Miller and Modigliani (M&M) Theory

Franco Modigliani and Merton Miller were among the first to describe how the capital structure decision affects firm value and the cost of capital.2 In its original form, Miller and Modigliani's (M&M) theory operated in a purely frictionless economy. Among other considerations, this economy is free of tax, bankruptcy, agency costs, and information asymmetries. The foundation of the theory is that the left side of the balance sheet—the assets of the firm and the management of those assets—drives firm value. M&M assert that as long as the firm is able to fund opportunities that create value, it does not matter how those opportunities are funded. Critics, however, were particularly troubled by the exclusion of tax considerations and the costs of bankruptcy. They claimed that the tax savings due to the deductibility of interest payments to debt holders, added significant value to the firm. They also argued that the costs of financial distress could not be ignored since as debt levels increased, the likelihood of financial distress also increased, causing the value of the firm to decline. M&M revised their theory to include the impact of tax on the cost of capital and the value of the firm.3 M&M proposition I, which relates to firm value, states that the value of a firm will increase as debt is added to the capital structure. The increase in firm value is equal to the present value of the interest tax shield, the tax savings that result from the tax deductibility of interest expense. M&M proposition II, which relates to the cost of capital, states that the cost of capital will decrease as leverage is increased. Although it is true that as leverage increases, equity becomes more risky and thus requires a higher return, it also means that a greater proportion of the firm is funded with debt. Since debt costs less and has a tax benefit, the cost of capital will decline with increased leverage, reaching a minimum when the capital structure is composed entirely of debt, at which point the WACC is equal to the cost of debt. The theory concludes that firm value is maximized and WACC is minimized with a capital structure of 100 percent debt.

Financial Distress Costs and Trade-Off Theory

Although the tax benefit of debt will cause the value of a firm to increase as leverage is increased, this will only be true to a point since as leverage increases, so too does the likelihood of default. The cost of financial distress eventually becomes so great that it erodes the benefits of the tax shield, and firm value begins to decline. The implication is that there is an optimal debt level. Beyond this level, firm value declines because of the increased probability of default. Although the revised M&M theory was an improvement by virtue of it incorporating the tax benefits of debt, it still failed to address the costs of financial distress. Trade-off theory built upon M&M, and addressed the impact of financial distress on the capital structure decision.

The underlying premise of trade-off theory is that a firm will identify an optimal target capital structure that they believe balances the benefits of the tax shield against the costs of financial distress. A number of dynamic trade-off theories emerged in the 1980s to support the empirical findings that despite the appearance of target capital structures, a firm's capital structure varies over time. They maintain that even though capital structure may diverge from a target, firms aim for a capital structure that they believe is optimal. Many forms of dynamic trade-off theories exist. Some attribute deviations from target levels of leverage to various exogenous factors including the accumulation of profits, investment expenditures, and changes in market prices. Others attribute the deviations to deliberate actions taken by managers to time the market. Dynamic tradeoff theories often include considerations of transaction costs, and suggest that as capital structure fluctuates, managers will act to move the capital structure back toward a target structure only when the costs of not doing so exceed the transaction costs of rebalancing.

Pecking-Order Theory

An opposing theory of capital structure is the pecking-order theory. This suggests that the choice of capital structure is not based on a target capital structure nor is it influenced by tax shields or bankruptcy costs. Instead, the choice of capital structure reflects the tendency of firms to prefer financing new projects with internal funds, and issuing debt rather than equity when external financing is necessary. The tendency to avoid external finance is motivated by management's desire to avoid the scrutiny of capital markets and the costs associated with information asymmetries. Management is concerned that the issuance of debt will draw attention to the firm's financial strength and may cause a reevaluation of its credit rating. Equity is thought to be particularly sensitive to information asymmetries since the market knows that a firm is unlikely to issue equity if it believes its stock to be undervalued. The market thus views the issuance of equity as a signal that the stock is overvalued, and responds by driving the stock price down. This effect is amplified by the fact that the market may be unsure about the firm's future prospects and what the firm plans to do with the newly raised equity capital.

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