The Pecking Order Theory on the other hand approaches capital structure through the perspectives of the agency theory and posits that organisational managements tend to first make use of retained earnings to finance their funding needs to avoid greater interference and conditions imposed by lending organisations and other stakeholders. The exhaustion of internal funding results in organisational attempts to obtain funds, in sequential order, from short-term sources, long-term sources and equity issuance.

The advancement of these three approaches has contributed significantly in enhancing understanding of the phenomenon and role of capital structure in modern business. There is little doubt of its importance, and with the organisational management being the key decision makers in its determination, the Pecking Order Theory appears to be the most appropriate for explaining it.

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