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Capital Structure is the finance term we use to explain how a firm
finances itself. On a personal level we each face some the same decisions
when we determine how much debt we should use. Capital Structure is
one
of the cornerstones of any corporate finance class (along with the
time
value of money, capital budgeting, and stockholder theory). If capital
budgeting is determining what to buy, capital structure is how to pay
for
what we do buy.
From Accounting we know that a firm’s assets must equal the sum of its
liabilities plus owner’s equity. From this simple identity comes the
general idea for everything to follow: we can finance assets with either
debt or equity. So how do we choose, or does it even matter?
The short answer is that capital structure probably does matter despite
how much of what will follow.
Most texts begin their decision of capital structure with Modigliani
and
Miller (MM). MM, who won the Nobel Prize for their work in Finance,
claim
that (under their assumptions) capital structure (nor dividends) matter.
So what gives? Why am I disagreeing with Nobel Prize winners? Because
my
statement that capital structure matters is not tied to their assumptions.
MM’s simplified assumptions are:
1) The firms operations are fixed
2) No transaction costs
3) Perfect markets
Under these assumptions the capital structure does not matter. Why?
Think of the Breiley and Myers pizza example. Do you get any more food
if
you cut the pizza into 12 pieces instead of 8? No, you are left with
smaller pieces, but the overall size of the pizza is the same.
All that MM’s 1st proposition is saying that it is the size of the pizza
that matters. Now MM were smart enough to realize that debt does make
the
stock riskier. To see why this risk didn’t lower the value of the firm
we
must introduce the concept of weighted average cost of capital (WACC).
Debt and equity each have a cost. Their cost, in the absence of taxes
is
the return investors require for holding the securities. Debt has a
lower
required return because it has a more senior claim on the firm’s assets
and the cash flows are less volatile.
The WACC= (weight of debt) x cost of debt + (weight of equity) x cost
of
equity.
Now suppose we know how much cut the firm will make. If we do then the
value of f should be
Value of firm= CF(1)/(1+ wacc)+ CF(2)/(1+wacc)^2 + CF(n)/(1+wacc)^n
Holding the CF constant the lower the WACC, the higher the value of
the
firm.
So suppose we start off with no debt then the value of firm suppose
Sum (CF/(1+Ke)) if no debt the wacc= Ke
Now firm issues debt
WACC= W(D)K(D) + W(E)*K(E)
But K(E) increases as riskiness increases.
The idea behind MM prop. #1:
That is as more debt (with a lower cost) gets added to capital structure,
the cost of equity increases. This increase offsets the lower cost
of
debt so that overall there is no change. Thus, capital structure does
not
matter.
Next Week we will relax the assumptions and see why capital structure
really does matter.
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