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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 conflictsa firms 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 companys 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.

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

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The Trade-Off of Debt


In this so-called MillerModigliani 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 tckd = 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.
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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.

Financing Choices and a Firms Life Cycle


Although companies may prefer to use internal financing to minimize the issuance (transaction) costs, the trend in financing depends critically on the firms life cycle. Start-ups are small, privately owned companies. They are likely to be financed by owners funds and bank borrowings. Their funding needs are high, but their ability to raise external funding is limited because they do not have sufficient assets to offer as security to finance providers. They will try to seek private equity funding. Their long-term leverage is likely to be low as they are mainly financed with short-term debt. Expanding companies are those that have succeeded in attracting customers and establishing a presence in the market. They are likely to be financed by private equity and/or venture capital in addition to owners equity and bank debt. Their level of debt is low and they have more short-term than long-term debt in their capital structure. High-growth companies are likely to be publicly traded, with rapidly growing revenues. They will issue equity in the form of common stock, warrants, and other equity options, and probably convertible debt. They are likely to have a moderate leverage. Mature companies are likely to finance their activities by internal financing, debt, and equity. Their leverage is likely to be relatively high but will depend on the costs and benefits of debt and their fundamental factors, such as business risk and taxation.

Conclusion
This article discussed the different financing methods companies can use and then argued that their choice depends on the costs and benefits of debt financing and the firms life cycle. For example, whereas startup companies are likely to be financed with private personal funds, making their leverage low, mature companies tend to have high leverage because they are able to mitigate the costs of debt and gain from the tax benefits. In addition to these factors, in practice firms may choose their financing mix by mimicking comparable firms, or they may adopt the average level of debt of all the companies in their industry. These methods are not highly recommendable as they may result in a suboptimal choice. In other cases they follow a financing hierarchy, where retained earnings are the preferred option, followed by external financing in the form of debt, and then equity. This preference is driven by the transaction and monitoring costs.

Making It Happen
The choice of financing is strategic and involves the following issues: Both low- and high-debt financing are suboptimal. Companies should aim for the most advantageous level of debt financing, whereby the costs are minimized and the benefits are maximized. The costs of debt include a greater probability of bankruptcy, an increase in the agency conflicts between managers and bondholders, a loss of future financial flexibility (including the availability of collateral assets), and information asymmetry costs. The benefits relate mainly to tax shields and the added discipline to mitigate the agency conflicts between stockholders and managers. This equilibrium applies primarily to mature companies. Start-ups and growth companies are likely to have lower leverage as their borrowing capacity is low. It also applies to companies that normally pay dividends and do not accumulate cash for reinvestment in order to avoid the need to raise external financing.
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Optimizing the Capital Structure: Finding the Right Balance between Debt and Equity

The recent financial crisis has highlighted another issue in debt financing, namely liquidity. Leverage concepts were developed mainly in times when debt financing was fully available. In the current credit crisis this is no longer the case. Companies therefore now have to pay an extra liquidity cost to raise additional capital. The question is whether this is a temporary situation or a permanent one, in which case debt will become more costly and leverage will be lower than in the past. Another challenge of debt financing relates to the ethics of the use of excessive debt financing, particularly by financial institutions. Pettifor (2006) was able to foresee the current crisis, tracing debt financing back to early times and arguing that religions are against debt because it results in usury. She provides interesting arguments, challenging the whole structure of debt financing, payment of interest, and interest tax deductibility. Possibly a new structure of debt that is linked to the profitability of assets and incurs no interest will emerge from the current crisis.

More Info
Books:
Damodaran, Aswath. Applied Corporate Finance: A Users 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 (2002): 823. Lasfer, M. A. Agency costs, taxes and debt: The UK evidence. European Financial Management 1 (1995): 265285. Modigliani, Franco, and Merton H. Miller. The cost of capital, corporation finance and the theory of investment. American Economic Review 48:3 (1958): 261297.

Websites:
About.com article Debt financingPros and cons: entrepreneurs.about.com/od/financing/a/ debtfinancing.htm Answers.com article Debt financing: www.answers.com/topic/debt-financing Washington State University teaching module Financing sources for ICTs: Debt finance: cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page31.htm

See Also
Best Practice Capital Structure: A Strategy that Makes Sense Capital Structure: Implications Capital Structure: Perspectives Checklists Conflicting Interests: The Agency Issue Investors and the Capital Structure Understanding and Using Leverage Ratios Understanding Capital Markets, Structure and Function Understanding Capital Structure Theory: Modigliani and Miller Thinkers Franco Modigliani Merton Miller

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