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Home > Financing Best Practice > Optimizing the Capital Structure: Finding the Right Balance between Debt and Equity

Financing Best Practice

Optimizing the Capital Structure: Finding the Right Balance between Debt and Equity

by Meziane Lasfer

Executive Summary

  • Just over 50 years ago Miller and Modigliani (1958) showed that under a certain set of conditions—namely perfect capital markets with no taxes and agency conflicts—a firm’s capital structure is irrelevant to its valuation.

  • Their results are controversial and have raised a large number of questions from academics and practitioners.

  • This article summarizes the main issues underlying the choice by firms of an appropriate capital structure, taking into account their specific fundamentals as well as macroeconomic factors.

  • It presents the benefits and costs of borrowing, describes how to assess these to arrive at the basic trade-off between debt and equity, and examines conditions under which debt becomes irrelevant.

Types of Financing

There are three financing methods that companies can use: debt, equity, and hybrid securities. This categorization is based on the main characteristics of the securities.

Debt Financing

Debt financing ranges from simple bank debt to commercial paper and corporate bonds. It is a contractual arrangement between a company and an investor, whereby the company pays a predetermined claim (or interest) that is not a function of its operating performance, but which is treated in accounting standards as an expense for tax purposes and is therefore tax-deductible. The debt has a fixed life and has a priority claim on cash flows in both operating periods and bankruptcy. This is because interest is paid before the claims to equity holders, and, if the company defaults on interest payments, it will be declared bankrupt, its assets will be sold, and the amount owed to debt holders will be paid before any payments are made to equity holders.

Equity Financing

Equity financing includes owners’ equity, venture capital (equity capital provided to a private firm in exchange for a share ownership of the firm), common equity, and warrants (the right to buy a share of stock in a company at a fixed price during the life of the warrant). Unlike debt, it is permanent in the company, its claim is residual and does not create a tax advantage from its payments as dividends are paid after interest and tax, it does not have priority in bankruptcy, and it provides management control for the owner.

Hybrid Securities

Hybrid securities are securities that share some characteristics with both debt and equity and include, for example, convertible securities (defined as debt that can be converted into equity at a prespecified date and conversion rate), preferred stock, and option-linked bonds.

The Irrelevance Proposition

In 1958 Modigliani and Miller demonstrated that, under a certain set of assumptions, the choice between any of these securities (referred to as capital structure or leverage) is not relevant to a company’s valuation. The assumptions include: no taxes, no costs of financial distress, perfect capital markets, no interest rate differentials, no agency costs (rationality), and no transaction costs. These assumptions are, in fact, the main drivers of capital structure and gave rise to the trade-off theory of leverage.

The Trade-Off of Debt

In this so-called Miller–Modigliani framework, firms choose their optimal level of leverage by weighing the following benefits and costs of debt financing.

Benefits of Debt

There are two main advantages of debt financing: taxation, and added discipline.

Taxation: Since the interest on debt is paid before taxation, whereas dividends paid to equity holders are usually paid from profit after tax, the cost of debt is substantially less than the cost of equity. This tax-deductibility of interest makes debt financing attractive. Suppose that the debt of a company is $100 million and the interest rate is 10%. Every year the company pays interest of $10 million. Suppose that the corporation tax rate is 30%. If the company does not pay tax, its interest will be $10 million and the cost of debt will be 10%. However, if the company is able to deduct the tax on this $10 million from its corporation tax payment, then the company saves $10 million × 30% = $3 million in tax payments per year, making the effective interest payment only $7 million. If the debt is permanent, every year the company will have a $3 million tax saving, referred to as a tax shield. We can compute the present value (PV) by discounting annual value by the cost of debt, as follows:

PV of tax shield = kd × D × tc ÷ kd = D × tc

where kd is the cost of debt, D is the amount of debt, and the product of kd and D gives the amount of the interest charge. tc is the corporation tax rate. We simplify the ratio by kd to obtain the present value of the tax shield as the product of the amount of debt and the corporation tax rate. Thus, the value of a company that is financed with debt and equity (such a company is referred to “levered”) should be equal to its value if it is financed only with equity plus the present value of the tax shield. We can write this value as:

Value of levered firm with debt D = Value of nonlevered firm + D × tc

These arguments suggest that the after-tax cost of debt can be computed as 10% × (1 − 30%) = 7%.

Added discipline: In practice, the managers are not the owners of the company. This so-called separation of managers and stockholders raises the possibility that managers may prefer to maximize their own wealth rather that of the stockholders. This is referred to as the agency conflict. In general, debt may make managers more disciplined because debt requires a fixed payment of interest, and defaulting on such payments will lead a company to bankruptcy.

Costs of Debt

Debt has a number of disadvantages, including a higher probability of bankruptcy, an increase in the agency conflicts between managers and bondholders, loss of future financial flexibility, and the cost of information asymmetry.

Expected bankruptcy cost. Given that debt holders can declare a company bankrupt if it defaults on its interest payment, companies that have a high level of debt are likely to have a high probability of facing such a default. This probability is also increased when a company is operating in a high business risk environment. Debt financing creates financial risk. Thus, companies that have high business risk should not increase their risk of default by taking on a high financial risk through their use of debt. Evidence indicates that much of the loss of value occurs not in the liquidation process but in the stage of financial distress, when the firm is struggling to pay its bills (including interest), even though it may not go on to be liquidated.

Agency costs: These costs arise when a company borrows funds and the managers use the funds to finance alternative, usually more risky, activities than those specified in the borrowing contract to generate higher returns to stockholders. The greater the separation between managers and lenders, the higher the agency costs.

Loss of future financing flexibility: When a firm increases its debt substantially, it faces difficulties raising additional debt. Companies that can forecast their future financing needs accurately can plan their financing better and may not raise additional funds randomly. In general, the greater the uncertainty about future financing needs, the higher the costs.

Information asymmetry: When companies do not disclose information to the market, their information asymmetry will be high, resulting in a higher cost of debt financing.

Redeployable assets of debt: Lenders require some sort of security when they fund a company. This security is referred to as collateral. Lenders accept assets that can be resold or redeployed into other activities, such as property (real estate), as collateral. In general, the lower the value of the redeployable assets of debt, the higher are the costs.

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Further reading

Books:

  • Damodaran, Aswath. Applied Corporate Finance: A User’s Manual. 2nd ed. Hoboken, NJ: Wiley, 2006.
  • Pettifor, Ann. The Coming First World Debt Crisis. Basingstoke, UK: Palgrave Macmillan, 2006.

Articles:

  • Graham, John R., and Campbell R. Harvey. “How do CFOs make capital budgeting and capital structure decisions?” Journal of Applied Corporate Finance 15:1 (Spring 2002): 8–23. Online at: dx.doi.org/10.1111/j.1745-6622.2002.tb00337.x
  • Lasfer, Meziane A. “Agency costs, taxes and debt: The UK evidence.” European Financial Management 1:3 (November 1995): 265–285. Online at: dx.doi.org/10.1111/j.1468-036X.1995.tb00020.x
  • Modigliani, Franco, and Merton H. Miller. “The cost of capital, corporation finance and the theory of investment.” American Economic Review 48:3 (June 1958): 261–297. Online at: www.jstor.org/stable/info/1809766

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