Question

The CEO of the company also talks to you on Monday morning as follows:- “How is the cost of equity and cost of debt related? Anyway, the cost of issuing debt is generally lower than the cost of issuing equity. However, I also worry that borrowing too much may lead to higher probability of bankruptcy. What major considerations we should make in the determination of the debt-equity ratio of our company? I have heard about the Modigliani and Miller (M&M) proposition. Would it give us any insight?” said the CEO. Regarding the talks of CEO with you on Monday morning, explain your points to your CEO. Illustrate your explanation with example. (limit your answer to 450 words)

Answer 1

Raising Capital is one of the most important aspects of running a company and raising this capital at the least available cost is critical for both profitability and sustainability of the company.

Generally capital can be raised in three forms: Debt, Preferred stock and Equity.

Debt is generally the cheapest among all the three since the risk is lower and is generally secured. Also the effective cost of debt is generally lower than the nominal cost due to the tax shield it offers

Equity is usually costlier in nature since the higher risk associated with it. Generally debt and preferred stock comes first in the pecking order theory and hence equity investors would ask for higher returns for the higher risk they are taking

The objective of most corporate finance professionals would be to determine an optimal capital structure comprising of debt, preferred stock and equity that would maximize the market value of the company while minimizing the weighted average cost of capital (WACC). Lower WACC would increase the present value of company’s future cash flows and hence would maximize the market value of the company

Ideally since debt is the cheapest source of money, every company should possess 100% of debt in their capital structure and no equity. But in real world this is not the optimal structure. Increase in debt financing of a company would pose the firm to a bankruptcy risk as the cash flows that the firm generates might not be able to service its debt. This would be a huge risk as the company can go out of business due to their poor choice of financing.

Also keeping 100% of equity in capital structure is also not optimal as the return of assets would be very low and the company would not be effectively using financial leverage. With debt in its capital structure, a capital will be able to take advantage of the tax shield of debt, thereby decreasing their tax outgo and increasing their cash flows. But once debt starts increasing on the books of a company, the equity holders would be at risk and starts asking for higher returns [Since equity holders are last in pecking order theory, they fear that as debt rises their claims on the company decreases]. Since cost of equity increases and even with the benefit of debt, the WACC of the firm increases.

Ideally there is no fixed number which says that a company should have this much amount of debt or equity. For a firm which has enough and sustainable cash flows, then it can go for higher debt. But for firms which have very variable cash flows, it is better for it to go for lower levels of debt.

Modigliani and Miller (M&M) proposition:

M&M Theory proposes that the market value of a firm will be same irrespective of their capital structure i.e. a company with 80% equity and 20% debt and a company with 40% equity and 60% debt will have same market value. The value of the firm is generally dependent on the future value of their earnings and its operating profits. Capital structure is irrelevant. But M&M theory assumes these cases in a perfect market with no taxes and other charges.

M&M theory’s Proposition II states that reducing WACC by increasing financial leverage will boost the value of the firm in the presence of tax information.

Hence even with M&M theory the conclusion would go like, as long as the cost of distress [bankruptcy] is lower than the benefit of tax due to debt, increased debt can increase the value of the firm