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Modigliani and Miller's Capital-Structure Theory

Write an essay to discuss the contribution of Modigliani and Miller to the theory of capital structure. What are the limitations of the models developed by Modigliani and Miller and which theories try to explain why in practice capital structure is determined differently? What is the connection between capital structure decision making and corporate governance?

The “capital structure” of a company is considered as the means by which an organization can finance its assets. A “company” is able to “finance its processes either with equity or debt or with combination of both. The “capital structure” may compose of majority of the “debt or majority of equity or mixture of both”. In the 1950s two instructors “Modigliani and Miller”, analysed a “capital-structure theory” profoundly. The theory advocates capital structure irrelevancy which suggest that a firm which is “highly leveraged” or bears “lower debt” constituent has no impact on the “market value”. It also advocates that the firm valuation has no relevance with the “capital structure of the company”. The main rationale of the value of market of the firm is discerned to be reliant on the operating profits. The learnings of the study aim to show the contribution of “Modigliani and Miller” to the theory of “capital structure”. The learnings of the study have also suggested it’s limitations and theories which try to explain why in practice capital structure is determined differently and draw a Connection between capital structure decision making and corporate governance (Ahmeti & Prenaj, 2015).

The main aspects of the analysis developed by “Modigliani and Miller” conjectured that the determination of “market value” is done by the earning power and “risk of underlying assets” along with the self-determining way it indicates to finance the investment and “distribute dividends”. The key assumptions of M&M proposition are considered with factors such as “No taxes, No transaction costs, No bankruptcy costs, Equivalence in borrowing costs for both companies and investors”. Along with the information, it also considers “symmetry of market information, investors who have the same information, and there is no effect of debt on a company's earnings before interest and taxes” (Kennedy et al., 2015).

The assumptions of the “M&M capital structure” show that there is irrelevance proposition and assumption of no taxes or bankruptcy costs. In simplified terms it shows that the WACC will continue to be persistent with the changes pertaining to “capital structure” of the company. No matter, the way firm borrow, there won’t be any “tax benefit” because of payment of interest and no variations or assistances in terms of WACC. Moreover, as there are no assistances from the increasing debt amount, the “capital structure” may not influence the “stock price”. The “MM 1” theory considers MM capital-structure insignificance proposal assumption with no taxes and “MM 2” theory is characterised with no bankruptcy costs (Abeywardhana, 2017).

Key Assumptions and Propositions


Henceforth, it may be assumed that “MM I theory” (without the consideration of corporate taxes) considers that firm's relative sizes of “debt and equity” don't matter. However, as per the MM 1 the firm with greater proportion of debt is more valuable due to the presence of interest tax shield. MMII considers the WACC. This is seen with the percentage of the debt in the “capital structure” which increases with its “return on equity” to the “shareholders” on a constant basis. The consideration of higher debt level makes the investment company more risk prone to the shareholder’s demand and increased risk premium on stock of the company. However, the changes pertaining to the “company's capital structure” is irrelevant and any deviations in the “debt-equity ratio do not affect WACC”. Moreover, MM II theory recognizes the “corporate tax” savings from the interest tax deductions and the disparities in the debt equity ratio, as they do not make an impact on WACC. Henceforth, a greater proportion of the debt reduces the WACC of the company (K. Ardalan, 2017).

The theory suggested by “Modigliani and Miller” does not consider the “taxes, transaction costs, bankruptcy costs, differences in borrowing costs, information asymmetries along with significant effects of the debt on earnings”. However, in real world such assumptions are not possible. The model is seen to be further criticised as perfect capital market do not exist and there is always provision needed to be made for the taxes existing in the capital market. As per the theory suggested by MM there does not exist any difference in the internal and external financing. However, this will be false in case there is any incidence in the flotation costs involved with the new issues of stocks. This theory is further seen to assume that the shareholders wealth is not affected with the dividends, while there may be a situation where the transaction costs are related to the selling of shares to make cash inflows, this calls for the preference over dividends for the investors. The different types of the assumptions made by Modigliani and Miller is based on a situation of uncertainty and unrealism. It needs to be understood that the dividends are also relevant under certain conditions. The limitations of the hypothesis have argued that there does not exist any difference among the investors of the firm and the firm retains earnings or declares the dividend (Kavous Ardalan, 2016).

Limitations of Modigliani and Miller's Theory

The retained earnings and the external financing are regarded as balancing value to each other. The assumptions made by them is unrealistic in nature and unpractical. Despite of several appealing theoretical evidences. The main problem associated to the “MM approach”, exists due to the “imperfect markets, transaction costs, floatation costs and uncertainty of future capital gains and the preference for current dividends”. The model accepts that there are perfectly “capital markets”, whereas such marketplaces does not exist. The MM model further accepts that there are no flotation costs or time gap necessary for raising the “equity capital”. While, in the practical world the initiation cost must take place in accordance to the legal formalities (Dierkes & Schäfer, 2017).

There is no assumption made for transaction costs, while there is significant expenditure associated to the “commission and brokerage to sell shares”. The shareholders also prefer the current dividend which is overlooked. The “MM model” considers that the company has the scope to issue equity shares. However, this model cannot be regarded as valid when there is any case of under-pricing based on the sale of the shares which is lesser than the present market price. This signifies that a firm will have to sell more number of shares if it does not want to give dividends. In this situation, the firm needs to retain the profits and not pay any dividends (Sofiane Aboura & Lépinette, 2015).

The determination of practice of capital structure is discerned with significant impact with the tax and bankruptcy assumptions. Due to this, the “capital structure” is inappropriate and have no effect on the stock price. This calls for the need of “trade-off theory of capital structure”. This hypothesis is considered with the use of Kraus and Litzenberger for determining a “trade-off dead-weight costs of bankruptcy and the tax saving benefits of debt” (O’Brien, David, Yoshikawa, & Delios, 2014).

The “trade-off theory of capital structure” is discerned as the main idea in which the company chooses for the determining the amount of “debt finance and equity finance to use by balancing the costs and benefits”. This theory mainly deals with “cost of financial distress and agency costs”. The important reason for the “trade-off” in the “capital structure” is to clarify the fact that the corporation are “financed partly with debt and partly with equity”. There has been significant advantage associated to “financing with debt, the tax benefits of debt and there is a cost of financing with debt”, “the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs” are also included in this theory (Ippolito, Steri, & Tebaldi, 2017).

Trade-Off Theory of Capital Structure

The assumptions made in this theory is able to state on the benefits to the leverage in the “capital structure” until the desired capital structure is attained. This is able to recognize the benefits of taxes from the payments made in interest. The interest paid on the debt is deductible from tax and effective issue of bond effectively decreases the tax liability while “paying dividends on equity does not”. In general, the real rate of interest which the “companies pay on the bonds they issue is depicted to be less than nominal interest rate due to the tax savings considerations. Several studies suggest that most companies have lesser leverage than suggested by the optimal theory” (Brusov et al., 2014).

The comparison of the theories shows that the possible benefit in the debt in a “capital structure comes from tax benefit of the interest payments”. This is due to the fact debt is tax deductible, thereby issuing bonds in an effective manner to reduce the tax liability. The “MM capital irrelevance theory assumes no taxes”; therefore, this advantage is not documented like “tradeoff theory of leverage” in which “taxes, and tax benefit of interest payments”, are taken into consideration (Allen, Carletti & Marquez, 2015). This theory is further able to consider the agency costs with the cost debt obligations and explain why the companies are not having 100% debt. Most of the empirical evidences are able to propose that there is significant conflict between the shareholders and debt holders. This is considered to be important for explaining the “Trade-off theory in relation with the capital structure”. Despite of criticisms from Fama and French, “the trade-off theory” remains central consideration in case of corporate capital structure. The dynamic version of the usage of this model is able to explain enough flexibility in terms of matching the data with the verbal argument along with “dynamic trade-off models” which are very difficult to cast-off empirically (S. Aboura & Lepinette, 2017).

In general, “corporate governance and capital structure” has a significant role in extension of shareholders wealth and value of the firm. Adherence to sound corporate governance helps in assuring that investors would get their capital back and obtain an acceptable return on their respective investment. Henceforth, developed financial system is able to provide a market for corporate control whereas, a strong legal system is able to ensure that investors contractual rights are protected by “minimizing the risk of loss arising from managerial opportunism” (DeAngelo & Stulz, 2015). Corporate governance is acknowledged as a system in which business corporations are controlled and directed to encompass the rules and framework of relationships process to ensure the directors act in the interest of the company. Maintenance of an optimized structure for capital is able to minimize the cost of financing thereby reducing any instance of bankruptcy (Graham, Harvey & Puri, 2015). 

Comparison of Theories


There is large evidence to support that corporate governance and capital structure are interrelated to each other. The evidence depicts that corporate governance particularly the part of ownership structure plays a pivotal role in determining incentives of insiders to expropriate minority shareholders. The review of literature has depicted that the role of ownership structure has an impact on the firm value. The empirical work suggests that the corporate financial decision and performance of firms are affected with issues such as agency conflicts between the shareholders and the managers (Mouton & Smith, 2016). In several situations corporate governance activities enhances the effectiveness and efficiency of the companies with the implementation of proper control and supervision. CG also acts as an important framework for aligning the interest of shareholders and management to reduce agency conflicts. Sound corporate governance structure for the organization makes it is easier to obtain loans from investors and predicting the interest of shareholders thereby increasing overall transparency (Cline, 2015). It is further discerned that firms bearing poor governance practices are more likely to face agency problem as managers, than those who can easily make use of private benefits due to slick corporate governance structure (Kakilli Acaravci, 2015).

As per the conduction of empirical studies to evaluate the relation between CG and CS, it is realized that there is a noteworthy relation between “board size and capital structure”. This shows that larger is the size of board membership, lower is the “debt ratio or leverage”. This also accepts that larger board size is able to translate itself into strong pressure from corporate board to make managers pursuant to lower leverage. It is seen that larger boards exert pressure on the manager for following lower gearing levels to increase firm performance (Gersbach, Haller, & Müller, 2015).

The statements given by Modigliani and Miller clearly proposed that financial system is of prime importance to both the managers and providers of the fund. Optimal capital structure may be attained in case there is tax sheltering benefit design with increasing “debt level equal to bankruptcy costs”. This model suggested that managers should be able to spot the optimal “capital structure” and try to sustain the same (Jaros & Bartosova, 2015).

However, Jensen and Ruback argued that managers are not always responsible to maximize the return to the shareholder. In several situations, managers may decide to adopt nonprofitable investment which will likely bring loss to the shareholders. These shareholders tend to utilize free cash flow available instead of investing in positive NPV projects which would have benefitted them. As per this model, the agency cost is likely to exacerbate the inclusion of free cash flow in the firm. The mitigation of agency conflict argues that capital structure may be used with increasing level of debt and agency costs (Serrasqueiro & Caetano, 2014)

Corporate Governance and Capital Structure

Conclusion

The depictions as per contribution of “Modigliani and Miller” to the philosophy of “capital structure” have shown that there is irrelevance proposition and assumption of no taxes or bankruptcy costs. In simplified terms it shows that the WACC will continued to be constant with the changes pertaining to capital structure of the company. No matter, the way firm borrow, there will be “no tax benefit” because of the “interest payments” and no variations or benefits in terms of “WACC”. Moreover, as there are no assistances from the increasing debt amount, the capital structure may not impact the stock price or the “capital structure”. The “MM 1” theory considers “MM capital-structure irrelevance” proposition assumption with no taxes and “MM 2” theory is discerned with no bankruptcy costs. It is further understood that the theory suggested by “Modigliani and Miller” does not reflect the effect of “taxes, transaction costs, bankruptcy costs, differences in borrowing costs, information asymmetries along with significant effects of the debt on earnings”. However, in real world such assumption is not possible. The model is seen to be criticised, as perfect capital market does not exist and there is always provision needed to be made for the taxes present in the capital market. As per the theory suggested by MM, there does not exist any difference in the internal and external financing. In addition to this, the link between “capital structure” decision making and “corporate governance” portrays that corporate governance particularly the part of ownership structure plays a pivotal role in determining incentives of insiders to expropriate minority shareholders. Several empirical works suggest that the corporate financial decision and performance of firms are affected with issues such as agency conflicts between the shareholders and the managers.

References

Abeywardhana, D. K. Y. (2017). Capital Structure Theory: An Overview. Accounting and Finance Research, 6(1), 133. https://doi.org/10.5430/afr.v6n1p133

Aboura, S., & Lepinette, E. (2017). New Developments on the Modigliani--Miller Theorem. Theory of Probability & Its Applications, 61(1), 3–14. https://doi.org/10.1137/S0040585X97T988010

Aboura, S., & Lépinette, E. (2015). Do banks satisfy the Modigliani-Miller theorem? Economics Bulletin, 35(2), 924–935.

Ahmeti, F., & Prenaj, B. (2015). A Critical Review of MM Theorem of Capital Structure. International Journal of Economics, Commerce and Management, III(6), 914–924.

Allen, F., Carletti, E., & Marquez, R. (2015). Deposits and bank capital structure. Journal of Financial Economics, 118(3), 601-619.

Ardalan, K. (2016). Capital structure theory: Reconsidered. Research in International Business and Finance. https://doi.org/10.1016/j.ribaf.2015.11.010

Ardalan, K. (2017). Capital structure theory: Reconsidered. Research in International Business and Finance , 39. https://doi.org/10.1016/j.ribaf.2015.11.010

Brusov, P., Filatova, T., Orekhova, N., & Cook, S. (2014). Mechanism of formation of the company optimal capital structure, different from suggested by trade off theory. Cogent Economics & Finance, 2(1), 946150. https://doi.org/10.1080/23322039.2014.946150

Cline, W. R. (2015). Testing the Modigliani-Miller theorem of capital structure irrelevance for banks.

DeAngelo, H., & Stulz, R. M. (2015). Liquid-claim production, risk management, and bank capital structure: Why high leverage is optimal for banks. Journal of Financial Economics, 116(2), 219-236.

Dierkes, S., & Schäfer, U. (2017). Corporate taxes, capital structure, and valuation: Combining Modigliani/Miller and Miles/Ezzell. Review of Quantitative Finance and Accounting, 48(2), 363–383. https://doi.org/10.1007/s11156-016-0554-4

Gersbach, H., Haller, H., & Müller, J. (2015). The macroeconomics of Modigliani-Miller. Journal of Economic Theory, 157, 1081–1113. https://doi.org/10.1016/j.jet.2015.02.003

Graham, J. R., Harvey, C. R., & Puri, M. (2015). Capital allocation and delegation of decision-making authority within firms. Journal of Financial Economics, 115(3), 449-470.

Ippolito, F., Steri, R., & Tebaldi, C. (2017). Levered returns and capital structure imbalances. SSRN.

Jaros, J., & Bartosova, V. (2015). To the Capital Structure Choice: Miller and Modigliani Model. Procedia Economics and Finance, 26, 351–358. https://doi.org/10.1016/S2212-5671(15)00864-3

Kakilli Acaravci, S. (2015). The Determinants of Capital Structure: Evidence from the Turkish Manufacturing Sector. International Journal of Economics and Financial Issues, 5(1), 158–171. https://doi.org/10.1108/AJEMS-11-2012-0072

Kennedy, L., Machado, C., Gerais, M., Gerais, M., Vieira, K. C., Gerais, M., … Gerais, M. (2015). Capital Structure and Performance of Firms: Durand or Modigliani and Miller, an Empirical Analysis of Brazilian Companies Listed in BM&FBOVESPA. Business and Management Review, 5(1), 83–96.

Mouton, M., & Smith, N. (2016). Company determinants of capital structure on the JSE Ltd and the influence of the 2008 financial crisis. Journal of Economic and Financial Sciences, 9(3), 789-806.

O’Brien, J. P., David, P., Yoshikawa, T., & Delios, A. (2014). How capital structure influences diversification performance: A transaction cost perspective. Strategic Management Journal, 35(7), 1013–1031. https://doi.org/10.1002/smj.2144

Serrasqueiro, Z., & Caetano, A. (2014). Trade-Off Theory versus Pecking Order Theory: capital structure decisions in a peripheral region of Portugal. Journal of Business Economics and Management, 16(2), 445–466. https://doi.org/10.3846/16111699.2012.74434

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