According to the MM proposition a firms' mixture of debt and equity does not affect its price in a perfect capital market. Investors measure the value of a firm on its returns not its funding. The WACC allows no relation to the debt to equity ratio. Expected return of the shareholders increased by leverage and makes the share riskier. The interest payments of the debt should be pay from the share earnings. Supplementary money owing a company receive on equity investor's demands higher return of their shares considering extra risk of bankruptcy.
MM is only a concept. There are taxes, tax shields, transaction costs, non-public information, and difficult outline of commercial expansion which all influence economic price of a firm depend on company's capital structure.
In reality the two propositions of M&M are not working. Lacking of taxes and bankruptcy costs the WACC is staying stable with alteration in company's capital structure. There will be no tax benefits from inertest payments and the WACC will be unchanged no issue how the firm borrowed the fund. The capital structure does not manipulate a company's stock price since there are no profits from increasing debt. Capital structure is not relevant to a company's stock price.
According to Parino, R and Kidwell, D (2009, p527-533) lower the cost of financing of a project. Lower will be the inertest rate and higher will be cash flow. Combined value of equity and debt will produce same value for the company after changing the capital structure. Let's consider a company which is fully financed by equity. The annual cash flow is $100 and discount rate is 10%. The value of the firm will be $1000. Suddenly the management of the company wants to change capital structure of the company. They want to use 80% equity and 20% debt to financing the company which called financial restructuring. Without affecting its real assets financial restructuring change the capital structure of the firm. The return on asstes would still be 10% and the interest payments will be 5%. The restructuring increases the cost of equity. The financial risk is high if a firm use large debt financing. Interest and principal amount need to pay to the debt holders before the cash distributed to the stock holders. The higher the percentage of debt used in a firm's capital structure, the interest and principal payments will be high and cash flow return of the stockholders will be low. The use of more debt reduces the firms WACC.
Critical discussion: Tax
According to the MM proposition I there is no relevance of capital structure in a world without taxation. After five years later Modigliani and Miller (1963) argue that corporate tax crates tax shield benefits to debt which will direct to a best capital structure for any company 100% depend on debt financing.
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Rising leverage carry no remuneration in terms of value creation if there are no taxation. Tax ensures the tax shield benefits when leverage is increased.
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There is an association between profitability and high target debt ratio. Higher tax savings from debt means higher profitability and lower profitability means bankruptcy. The firm which profit is high will issue debt rather than equity if the target leverage is important.
Corporate tax permits the company to subtract interest payments. After adding up debt to a firm's capital structure tax liability is low and after tax cash flow is increase. The value of the debt is increasing with level of debt because of tax shield
There are many experimental studies about the effect of taxation on corporate financing decision. Graham (2000) Mackie-Mason (1990) calculated about the tax outcome on corporate financing decision. From the study confirmation tax has large effect on choosing debt and equity.
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According to Parino, R and Kidwell, D (2009, p537-541) Firm is financed by only equity; there will be no interest payments. The firm need to pay tax on income. After the tax deductions the shareholders will receive the profit. If a firm uses debt some part of the income will be tax deductable and firm need to pay less tax. The value of the firm which uses both debt and equity financing increases because the firm paying less tax on its profit. A firm value is increased by using more debt.
Bankruptcy Costs:
Cost is determined by the tangibility of a company's primary resources. Plants and properties are tangible assets even in bankruptcy these tangible assets retain their values. Higher levels of debt at lesser cost can be supported by capital concentrated firms and threat to the bondholders is low.
Studies conducted by Titman and Wessels (1988), Williamson (1988), and Harris and Raviv (1990) find out that leverage enhances with fixed assets and non debt tax shields.
Bankruptcy cost is considered as a threat has large effect on the worth of the firm. Mangers facing bankruptcy cost may approve positive NPV projects which will raise the price of the business. Debt brings threat of bankruptcy produce hindrance for the expansion of wealth.
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According to Parino, R and Kidwell, D (2009, p545-46) because of using debt financing the firm faces financial difficulties will result bankruptcy cost. When a firm is not able to pay interest and principal amounts to the lenders bankruptcy cost occurs. The management of the bank need to negotiate with the lenders to postpone the interest and principal amounts after the firm becomes bankrupt. The bank needs to hire people such as lawyers, accountants and consultants to negotiate with the lenders by paying fees. The cost of hiring these people is considered as direct bankruptcy costs. Bankruptcy cost is increases with the amount of debt the firm uses. The direct bankruptcy cost increases with the leverage and the investors charge higher interest rate for the debt.
The changed behaviour of the people who deal with a firm increased indirect bankruptcy cost. The interest of the people who deal with the firm has common similar interest with the stockholders. The interest of the people began to change when the firm get into bankruptcy. They take all the actions for their own interest reduce the firm value.
Because of bankruptcy the firm is not able to provide service to the customers and the customers will move to competitors. As results the firm will lose the revenue and value of the firm will decrease. Supplier can asked for cash payments from a nearly bankrupt firm. Asking for cash at that moment is totally disturbing because the firm have not that much cash in hand. It might not be possible by firm to operating business together with a supplier. So that the customers are not getting the products what they need. The firm is losing revenues and value at a time. Employees of the bankrupt firm might be anxious about their job and some of them might be looking for new jobs. By losing the skilled employees firm value is reduced.
Bankruptcy cost increases the difficulties for firm to increase new capital for new project. The possibility of bankruptcy cost increase as the level of leverage increases.
Agency Costs:
Agency problems started when interest of one group is contradict with other groups. Agency problems have an impact on capital structure and value of the company depends on how well the companies can controls the losses connected with agency costs.
Managers fail to represents the interest of the share holders in two primary areas such as below leveraging and excessiveness. Managers do not like to leverage the firm because the extra debt may enhance the entire risk. They may stay away from extra debts which will increase the value of the company. Mangers demand extra money even though they under leverage the company. Overspending is also a problem for the share holders. Mangers have the tendency to spend more because it's not their own money.
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According to Jensen and Meckling (1976) the agency cost theory suggests that the superior intensity of debt boost shareholders price by relocating the risk to creditors and mangers assign cash for debt payments rather than investments. Managers have frequent interest with shareholders and they will make business decisions for the shareholders not for the creditors when there is conflict between debt and equity investor. The preference of capital structure could assist to diminish agency costs. High leverage reduces the agency cost and boost firm value by restricting or cheering the mangers to work in the interest of the shareholders. Mangers affected by the higher financial leverage which is a threat of liquidation causes personal losses to mangers. Additional increases of leverage which already becomes high may create major agency costs of external debt. Decreased effort of controlling risk will result superior expected cost of economic suffering, insolvency or bankruptcy. Total agency cost is reduced when low level of leverage increases.
Capital structure decisions may be related in the nonexistence of taxes and bankruptcy costs. Shareholders need to monitor costs because debt holders expect such cost so that they can charge higher interest rate. The higher the interest rates lower the firm value.
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According to Parino, R and Kidwell, D (2009, p547-50) when the firm is financially bankrupt the behaviour of managers and stock holder reduce the firm's value. Managers take some decisions for their own benefits oppose by the board of the directors are consider as expense for the shareholders. The mangers need to focus on maximising the firms cash flow and cut down the wastage of stockholders money by investing negative NPV projects. Debt financing can increase the agency cost. The use of debt increases the unpredictability of firms earning and financial difficulty. This extra risk forces the mangers to make conformist decisions. Mangers of a highly leverage firms like to distribute less profits to the share holders and maintain retail earnings to face possible bankruptcy. This type of actions taken by mangers reduces the value of the firm. The lenders expect that the stockholders will invest money in an appropriated way so that they can get back their interest and principal in promised date. Stockholders might take decision not to investing the money to grow the firm; they will distribute it to themselves as dividend. This type of dividend payments decreases the firm's incomes that are available for the lender payments. Stockholders invest in a negative NPV rather than a positive NPV project after knowing that the return of the project will received by lenders not by themselves. Considering this type of situation lenders can increase the interest rate they usually charge. This extra money enhances the price of the debt of firm's capital structure.
According to Ross, S. Westerfield, R. and Jordon, B. (2008, P567-8) debt equity ratio rises and the stockholders will be not capable to pay promised payments to the bondholders. The ownership of the firm assets transfer from stockholders to bondholders. A firm is considering as bankrupt when the value of the firm's assets is equal to value of the debt. The assets value is decreasing because the management is busy to avoid bankruptcy as an alternative running the business.
Transaction costs:
Transaction cost is related to buying or selling securities. Transaction cost included brokerage commissions and spread. The higher the transaction cost lower will be value of the firm. The firm losing value by paying brokers commission. In spread the price paid by dealer is different by the price the securities is sold. The firm value is decreased for spread.
Conclusion:
The value of the firm is decreased because of the tax, agency cost and bankruptcy cost. Though there is some tax benefit on debt. According to MM proposition perfect world not exist in the word of reality. The investors need to consider all these cost before investing and the return on invest might below because the value of the firm is reduced.
