Level 1 CFA® Exam:
Capital Structure – MM & Other Theories
Every enterprise must make a difficult decision that concerns its capital structure. Especially in small companies, this aspect is often neglected. The capital structure reflects how the company finances its business. In practice, two sources are widely used. They are: debt and equity.
Therefore, it's safe to say that capital structure is a mix of different financial instruments. The goal of an enterprise is to create such a capital structure that maximizes the value of the company or minimizes the weighted average cost of capital (WACC). The WACC is the weighted average of marginal costs of particular sources of financing:
Please note that the cost of equity, the cost of debt, and also tax rate are marginal values. What does it mean?
In the case of financing sources, these are costs incurred in connection with obtaining an additional unit of debt or equity. The marginal tax rate is an additional share of income paid as tax.
At the end of the 1960s most theoreticians and practitioners in the world of business largely ignored the capital structure of a company. Merton Miller and Franco Modigliani were the first to focus on this aspect. In 1958 they published a series of articles on capital structure theory and its impact on a company's value. By doing so they initiated a wide-ranging discussion on sources and strategies of financing.
MM Proposition I states that when making some assumptions in a tax-free economy, the value of an unlevered company is the same as of a levered one. So, the capital structure of the company doesn't affect its market value.
The assumptions in this theory are the following:
- Miller and Modigliani assumed homogeneous expectations. In other words, all financial market participants have the same expectations concerning different financial variables for example they estimate income or cash flows in the same way.
- Capital markets are perfect. And so there are no transaction or bankruptcy costs and everyone has the same access to information.
- Investors may lend and borrow at the same risk-free interest rate.
- There are no agency costs. In other words, we assume that managers strive to maximize shareholders' wealth.
- Investment and financing decisions are made independently. It means that operating profit is not sensitive to changes in the capital structure.
So, the cost of equity for the levered company takes the following form:
At the end of our discussion on the Modigliani-Miller theorems in a tax-free economy let’s take a look at a relationship that allows for splitting the systematic risk for the whole company into the risk dependent on debt and equity:
As you can see the asset beta that reflects the systematic risk of the company is the weighted average of the beta of debt and the equity beta.
We can rearrange this equation and calculate the equity beta. Have a look:
Let's assume our economy is tax-free. The marginal cost of the debt of the company is 8% and debt constitutes 40% of the company's liabilities. If it was an all-equity company, its WACC would amount to 14%. Compute the cost of equity of the company.
We've already discussed two MM propositions without taxes. Critical views of the capital structure theory and its assumptions that are hardly possible to hold in the real economy made Miller and Modigliani study the subject from a different perspective. In 1963 they published an article on the economy with taxes.
The starting point here is the debt tax shield. As you know interest paid can in fact lower the company's taxable profit. It translates into lower corporate taxes. This effect is called a debt tax shield.
The value of a levered company will be higher than that of an unlevered company by the value of the tax shield. Here's the formula to be used in your level 1 CFA exam:
Please note that if a company that pays taxes has a higher value than a company that doesn't pay them, the WACC of the company that pays taxes will be lower than that of the company that doesn't pay taxes. And so the cost of equity has the following formula:
Calculate the tax shield when the marginal tax rate is 40%. The company is financed by the equity in 60%. The market value of equity is EUR 12 million.
What is the WACC of a company that is financed by debt in 30% with a marginal tax rate of 30%, when the cost of equity is 20% and the cost of debt is 10%? What would the WACC be if the company operated in an economy without taxes?
Calculate the value of the all-equity Company using the following data:
\(EBIT\) = USD 1 million
\(t\) = 30%
\(r_e\) = 20%
Assume that the company operates in an economy with taxes.
In the future, the company is planning to issue debt of USD 4 million to repurchase some part of equity financing. Compute the value of the leveraged company.
Although the MM model was improved as it considered the economy with taxes, empirical tests showed that the model couldn't explain some things. There is a wide range of theories that apply some basic assumptions of the MM models. Let's go through them.
Cost of Financial Distress Theory
We're going to start with the cost of financial distress theory. Every company even in a prosperous economy faces at least some temporary financial difficulties, mostly connected with liquidity. It means the company is unable to pay its debts on time.
In more serious cases, it may even be facing bankruptcy. Irrespective of the severity of the problems, the situation may generate some extra costs for the company. Generally, expected costs of financial difficulties may be divided into two areas:
Another point of our discussion in this lesson is the theory of agency costs. It refers to the so-called agency relationships. It is a situation when one party hires another that is called an agent to perform tasks and services ordered by the hiring party.
We can observe agency relationships on different levels. That is the relationship between the shareholders and the management as well as between the shareholders and the creditors (or managers and creditors).
The costs that arise from the conflict of interest between managers and shareholders are called the agency costs of equity. The problem comes down to the fact that an agent may be more interested in attaining his own goals than in a long-term increase in company value that lies at the core of the interest of the shareholders.
However, shareholders are aware of potential problems so they should be trying to prevent them. The costs that are to minimize agency costs are called the net agency costs of equity. They include:
- monitoring costs that is the costs of monitoring the work of managers. These include for example the costs incurred in connection with reports or annual meetings.
- bonding costs that is the costs that are to bond the goals of the management with the goals of shareholders. In this case, the expenses must be incurred to ensure that the managers run the business for the benefit of the shareholders.
- finally, we have residual costs. These are borne when there is a loss incurred by shareholders despite monitoring and bonding.
When discussing the theory of agency costs it's worth mentioning the free cash flow hypothesis. It assumes that debt financing is beneficial for the company’s owners as the managers have fewer cash flows they can use for their own purpose.
Finally, we can discuss an unequal distribution of information. Typically, managers know more about the company than its shareholders and creditors. Some enterprises that operate in complex areas of business like new technologies or those that apply an unclear information policy may expect their shareholders or creditors to demand a higher return.
Shareholders that are aware of asymmetric information try to closely observe the work of the managers. A company that issues a fixed-rate debt is believed to be in good financial health with good perspectives. While attempts to acquire extra equity are usually perceived as a signal that the company may be facing some problems.
Of course, how a company is perceived is based on the assumption that the managers actually know more about the company's health and its perspectives so they choose some particular sources of financing over others.
The theory of asymmetric information is also linked to the concept of the pecking order theory. It is based on the assumption that the managers select forms of financing with the least potential information content. According to the pecking order theory, enterprises obtain new capital first from internal financing. Usually, these are profits generated in previous years. Next, they reach for debt, namely, they issue bonds or take loans. In the end, they decide to issue shares.
Level 1 CFA Exam Takeaways: Capital Structure – MM & Other Theoriesstar content check off when done
- The capital structure reflects how the company finances its business: by debt or equity.
- The assumptions in Modigliani-Miller theory: homogeneous expectations, capital markets are perfect, investors may lend and borrow at the same risk-free interest rate, there are no agency costs, investment and financing decisions are made independently.
- In a tax-free economy, the value of an unlevered company is the same as of a levered one (MM proposition I). So, the capital structure of the company doesn't affect its market value.
- In a tax-free economy, the cost of equity is a linear function of the company's debt to equity ratio (MM proposition II).
- In an economy with taxes, the value of a levered company will be higher than that of an unlevered company by the value of the tax shield.
- There are direct (e.g. administrative & legal fees) and indirect costs (e.g. loss of reputation) of financial distress.
- The costs that arise from the conflict of interest between managers and shareholders are called the agency costs of equity.
- The pecking order theory is based on the assumption that the managers select forms of financing with the least potential information content.