Within a corporate, the capital structure decision is one of the most important decisions made by the management. The capital structure of a firm affects the risk profile of the firm as well as its profitability.

The capital structure refers to how the assets and operations of the business are financed. The financing can be done with a combination of debt, equity, and hybrid securities.


An Introduction to Capital Structure

This video highlights the basic capital structure differences between two firms.

In the example taken, the two shoe firms, namely, Ben's Shoes and Jason' Shoes are two exactly same businesses, they operate similarly, and have the same revenue and operating profits. However, they have different capital structure which affects their net profits, and earnings per share.

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This video is from Khan Academy.

Basic Differences in Capital Structure of Two Firms

The value of the firm is measured as the sum of the value of the firm’s equity and the value of the debt. Any firm’s objective is to maximize its value for the shareholders. The value of the firm can be measured as the present value of the operating free cash flows over time.

The value of the firm can be expressed using the following formula:

<div class="formula1">[latex]Firm Value (V) = \sum_{t=1}^{\infty }\frac{OFCF_{t}}{(1+WACC)^{t}}[/latex]

Where:
V is the Value of the firm
OFCF is the Operating Free Cash Flow After Tax
And WACC is the Weighted Average Cost of Capital
</div>



The Operating Free Cash Flow (OFCF) is measured as:

<div class="formula1">OFCF = Revenue – Operating Expenses – Capital Expenditure</div>

The Weighted Average Cost of Capital (WACC) is measured as:

<div class="formula1">[latex]WACC = r_{e}\frac{E}{V}+r_{d}(1-t)\frac{D}{V}[/latex]

Where:
r<sub>e</sub> = Cost of equity 
r<sub>d</sub> = Cost of debt 
E = Value of the firm's equity 
D = Value of the firm's debt 
V = E + D 
E/V = Percentage of equity financing 
D/V = Percentage of debt financing 
t =  Tax rate 
</div>
The expected future cash flows of a firm can also be expressed as a perpetuity. In that case, the firm’s value can simply be expressed as:

<div class="formula1">[latex]V = \frac{OFCF_{t}}{WACC}[/latex]</div>



Value of a Firm (Using Operating Free Cash Flows)

A firm has to choose an appropriate mix of equity of debt in such a way that it maximizes the value of the firm.

Any change in the debt-equity mix will have an impact on the value.

It has been observed that adding debt to the capital structure of a firm increases the value of the firm upto a point. This point corresponds to the optimal capital structure. Beyond this point any increase in the debt the value starts decreasing again.

Let us understand this in more detail.

According to a Modigliani and Miller (1958 article), if there are no corporate taxes, the mix of debt and equity does not matter and does not have any impact on the value of the firm. The value of the firm is simply equal to the operating income divided by the overall cost of capital.

The reason behind this is that any benefit that arises from the lower cost of debt is offset by the increase in the cost of equity caused by borrowing.

However, thinking about businesses without corporate taxes in unrealistic. Modigliani and Miller revised their theory in 1961 and this time assumed the presence of corporate taxes.

If we assume that corporate taxes exist, the theory that the value of the firm doesn’t depend of the capital structure doesn’t hold good.

In the new article, they recognize that with the increase in leverage, the value of the firm will increase or the cost of capital will decrease. This is because the interest paid on debt is a deductible expense.
Because there is no tax to be paid by the bondholders, the value of the leveraged firm is higher than the unleveraged firm.

The increase in the value of the leveraged firm will be equal to the present value of the tax shield due to tax savings given by the tax deductibility of interest expense on debt.

This is also known as the trade-off theory. The trade-off theory says that companies have optimal debt-equity ratios, which they determine by trading off the benefits of debt against its costs.

One benefit of debt as we saw is the tax deductibility.  More recent versions of the model also attempt to incorporate Jensen’s “free cashflow” argument, in which debt plays a potentially valuable role in mature companies by curbing a managerial tendency to overinvest. 


Does Capital Structure Matter?

Agency cost refers to the cost incurred by a firm because of the problems associated with the different interests of management and shareholder and the information asymmetry that exists between the principal (shareholders) and the agent (management).

<strong>Agency Cost of Equity</strong>

The agency cost of equity arises because of the difference in interests between the shareholders and the management. As long as the management’s interests diverge from that of the shareholders, the shareholders will have to bear this cost. Management may be tempted to take suboptimal decisions that may not work towards maximizing the value for the firm. Any measures implemented to oversee and prevent this will have a cost associated with it. So, the agency costs will include both, the cost due to the suboptimal decision, and the cost incurred in monitoring the management to prevent them from taking these decisions.

<strong>Agency Cost of Debt</strong>

The agency cost of debt arises because of different interests of shareholders and debt-holders. Assume that the management is in favour of the shareholders. If so, the management can in many ways transfer the wealth to the shareholders and leaving debt-holders empty handed. Anticipating such activities, the debt-holders will take various preventive measures to disallow management from doing so. The debt holders may do so in the form of higher interest rates to protect themselves from the losses. Alternatively they may impose restrictive covenants.

One example of such behaviour is seen in the priority given to dividends. In their pursuit to please the shareholders, the management may give cash dividends to the shareholders, leaving very less to pay to the debt holders. To avoid this situation, there is this requirement that the interest must be paid before dividends.

Similarly there are other situations where such covenants are placed, for example, debts with different seniority.

<strong>Information Asymmetry</strong>

In general, we can say that the management is more information about the prospects of the business compared to shareholders, debt-holders and other parties. This is called information asymmetry.

The information asymmetry directly affects the agency costs: the higher the information asymmetry, the greater will be the agency costs.

Agency Costs of Equity and Debt

It is generally observed that when a firm issues additional equity, the share prices fall. Why does that happen? Since the firm uses equity in value-adding investments, it may surprise people that the stock prices actually fall.

One explanation of this phenomenon can be given by the theory of information asymmetry. According to this concept the management has more information about the prospects of the firm, compared to shareholders, debt-holders and other stakeholders.

We also know that the management issues more equity when the equity value is high.

Since the management knows best, when they issue additional equity, the market interprets that the equity is overvalued. And therefore the stock prices fall.

Why Issue of Additional Equity Leads to Share Price Fall?

In 2001, John Graham and Campbell Harvey conducted a survey of that analyzed the current practice of corporate finance, with particular focus on the areas of <a title="Basic Principles of Capital Budgeting" href="https://financetrain.com/basic-principles-of-capital-budgeting/" target="_blank">capital budgeting</a> and <a title="An Introduction to Capital Structure" href="https://financetrain.com/an-introduction-to-capital-structure/" target="_blank">capital structure</a>. In simple terms, they asked American Chief Financial Officers what factors they consider while making capital structure decisions.

As per this survey, the key considerations the firms have while issuing debt are:

<strong>Tax benefits: </strong>The extent of tax benefit from the debt. If the firms have other tax shields (such as depreciation, expenditure on research and development, etc.), they will generally issue less debt.

<strong>Distress cost:</strong> Firms with high volatility in their earnings will have less debt. Small firms will have less debt. Large firms will have high debt.

Apart from this <strong>flexibility</strong> and <strong>credit ratings</strong> were cited as very important considerations in corporate debt policy. By maintaining flexibility, most companies mean preserving unused debt capacity. It’s also interesting to note that although many companies say their excess debt capacity is intended mainly to finance possible future expansions and acquisitions, such firms also seem intent on retaining much of that unused debt capacity even after expanding.

And, as suggested earlier, such flexibility tends to be associated with maintaining a target credit rating. The paper can be downloaded from the fellow link:

<a href="http://faculty.fuqua.duke.edu/~jgraham/website/SurveyJACF.pdf" target="_blank">Download the Survey Paper</a>

What CFOs Consider While Making Capital Structure Decisions?

Basics of Capital Structure

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