Introduction
Financing decisions are crucial for businesses as they determine the company's capital structure – the mix of debt and equity used to fund its operations and growth. We will explore the fundamentals of financing decisions and capital structure, including the Modigliani-Miller theorems, WACC, business risk, financial risk, and the trade-off theory. We will also explore how taxes and financial distress affect capital structure decisions and discuss insights from empirical studies on default risk.
Financing Decisions and Capital Structure
Companies need to make financing decisions to fund their operations and growth, whether it's through debt, equity, or a combination of both. The capital structure is the mix of debt and equity that a company employs. Optimal capital structure maximizes the value of the firm while minimizing the cost of capital.
Capital Structure Empirics
Empirical studies of capital structure have shown that firms tend to maintain a target debt-to-equity ratio, which may vary across industries and individual companies. These studies also indicate that firms adjust their capital structure in response to changes in economic conditions, taxes, and regulatory environments.
Capital Structure Theory: Modigliani-Miller Theorems
The Modigliani-Miller (M&M) irrelevance theorems provide a foundation for understanding capital structure theory. They state that, in a world without taxes or other frictions, the value of a firm is independent of its capital structure. The M&M theorems also show that the firm's weighted average cost of capital (WACC) remains constant as the firm changes its capital structure.
WACC (Weighted Average Cost of Capital)
The weighted average cost of capital (WACC) is the average rate that a company expects to pay to finance its assets. It is the weighted average of the cost of debt and the cost of equity, where the weights are determined by the proportion of each in the capital structure. A lower WACC is generally preferred, as it indicates a lower cost of financing.
Business Risk vs. Financial Risk
Business risk refers to the inherent uncertainty in a company's operations and profitability due to factors like competition, demand fluctuations, and cost variations. Financial risk, on the other hand, arises from the company's financing decisions and the use of debt in its capital structure. Higher levels of debt increase financial risk, as the company must meet interest payments and principal repayment obligations.
Debt overhang is a financial term that refers to a situation where a company's existing debt level is so high that it impedes the firm's ability to raise additional capital or invest in new projects. This phenomenon occurs because potential investors and lenders are concerned that the company's future cash flows will be primarily used to service its existing debt obligations, leaving little room for returns on new investments.
The presence of debt overhang can create a vicious cycle for a firm, as the inability to obtain new financing or pursue growth opportunities may further deteriorate its financial position. This can lead to decreased firm value, lower stock prices, and increased risk of bankruptcy. Additionally, debt overhang may also discourage management from undertaking positive net present value (NPV) projects, as they may not receive the full benefits of these investments due to the high debt burden.
Resolving debt overhang typically involves debt restructuring, debt reduction, or the infusion of new equity capital to improve the company's financial situation. By addressing the debt overhang issue, a firm can regain its ability to access capital markets, invest in growth opportunities, and restore investor confidence, ultimately leading to improved financial performance and increased firm value.
Insights from Modigliani-Miller
Although the M&M theorems provide a useful starting point for understanding capital structure, they rely on several unrealistic assumptions. In practice, factors like taxes, bankruptcy costs, and agency costs all influence a firm's capital structure decisions.
Corporate Debt and Default Risk
Debt financing comes with the risk of default, which occurs when a company cannot meet its debt obligations. Default risk depends on factors such as the company's profitability, cash flow, and debt maturity structure.
Default Premium and Risk Premium
The default premium is the additional interest rate that lenders charge to compensate for the risk of default. The risk premium, on the other hand, is the extra return that investors require for taking on higher risk investments, such as equities.
What We Have Learned from Empirical Default Risk Statistics
Empirical studies show that default risk is related to a firm's credit rating, financial leverage, and profitability. Firms with higher credit ratings, lower leverage, and greater profitability tend to have lower default risk.
How Taxes, Cost of Debt, and Other Frictions Impact Modigliani-Miller Assumptions
Tax Impact on Modigliani-Miller: In the presence of corporate taxes, the M&M propositions change. The interest paid on debt is tax-deductible, creating a debt tax shield that increases the value of the firm. This leads to a preference for debt financing over equity financing.
Debt Tax Shield: The debt tax shield is the reduction in taxable income that results from the tax deductibility of interest expenses. This shield effectively lowers the after-tax cost of debt, making debt financing more attractive.
Present Value of Debt Tax Shield: The present value of the debt tax shield represents the total value of tax savings over the life of the debt. It is an essential factor in determining the optimal capital structure in the presence of taxes.
Other Tax Shields: Companies may also benefit from other tax shields, such as depreciation allowances and investment tax credits, which can influence capital structure decisions.
Personal Tax Impact on Modigliani-Miller: Personal taxes on dividends and capital gains can also affect capital structure decisions. Generally, if personal taxes on dividends are higher than those on capital gains, firms may prefer debt financing to reduce their tax burden.
Trade-off Theory of Capital Structure
The trade-off theory posits that firms balance the benefits of debt financing, such as tax shields, against the costs, such as financial distress and agency costs. Firms seek an optimal capital structure that maximizes their value by balancing these benefits and costs.
The following chart shows the tradeoff between increasing leverage when a firm experiences the benefit of a tax shield and the penalty of excess debt in the form of potential costs of distress. The value of an unlevered firm can be increased by taking on more debt. But taking on too much debt will eventually result in the costs of distress outweighing the benefits of the tax shield.
Financial Distress
Financial distress occurs when a firm has difficulty meeting its financial obligations, such as interest payments and principal repayments. It can lead to bankruptcy or restructuring and is a crucial factor in determining a firm's optimal capital structure.
Cost of Financial Distress
Direct Costs: These costs include legal, court, and advisory fees associated with bankruptcy or restructuring. They also include the time and resources spent managing the distress.
Indirect Costs: Financial distress can lead to several indirect costs, such as damage to supplier and customer relationships, increased agency costs, and debt overhang, which occurs when the firm's debt burden hinders new investments.
Conclusion
Financing decisions and capital structure are crucial for a company's value and growth. The Modigliani-Miller theorems provide a foundational understanding of capital structure theory, while the trade-off theory offers a more realistic perspective by considering taxes, financial distress, and other factors. Ultimately, firms must balance the benefits and costs of debt and equity financing to determine their optimal capital structure, taking into account their unique circumstances, industry trends, and economic conditions.