Before going into the detail of Modigliani and Miller’s theory of capital structure (M-M Model), some of the basic concepts are important to be discussed.
Total Risk of a Company
So total risk faced by a company is composed of two types which are as follows.
Total Risk (Company) = Business Risk + Financial Risk
The risk of a company related to its assets and operations (except debt) is called business risk. It covers both the diversifiable (company-specific) and non-diversifiable (market) risks.
The basic reasons for an increase in the business risk of a company are the fluctuations and uncertainty in the costs and prices. This in turn results in higher operating leverage.
When a company takes debt its shareholders bear some additional risk, which is called financial risk. It is purely related to debt and as the debt increases the financial risk also increases. The higher the financial risk of a company is the higher would be the required ROR of its shareholders.
Operating Leverage (OL)
Operating leverage (OL) is considered to be the effect of a small change in sales on the return on equity (ROE). It means that if the sales of a company fall little, its ROE would fall to a great extent (provided the sales are less than the breakeven point). Numerically it is given as the ratio of fixed costs to the total costs.
Operating Leverage (OL) = Fixed Costs / Total Costs
As the OL of a company increases, its risk also increases.
Financial Leverage (FL)
The extent to which a company’s total capital is formed of debt is considered as financial leverage (FL). In other words, a company whose capital structure contains 70% debt and 30% equity is highly leveraged. Numerically
Financial Leverage (FL) = Debt / (Debt + Equity)
FL increases the risk of a company in such a way that the net income and ROE is greatly affected by small changes in EBIT, which is affected by the interest payment of high debt.
Modigliani and Millar’s Theory of Capital Structure
The effective proportion of debt acquired by a firm is not fixed by any general rule. Debt is a delicate matter for any company, therefore there is a model presented by two professors, which gives guidance in the composition of the capital structure of a company. This model or theory is called Miller & Modigliani Theory of Capital Structure.
This theory is presented by two professors in America named Modigliani & Miller. It was published in the form of an article in June 1958 in the American Economic Review. This theory is based on certain assumptions and Miller & Modigliani won the Nobel Prize for it.
Assumptions of the Theory
It is clear that the proportion of debt in the capital structure is not certain for a company and on the basis of certain factors this ratio changes from one company to another. The Modigliani & Millar model is an ideal case that gives guidance in this problem, but it is based on certain conditions which are as follows.
- There are no taxes to be charged.
- There are no costs associated with bankruptcy.
- The markets are efficient.
- All the investors have equal information.
- In the light of the above assumptions, the theory concluded the following generalizations.
- The capital structure of a company is irrelevant to its value.
- The proportion of debt has no effect on the firm’s operations and its overall value that is calculated through NPV.
- Capital Budgeting decisions are not affected by the capital structure of the firm. It means that the decisions of the investments are made without taking into account the capital structure of the company.
Modification in the Modigliani and Millar Theory
The pure Modigliani and Miller theory is an ideal case that does not apply to the real world. Therefore, certain modifications had been made to the theory in order to make it practical. Some of these changes were made by Modigliani and Miller themselves while the rest were applied by other economists.
Modigliani and Miller’s Theory with References to Taxes
In this case, Modigliani and Miller themselves included the effects of taxes in two ways that are as follows:
M-M Model (Corporate Taxes)
The interest payment to bondholders doesn’t tax in most of countries, whereas the Dividends paid to shareholders are taxed. From the company’s point of view, there is a tax saving associated with the bonds. So the company should favor debt for its capital structure.
M-M Model (Personal Taxes)
The investors bear higher personal income tax on their interest payments on bonds as compared to the personal income tax on dividend payments in most countries. So from the investor’s perspective, he should prefer to invest in shares (equity) than in bonds (debt).
The effects of the taxes are different on optimal capital structure from both perspectives. Therefore the net effect is difficult to measure, but practically the effect of corporate tax is stronger. So, the companies should favor debt for their capital structure.
M&M Theory with Reference to Cost of Bankruptcy
The pure M-M model has another unrealistic assumption related to the cost of bankruptcy. There are many difficulties in the way of companies in the modern world regarding the cash shortfall, an increase in the interest rates, loss in operations, and dominance of operating cash outflows over cash inflows, etc. All of these problems can lead a company to bankruptcy.
A company is said to be bankrupt when it is compelled to close down permanently as a result of the reasons like nonpayment of regular interest on debt and continuous loss etc.
A company does not die free of cost; there must be a number of costs attached to it. Following are some of the costs incurred in the whole process of bankruptcy of a company.
- The fee is given to the lawyers and accountants
- Legally protected penalties of the partner firms
- Bearing loss by selling the assets of salvage value.
A company bears certain costs even as a result of spreading rumors about its bankruptcy. These costs are in the shape of problems that are faced by the company in carrying out its operations successfully. Examples of these problems are the Enhancement of interest rates by banks, refusal of suppliers in giving raw materials on credit, and cancellations of purchase orders by customers.
The highly excessive leveraged companies have more chances to become bankrupt because the liability of the interest payments increases on the basis of large debts. Moreover, certain companies are more likely to become bankrupt.
- A company that does not keep liquid assets and has a fluctuating EBIT.
- A company that has higher operating leverage/fixed cost.
Capital Structure Tradeoff Theory
The trade-off theory is the modified Modigliani and Miller theory that takes into account both the impact of bankruptcy as well as taxes. This theory is best explained with the help of an example illustrated by a graph. Suppose a company has an unleveraged capital structure or its capital is purely composed of 100% equity. Now, as the proportion of debt increases in its capital structure, the value of the company changes. The following graph shows a clear picture.
Value of the Company = Price of Single Share x Number of Outstanding Shares.
In the above graph, the value of a company/ stock’s price is shown on the y-axis and the financial leverage is represented on the x-axis in percentage terms. At the start, the company has 100% equity (unleveraged) and its value remains unchanged throughout the graph as represented by the straight horizontal lines. It means that the value of a stock is not affected by financial leverage.
Now consider another case of the leveraged company that gradually increases the proportion of debt in its capital structure.
- When the proportion of debt is added to the capital structure, initially the value of the company increases because the total return enhances. Total Return = Net Income (Given to Shareholders) + Interest (Given to Debt holders)
- As the ratio of debt increases in the capital structure, the value of the company also rises continuously until it reaches its maximum point. This point is most suitable for the company as it has the maximum value and minimum Weighted Average Cost of Capital for its capital structure.
- On further increase in the debt, the value of the company starts decreasing while the WACC gradually increases. The result is in the shape of an increase in the interest rates, loss of purchase orders and credit facilities, and the threat of bankruptcy. In other words, the confidence of the investors declines upon the stock value of the company which pushes the company towards bankruptcy.
- The threats of bankruptcy equalize the previous benefits of debt and the price of the stock falls.
- The tradeoff between the advantages and disadvantages of debt provides the base for the decision of the proportion of debt in the capital structure.
Trade-off theory gives the range of the optimal Capital Structure for a company. It does not indicate the exact proportion of debt that should be maintained in the capital structure for the success of the company. The range where the company has the highest value along with the lowest WACC is the optimal capital structure proportion of debt.
Capital Structure Signaling Theory
Further modification in the Modigliani and Miller theory is made regarding the equal availability of the market information to all investors. The Signaling Theory takes into account the practical fact that all investors are not rational. The features of this theory are as follows.
- There are certain investors who have more knowledge about the company than others. In other words, the insiders (including owners & managers) know more than the outsiders.
- When the company is in healthy condition and it has potential cash flows in the future, then the managers of the company prefer to raise money through debt. As the managers clearly know that the company prospers in the future, so they do not want to share the high profits with new people. Instead, they acquire debt and pay certain interest payments that are relatively less than the expected profit ratio.
- When the conditions of the company are unhealthy then the managers wish to raise capital through equity. In this way, they actually share the future losses with the new people. On the other hand, if they acquire debt, then they will have to pay certain interest payments to debt holders and this will increase the chances of the bankruptcy of the company.
In the practical world, the companies should keep the debt ratio less than the optimal capital structure of the tradeoff theory. In other words, the company should keep some spare capacity for debt ratio so that in the near future if any good opportunity for investment comes in front of it, it can catch it by acquiring debt. There are three advantages in this regard.
- The managers do not want to share the high profit with the new shareholders.
- The managers spread good signals to the investors in the market about the health of the company.
- Another advantage of debt financing is that the managers do not waste money on extra expenses. Instead, their cash is effectively handled.
If the company raises money through equity, then it spreads the bad news in the market about the future health of the company. Resultantly they lose confidence in the stock of the company and sell the stock, which will decrease the demand, and hence the price of the stock will also decrease. Furthermore, the Required ROR of the investors also increases along with the increase in WACC.
Hello everyone! This is Richard Daniels, a full-time passionate researcher & blogger. He holds a Ph.D. degree in Economics. He loves to write about economics, e-commerce, and business-related topics for students to assist them in their studies. That's the sole purpose of Business Study Notes.
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