Discuss.
“If debt is available companies should attempt to become as highly geared as possible.”
Introduction
Debt forms part of a company’s capital structure which is mostly determined by decisions which are based on the weighted cost of capital (WACC). The capital structure of firm influences its WACC (Brigham, 1989). The proportion of debt compared to the equity in business is compared using the gearing ratio. Gearing ratio is a financial ratio that is used to generalize the status of a company especially when prospective investors are interested on the financial stability of a company. Gearing is a tool that is utilized to estimate the level of risks associated with non-payment of loans. High gearing ratio allows companies to expand and utilized opportunities that increase the chances of the business earning more profits.
When a company has very low gearing then fluctuation in interest rates has little impact on the company and its operations. A company that has low gearing ratio also has low financial risks that are associated with high levels of loans. Low gearing ratio also indicates high cash flows as the company has less loans to service hence the company can invest more. A company’s capital structure reveals the mixture of the sources of capital that the firm has used to fund the projects in an organization (Modigliani and Miller, 1958). The capital structure identifies the percentage of financing that is debt, common equity or preferred stock. The optimal capital structure of a firm provides the most cost effective capital mix that the company can adopt (Williams, Haka, Bettner & Carcello, 2008). The objective of financial managers is to identify and maximize the firm’s value. The achievement of optimal capital structure is only possible through financing that has a good ratio of both debt and equity. Several theories explain how organizations determine the optimal capital structure. The capital structure pioneer theorists are Modigliani and Miller and they assist in the determination of the optimal mixture of equity and debt funding however several assumptions apply; (Barges, 1982).
- The expectations of the investors are homogenous
- The capital markets are perfect and there are no transaction costs and companies or individuals are allowed to borrow at the same costs.
- The risk free rate represents the cost of debt and which is constant.
- The firms are assumed to have zero-growth and earnings are presumed to be perpetual and constant while all profits are issued as dividends.
The two theories apply under two conditions a) with taxes b) without taxes.
MM model (without taxes)
Modigliani and Miller applied the arbitrage proof to show that when taxes are not included then the value of a firm that has no debt is similar to the one that has debt. The equation is Vu = Vg where Vu = The value of a firm that is unlevered (has no debt)
Vg = The value of a firm that is geared (with debt)
All profits are paid as dividends while they are expected to remain constant for period is indefinite. Hence common stock behaves like preferred stock.
When a company increases its usage of debt then its constraints increases as interest payments also increases on its cash flows (Brooks & Mukherjee, 2013).
The cost of an average company debt is generally cheaper than the actual cost of a company’s common stock. Companies’ experience some saving when debt is used but the benefits are mostly wiped out by the common stock increased costs.
When corporate taxes do not apply, a firm’s value is basically not influenced by the company’s capital structure or in other words a firm’s value is not in any way affected by the use of debt (Garrison, Noreen & Brewer, 2009). Hence the WACC of the company is also unaffected.
When a company increasingly uses more debt, the current and all prospective shareholders will consider the company as getting more risky (Rosenand Gayer,2010). This is largely the case as more debts will attract more interest payments. Companies cannot escape interest payments hence greater cash constraints would be experienced as the usage of debt increases (Modigliani and Miller, 1958). To attract the shareholders due to the high interest payments then the company would have to pay high returns as an advantage to investors not to sell the stocks hence a higher cost equity results. A firm enjoys larger savings when more debt is used as the cost of debt is less expensive that the use of equity. However, the cost of equity increases as more debt is increased by the firm. From the model we learn that, all the savings made from the use of debt capital is used up by the payments of interests hence the increased cost of equity. The weighted average cost of capital largely remains unchanged (Black, Jensen and Scholes, 1972).
The MM model concludes that a company enjoys no benefit from increased use of debt and whatever a company saves is all used up to offset the increasing cost of equity (Brigham, 1989).
II. Modigliani & Miller Model (with corporate taxes)
In the year 1963, Modigliani and Miller formerly published an article based on a more refined model where taxes were incorporated (only corporate taxes not personal taxes). The model is commonly referred to as the MM model 2 (Brealey, Myers & Allen, 2005).
MM proposition 2: rsl = rsu + (rsu – rd) (1-rc) (Dl/Sl) (Damodaran, 2005).
MM proposition 1 was; Vl = Vu + tc Dl
Where Vu = EBIT(r-tc)/rsu (Vu or the value of unlevered firm has changed because of the taxes)
The two models with corporate taxes can be represented by the following two graphs;
Cost of Capital Value of Firm
rsl Vl
Vu
WACC (1-tc) rd
Debt/Value Debt
The two lessons from the two graphs are;
- In proposition 1, the capital structure of the company has some impact on the firm’s value. The positive impact on the value of the firm indicates that the value of the firm increases as the usage of debt increases. The tax advantage can be increases as represented by the following equation (Dunn, 2009).
Tax advantage = rcDl
The reason why there is tax advantage in increasing debt as compared to equity is that when a company is determining its taxes, all the interest payments can be written off and not dividends as in the case of equity. The effect of the taxes on companies is similar to receiving subsidy from the government for using debt when raising capital funds and not when using equity funds (Myers, 1984).
The second lesson is that, in proposition 2 where corporate taxes are apply, just like in proposition 2, there are two benefits for using debt financing, debt when compared to equity, is a less expensive source of capital and secondly the taxes payable are written off when debt is utilized as capital for the firm. In the initial discussion of the MM model, the benefits of using debt as capital financing were directly consumed by the increased cost of equity in form of interests’ payments. However, where corporate taxes are involved, the benefits of using debt surpasses the costs that accrue to equity hence the ultimate costs of a geared company in an environment where taxes apply increases gradually than in an environment where there are no corporate taxes. The shareholders have less compensation for financial risks where corporate taxes exist. The risk premium to shareholders drastically reduces in an environment where taxes apply. As the increased benefits of using debts outweigh the benefits of using equity capital, the WACC is also affected the same way and the weighted average cost of capital also decreases as the debts is used (Rosen and Gayer, 2010).
The Modigliani-Miller principle concludes that where corporate taxes exist, a company enjoys the usage of debt which comes as a tax shield on interest payments. As the use of debt increases the value of a firm also increases (Ferrara, 2010). A company will achieve the highest value with the lowest cost of capital when debt financing is 100% (Weimer and Vining, 2005).
Finally debt financing enables the ownership of a company to maintain the control of the business without diluting the company’s ownership of the company. The owners of the company retain the right to make decisions and enjoy the profits of the company. The interest payments on debt are tax deductible (Barges, 1982). However the risk of bankruptcy is very high when the company is highly geared. The calculations of the debt to equity financial ratios determine the level of debt in a company. The higher the debt to equity ratio the more geared a company is (Crfonline.org, n.d.). Excessive debt is not good for a company but the management of a firm must decide to maintain the most optimal mixture of a company’s debt and equity.
References
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