FSMA 312

Capital Structure Theory: A Current Perspective

This is case study analyses is capital-structure theory and provide some suggestions for
capital structure in the most recent period.
The authors of the case study introduce a perspective on capital-structure choice where one
should view it as posing trade-offs among the tax benefits of financing, the explicit costs of
financial distress, the agency costs of debt (including an array of indirect costs linked to
financial distress, the agency costs of equity, and finally, the signaling effect of security
issuance. Following this study, one may conclude that the first two elements reflect the
"modern, traditional" balancing theory of capital structure. The third and fourth build on
agency theory and imperfect information while the fifth element recognizes that the very act
of issuing a security can convey new information to investors when there is imperfect
information.
Through recent history various scholars with a single goal to reach an optimal capital
structure presented many different theories and hypothesis. Some of these theories are: Net
income, net operational income, traditional approach theory, Miller and Modigliani theory,
static trade-off theory, asymmetric of the information hypothesis, pecking order theory,
signaling theory, agency cost theory, free cash flow hypothesis, dynamic trade-off theory and
market timing theory.
With many theories of capital structure being proposed one should think about only those
that seem to have large number of advocates. Notably, most corporate finance textbooks
point to the trade-off theory in which taxation and dead weight bankruptcy costs are key.
Myers (1984) proposed the pecking order theory in which there is a financing hierarchy of
retained earnings, debt, and then equity. Recently, the idea that firms engage in market
timing has become popular. Finally, agency theory lurks in the background of much
theoretical discussion. Agency concerns are often lumped into the trade-off framework
broadly interpreted. (Frank, M. Z., & Goyal, 2009)
However, in practice the capital structure of a company refers to the mixture of equity and
debt finance used by the company to finance its assets. Some companies could be fully
financed by equity and have no debt at all, while others could have low levels of equity and
high levels of debt. Making financing decision is always crucial part of decision making in
the company as financing decision would have direct effect on the weighted average cost of
capital (WACC). The WACC is the simple weighted average of the cost of equity and the

cost of debt. The weightings are in proportion to the market values of equity and debt;
therefore, as the proportions of equity and debt vary, so will the WACC.
One should not forget that the overall corporate objective is to maximize shareholder wealth,
where that wealth is the present value of future cash flows discounted at the investors
required return, the market value of a company is equal to the present value of its future cash
flows discounted by its WACC.
With a right mixture of debt and equity managers attempt to reduce WACC by reviewing
which of the two components is less of expensive one, to reduce the average of the two.
From both theory and practice, one knows that cost of debt is cheaper than cost of equity. As
debt is less risky than equity, the required return needed to compensate the debt investors is
less than the required return needed to compensate the equity investors. Debt is less risky
than equity, as the payment of interest is often a fixed amount and compulsory in nature, and
it is paid in priority to the payment of dividends, which are in fact discretionary in nature.
Another reason why debt is less risky than equity is in the event of a liquidation, debt
holders would receive their capital repayment before shareholders as they are higher in the
creditor hierarchy (the order in which creditors get repaid), as shareholders are paid out last.
Debt is also cheaper than equity from a companys perspective is because of the different
corporate tax treatment of interest and dividends. In the profit and loss account, interest is
subtracted before the tax is calculated; thus, companies get tax relief on interest. However,
dividends are subtracted after the tax is calculated; therefore, companies do not get any tax
relief on dividends.
In addition, while some results propose that long-term debt is positively related to investor
protection, disclosure requirements and public enforcement, it is also negatively related to
political risk. Cespedes, Gonzalez and Molina (2010) investigated 806 Latin American firms
since 1996-2005. They examined determinants of capital structure. Results propose that
ownership based firms avoid issuing shares because they dont want to lose or to decrease
the control right of the firm.
In summary, when trying to find the lowest WACC, managers could issue more debt to
replace expensive equity. This will in turn reduce the WACC, but in the same time more debt
could also increases the WACC as gearing is increase, which is followed by increase in
financial risk (Beta).
In 1958, Modigliani and Miller stated that, assuming a perfect capital market and ignoring
taxation, the WACC remains constant at all levels of gearing. However, in 1963, when
Modigliani and Miller admitted corporate tax into their analysis, their conclusion altered

dramatically. As debt became even cheaper (due to the tax relief on interest payments), cost
of debt falls significantly and thus decreases the WACC.
As many scholars pointed out, there is clearly a problem with Modigliani and Millers
models, because companies capital structures are not almost entirely made up of debt.
Companies are discouraged from following this recommended approach because of the
existence of factors like bankruptcy costs, agency costs and tax exhaustion. All factors
which Modigliani and Miller failed to take in account.
Another aspect mentioned in the case study is agency cost arising out of what is known as
the principal-agent problem. In many companies, the equity and debt-holders (principals)
are not able to actively manage the company while in the same time they provide funds for
that company. For that reason they employ managers (agents). In reality, due to human
nature, it is possible for these agents to act in ways, which are not always in the best interest
of the equity or debt-holders.
If we assume that there is no potential conflict of interest between shareholders and the
management and that the managements primary objective is the maximization of
shareholder wealth than they would make decisions that benefit the shareholders at the
expense of the debt-holders.
Management may raise money from debt-holders stating that the funds are to be invested in
a low-risk project, but once they receive the funds they decide to invest in a high risk/high
return project. This action could potentially benefit shareholders as they may benefit from
the higher returns, but the debt-holders would not get a share of the higher returns since their
returns are not dependent on company performance. Thus, the debt-holders do not receive a
return, which compensates them for the level of risk.
To safeguard their investments, debt-holders often impose restrictive covenants in the loan
agreements that constrain managements freedom of action. These restrictive covenants may
limit how much further debt can be raised, set a target gearing ratio, set a target current ratio,
restrict the payment of excessive dividends, restrict the disposal of major assets or restrict
the type of activity the company may engage in.
As gearing increases, debt-holders would want to impose more constrains on the
management to safeguard their increased investment. Extensive covenants reduce the
companys operating freedom, investment flexibility (positive NPV projects may have to be
forgone) and may lead to a reduction in share price. Management do not like restrictions
placed on their freedom of action. Thus, they generally limit the level of gearing to limit the
level of restrictions imposed on them.

Further aspect mentioned in the case study is that interest is tax-deductible, which means
that as a company increases its debt, it generally reduces its tax bill. The tax advantage
enjoyed by debt over equity means that a company could reduce its WACC.
However, as interest payment rise it may reach a point where it is equal to the profit from
which it is to be deducted; therefore, any additional interest payments beyond this point will
not receive any tax relief. This is the point where companies become tax-exhausted and the
cost of debt rises significantly.
Another theory mentioned earlier in this essay and case study is the pecking order theory.
This theory is in sharp contrast with the theories that attempt to find an optimal capital
structure by studying the trade-off between the advantages and disadvantages of debt
finance. In this approach, there is no search for an optimal capital structure. Companies
simply follow an established pecking order, which enables them to raise finance in the
simplest and most efficient manner, by following simple order. Firstly, company would use
all retained earnings available, and then issue debt. Finally as last resort, company would
issue equity. The justifications come from the fact that companies will want to minimise
issue costs and the time and expense involved in persuading outside investors of the merits
of the project.
As final point, one should underline a fact that managers know all the detailed inside
information, whilst the other stakeholders only have access to past and publicly available
information. This imbalance in information (asymmetric information) means that they
closely scrutinize the actions of managers. The managers decisions are often interpreted as
the insiders view on the future prospects of the company. A good example of this is when
managers unexpectedly increase dividends, as the investors interpret this as a sign of an
increase in management confidence in the future prospects of the company thus the share
price typically increases in value.
In conclusion, companies should pursue sensible levels of gearing and it is important to
emphasize that theories indeed describe various financing methods, but according to authors
none have been able to provide optimized model, which when applied by
managers/investors would reach the maximum return with minimum risk and increase the
value of corporations.

To support this, one can quote a journal Do Tests of Capital Structure Theory Mean What
They Say? written by I. Strebulaev and published in the Journal of Finance, which states
the following: The main findings of the paper are that (1) the properties of leverage in the
cross section in true dynamics and in comparative statics at refinancing points differ
dramatically, and (2) the model gives rise to data that are consistent with a number of
empirical results and that, using methodologies commonly employed in the literature, may
lead to rejection of the model. These findings highlight the need for further research in this
area.
Still, companies should somehow take into consideration the pecking order theory as well,
which takes a totally different approach, and ignores the search for an optimal capital
structure, and many of them do.

Reference:
- Cspedes, J., Gonzlez, M., & Molina, C. (2010). Ownership and capital structure in Latin
America.

Journal

Of

Business

Research,

63(3),

248-254.

http://dx.doi.org/10.1016/j.jbusres.2009.03.010
- STREBULAEV, I. (2007). Do Tests of Capital Structure Theory Mean What They Say?.
The

Journal

Of

Finance,

62(4),

1747-1787.

http://dx.doi.org/10.1111/j.1540-

6261.2007.01256.x
- Frank, M., & Goyal, V. Capital Structure Decisions: Which Factors are Reliably
Important?. SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.567650
- Servais, H., & Tufano, P. (2006). The Theory and Practice of Corporate Capital Structure.
Retrieved from http://faculty.london.edu/hservaes/Corporate%20Capital%20Structure%20%20Full%20Paper.pdf-