Financial managers have to ensure that they are maximising shareholder wealth and ensuring that the business uses an optimal mix of debt and equity finance.
There are three theories that emphasize how the capital structure of a company affects the company:
- Traditional view
- Modigliani-Miller (M&M)- No tax consideration and Tax is considered
- Pecking-order theory
This theory assumes that the greater the level of debt in a company the greater the weighted average cost of capital. The more dependent a company is on debt the greater their financial risk because debt is less flexible so company has to meet these payments even if it means delaying payments to shareholders. Shareholders will classify these companies as more risky, which means, they will expect a higher return from dividends, which means cost of equity of the company increases.
This model emphasizes the need to find the level at which the cost of debt/equity is minimised by finding the most acceptable risk point.
Modigliani-Miller (M&M) – No tax consideration
This theory assumes that a company’s capital structure is not related to its weighted average cost of capital, rather it depends on company earnings and level of business risk of those earnings (it’s future cash-flows . How those cash-flows are split in order to pay debt/equity holders is irrelevant.
Modigliani-Miller (M&M) – with Tax
This theory takes into account how the tax system influences companies. This theory is similar to the no tax consideration but takes into account that the tax relief on debt interest will mean the cost of debt is lower than shown by M&M no tax. For this reason businesses should take on as much debt as possible.
This model makes several assumptions including:
- Debt is risk-free – Ignores that bankruptcy is possible as gearing increases.
- No tax
- Transaction Cost
- Perfect capital market – Every Investors has same level of information.
These assumptions make this model unrealistic.
The pecking order theory suggests that companies follow a preferred order to obtaining finance, which is:
- Retained earnings
- Debt – Straight then convertible debt.
- Equity – Preference shares then Equity shares
This theory emphasizes that firms try to finance investment opportunities with internal sources of finance. If this is not adequate then they might gain external finance through the use of debt or equity.
Capital Asset pricing method Project Appraisal
When the weighted average Cost of Capital cannot be used to evaluate investment appraisals, the CAPM can be used to determine the discount rate. This method can be used to identify how taking on projects with higher risk than the company’s usual business risk will affect the company.