Question

(Conceptual Question) Address the following questions pertaining to capital structure theories:

• What does the MM theory with no taxes (i.e., perfect capital markets) state about the value of a levered firm versus the value of an otherwise identical but unlevered firm? What does this imply about the optimal capital structure?
  

• Why does the MM theory with corporate taxes (otherwise markets are perfect) lead to 100% debt?
  

• According to the static trade-off theory, if a firm went from zero debt to successively higher levels of debt, why would you expect its stock price to first rise, then hit a peak, and then begin to decline?
  

• Explain how asymmetric information and signals affect capital structure decisions.
  

• Which capital structure theories does the empirical evidence seem to support? What issues should managers consider when making capital structure decisions?

Answer 1

Ans ) Capital structure : The capital structure is the particular combination of debt and equity used by a company to finance its overall operations and growth. Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock, or retained earnings.

Modigliani Millar approach :

The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is an influential element of economic theory; it forms the basis for modern thinking on capital structure.The basic theorem states that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.Since the value of the firm depends neither on its dividend policy nor its decision to raise capital by issuing stock or selling debt, the Modigliani–Miller theorem is often called the capital structure irrelevance principle.

The key Modigliani-Miller theorem was developed in a world without taxes. However, if we move to a world where there are taxes, when the interest on debt is tax-deductible, and ignoring other frictions, the value of the company increases in proportion to the amount of debt used.The additional value equals the total discounted value of future taxes saved by issuing debt instead of equity

Y​​​​​​U = Y​​​​​L

To see why this should be true, suppose an investor is considering buying one of the two firms, U or L. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does. The eventual returns to either of these investments would be the same. Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt.

This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly assumed that the investor's cost of borrowing money is the same as that of the firm, which need not be true in the presence of asymmetric information, in the absence of efficient markets, or if the investor has a different risk profile than the firm.

Proposition II

higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. The formula is derived from the theory of weighted average cost of capital (WACC).

These propositions are true under the following assumptions:

• no transaction costs exist, and
• individuals and corporations borrow at the same rates.

These results might seem irrelevant (after all, none of the conditions are met in the real world), but the theorem is still taught and studied because it tells something very important. That is, capital structure matters precisely because one or more of these assumptions is violated. It tells where to look for determinants of optimal capital structure and how those factors might affect optimal capital structure.

With taxes ( trade off theory of leverage )

MmM assume no tax .but in real world,this is far from truth.this theory recognise the tax benefits accrued by interest payments.The int. Paid on borrowed fund is tax deductible. Which not in case of equity. To put in the other word the actual cost of debt is less then nominal cost of debt Bec of tax benefits. The trade off theory advocate that a company can capitalise it's requirements with debt as long as the cost of distress i.e cost of bankruptcy exceed the value of tax benefits. Thus the increased debt until a given threshold value will add value to a company.

V​​​​​​L = value of unlevered + tax shield on debt

Assumption of MM

1 ) No Taxes ( later dropped )

2 ) symmetry of information

3 ) no transactions cost

4 ) bankruptcy cost is nil

5 ) cost of borrowing is the same for investors as well as companies.

6 ) debt financing does not effect companies EBIT.

Miller's approach with corporate and personal tax : to establish a optimal capital structure both corporate and personal tax paid on operating income should be minimize. T​​​​​​The personal tax is difficult to determine bec.of different tax status of investors and that the capital gains are only taxed when the shares are sold .

merton Millar proposed that original MM proposition 1 in a world with both corporate and personal tax because he has the personal tax rate on equity income is ZERO.

company will issue that up to point at which the tax bracket of the marginal bond holder just equal the corporate tax rate.

value of levered = value of unlevered + tax shield

personal tax on equity income= dividend tax rate = Zero

Only the net income approach and traditional approach support the capital structure decision.

Issues faced

This paper points out two common problems in capital structure research. First, although it is not clear whether they should be considered debt, non-financial liabilities should never be considered as equity. Yet, the common financial-debt-to-asset ratio (FD/AT) measure of leverage commits exactly this mistake. Thus, research that explains increases in FD/AT explains, at least in parts, decreases in non-financial liabilities. Future research should avoid FD/AT altogether. Second, equity issuing activity should not be viewed as equivalent to capital structure changes. Empirically, the correlation between the two is weak. The capital structure and capital issuing literature are distinct.