Debt versus equity
How much should a company borrow? Capital structure theory weighs tax benefits of debt against the costs of financial distress.
Capital structure
Capital structure is the mix of debt and equity a firm uses to finance its assets. Leverage magnifies returns: borrowing at a lower rate than the return on assets raises return on equity, but also increases the volatility of returns and the risk of bankruptcy.
Modigliani-Miller without taxes
In 1958, Franco Modigliani and Merton Miller showed that, in a perfect market with no taxes, bankruptcy costs, or information problems, a firm's value does not depend on its capital structure. Debt seems cheaper, but adding debt raises the cost of equity exactly enough to offset the benefit. Both later won Nobel Prizes.
Adding corporate taxes
With corporate taxes, interest is deductible, creating an interest tax shield. Modigliani and Miller showed in 1963 that this makes debt valuable: the value of a levered firm = value of an unlevered firm + present value of tax shields. Taken alone, this would suggest firms should use almost all debt.
Costs of financial distress
Too much debt brings costs: direct bankruptcy costs (legal and administrative fees), indirect costs (lost customers, suppliers demanding cash, employees leaving, managers distracted, forgone investments), and conflicts between shareholders and creditors. These costs rise with leverage.
The trade-off theory
The trade-off theory says firms choose leverage by balancing the tax benefits of debt against expected distress costs. The optimal capital structure is where the marginal tax benefit equals the marginal expected cost of distress. Firms with stable cash flows and tangible assets, such as utilities, can carry more debt.
The pecking order theory
The pecking order theory, associated with Stewart Myers, argues that firms prefer internal funds first, then debt, and issue new equity only as a last resort, because issuing shares may signal that managers think the stock is overvalued. This helps explain why profitable firms often borrow little.
Leverage in practice
Capital structures vary widely by industry: utilities and real estate firms tend to have high debt, while technology firms often have little. Credit ratings constrain borrowing, since many firms target investment-grade ratings. Leveraged buyouts finance acquisitions with large amounts of debt, aiming for high returns but with high risk.
Worked example
A firm with 10 million dollars of assets earns 15% on assets (1.5 million operating income). Financed fully by equity, ROE = 15%. If it borrows 5 million at 6%, interest is 0.3 million, profit (ignoring taxes) is 1.2 million on 5 million equity: ROE = 24%. If returns on assets fall to 4%, operating income is 0.4 million, profit 0.1 million, and ROE falls to 2%, versus 4% unlevered.
Key takeaways
Capital structure is the debt-equity mix; leverage magnifies returns and risk. Modigliani-Miller (1958) showed capital structure is irrelevant in perfect markets. With taxes, debt adds value through interest tax shields. Financial distress costs rise with leverage. The trade-off theory balances tax benefits and distress costs. The pecking order theory says firms prefer internal funds, then debt, then equity. Leverage varies by industry and is constrained by credit ratings.
Flashcard
Mix of debt and equity
Check your understanding
According to the trade-off theory, a firm's optimal capital structure balances: