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Last week we looked at Capital Structure when Modigliani and Miller’s
(MM)
assumptions held. That is the markets were perfect, no transaction
costs,
no taxes, and no interactions between operations and how the firm is
financed. This week we are going to relax the assumptions. These
assumptions are of paramount importance; indeed the assumptions may
be the
real reason for MM winning the Nobel Prize! Let me explain:
In a sort of inadvertent backdoor way the assumptions of MM models to
identify when Capital Structure does matter. In fact, they serve to
show
when anything matters. For anything to matter in finance it must either
effect transaction costs, effect taxes, effect market perceptions,
or
effect operations.
For example, let’s relax the “no transaction cost” assumption. It is
probably the easiest to understand and it will get you thinking in
a way
that will make the next two lessons easier to understand. If there
are
transaction costs, then capital structure begins to matter since investors
can no longer undue whatever action the firm does. Another assumption
that need be relaxed is that of no taxes.
In many nations, the US included, debt and equity are taxed differently.
To this extent, capital structure is influenced by taxes. If firms
are
allowed to deduct interest payments then the true cost of a dollar
paid
out in interest is not a dollar. Why? The interest payment comes off
of
pre-tax income, which thereby lowers the cost of tax that must be paid.
Thus, the true cost of the dollar paid out in interest is $1 (1- Marginal
Corporate Tax rate). For example, if the Corporate Tax = .33, then
a
dollar paid out only costs the firm 67 cents.
Under the assumption of only having a corporate tax rate, the cost
of
debt is in some ways “artificially” low. Thus, the Kd drops faster
than
the cost of equity rises.
Here we have:
WACC = Weight of Debt (YTM ) (1-Corporate Tax) + Weight of equity *
Cost
of equity
Where YTM stand for the Yield to Maturity (fancy term for total return
that investors require on debt).
As would be expected we can now increase the value of the firm by
replacing relatively higher costing equity with cheaper debt (made
cheaper
still by the deductibility).
How much does firm value go up? In theory, by the present value of all
future tax savings. This equals (Corporate Tax)(Amount of Debt).
Firm Value
|
|
* Value of firm with debt
|
*
| *
| *
| *************** Value of firm with no debt
|
|
|
|------------------------------- % debt in capital stucture
Value of firm with debt = Value of firm without debt + (Corporate Tax
*
Amt. of Debt)
Under this model, MM II, we can see that to maximize firm value you
borrow
as much as you can (WD = 99.9%). Ignoring the IRS’ disallowance of
deductibility if a firm has too much debt, this just does not seem
correct. Intuitively, do you want your firm to have that much debt?
No.
Why not? There are probably many reasons you do not want your firm
to
have that much debt. For example, as debt increases, risks increase.
Or
as debt increases, your employees may act differently, they may leave!,
or
you customers may not want to do business with you. These are all costs
of the debt that do not show up in the interest payments. We call these
costs, some of which are opportunity costs, the costs of financial
distress.
The costs of financial distress increase with debt levels. That is,
the
higher the debt, the higher the cost of financial distress. When these
costs are included our new firm value is
Value of firm with debt = Value of firm without debt + (Corporate
Tax)(Amount of debt) - PV of Financial distress
So when are financial distress costs the highest? Where firms assets
make
poor collateral, where the likelihood of getting into distress is high,
and where getting into financial difficulties will impact operations.
This means that a stable business with tangible, unspecialized assets
borrow more than firms in risky businesses and with assets that make
poor
collateral (either specialized or intangible).
Next Week: Capital Structure, Incentives, and Signaling
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