The theory of capital structure is closely related to the firm's cost of capital. The decision regarding the capital structure or the financial leverage or the financing wise is bases on the objective of achieving the maximization of shareholders wealth. The optimal capital structure is the one that minimizes the firm's cost of capital and maximized firm value. In addition, independence hypothesis is called Net Operating Income Approach. If the capital structure has no impact on the total market value of the firm, then the value of the firm is arrived by capitalizing (discounting) the firm's operating income (EBIT). The dependence hypothesis is also called Net Income Approach. It is the income (earnings available to common shareholders) that is capitalized to arrive at the market value of common equity.
Modigliani and Miller's Without Tax Approach
Modigliani and Miller (M & M) assume a very simple world in which there is no such thing as taxes, bankruptcy costs, or unbalanced access to information. All financial markets are also assumed to be very efficient. Furthermore, M & M argued that the cost of debt is lower than the cost of equity, based upon its lower level of risk. When a company is first starting up, it is often financed entirely by the shareholders since the company does not have a history or established ability to generate profits. This means that the company's overall cost of capital is the same as its cost of equity.
Figure 1: Modigliani and Miller's Without Tax Approach
In Figure 1 show the financial leverage is plotted along the X, while the cost of capital (Ko) in percent is plotted on Y. As the cost of debt (Kd) and cost of equity (Ke) is constant with leverage, we find that both the curves are in parallel to X. Ko is maximum when there is zero debt and it is minimum when there is 100% debt. In addition, the more debt financing used, the greater the tax benefit, and the greater the value of the firm it is mean that all firm should be financed with 100% debt? In practice, 100% debt may not be possible. There should be some equity capital in the capital structure of any company.
Besides that, the explicit and implicit costs of debt are one and the same. The use of more debt does not change the cost of equity. Cost of debt is lower than cost of equity as leverage increases and both are not affected by leverage, because of the tax benefit associated with debt financing. When the cost of capital as leverage increases, it will be the low cost of debt reduces the cost of capital.
Modigliani and Miller's with Tax Approach
In reality the world is quite different from M & M without tax approach. The whole analysis takes a different turn with the assumption of tax environment in M & M approach. Most of the tax structures in different nations are differential to debt and equity. The interest paid on debt is treated as an expense and, thus, reduces the taxable profit of the firm. The result is that there is a tax saving which reduces the effective cost of debt capital for the firm and, hence, the overall cost of capital.
Figure 2: Modigliani and Miller's With Tax Approach
As shown in Figure 2, it is clear that as the financial leverage is increased, Ko and Kd remains at the same level. The cost of equity rises but the extent of the rise is insufficient to exactly offset the cheaper debt. Thus, the overall cost of capital falls throughout the range of leverage.
If we have an all-equity financed firm, the cost of capital is just the cost of equity. Suppose we begin adding debt financing at a cost of Kd. If Kd is lower than Ko, then the cost of capital should be go down. According to the independence hypothesis, the increase in debt will cause Ko to rise, therefore, increasing leverage will affect Ko. In addition, increase leverage also causes the cost of equity to rise. The net effect on the overall cost of capital is the cost of capital does not change. Leverage has no effect on the cost of capital and therefore, it has no effect on the value of the firm.
Firm's cost of equity will rise at precisely the same rate as the earnings and dividends do. Use of financial leverage brings a change in the cost of common equity large enough to offset the benefits of higher dividends to investors. This will keep the composite cost of funds constant.
Market Imperfections
Independence hypothesis in a perfect market environment, capital structure is irrelevant. In other words, changes in capital structure do not affect firm value. Still, financial risk management may be desirable in perfect markets if the agents are risk-averse.
For example, if the company continues to gear up, the weighted average cost of capital (WACC) will then rise as the increase in financial risk outweighs the benefit of the cheaper debt. At very high levels of gearing, bankruptcy risk causes the cost of equity and debt to rise at a increases rate. Shareholder wealth is affected by changing the level of gearing. There is an optimal gearing level at which WACC is minimized and the total value of the company is maximized. Financial managers have a duty to achieve and maintain this level of gearing.
Besides that, the bankruptcy cost is the costs of financial distress. When a firm experiences financial distress, its managers and creditors must decide whether the problem is temporary, and the firm is really financially viable, or whether a permanent problem exists that endangers the firm's life.
Traditional Approach
The traditional approach states that moderate degree of financial leverage increases the cost of equity, but not to a very large extent. This forces shareholders to demand higher return for the higher risk they are exposed to. Besides that, when the firm increases its debt levels, the cost of equity increases slowly at first, however, the cost of equity rises steeply under extreme debt borrowing.
Figure 3: Capital costs and traditional approach to capital structure
In the first phase, cost of equity remains constant or rises slightly with the debt. When it increases, it does not increase fast enough to offset the advantage of low cost debt. Cost of debt also remains same or rises slightly with the leverage. As the cost of debt is less than cost of equity, increased use of debt reduces the overall cost of capital during the 1st Phase.
Beyond a certain point, use of debt has unfavorable effect on cost of capital and value of the firm. This happens because the firm would become more risky to investors and hence penalize the firm by demanding a higher rate of return. The advantages of using low cost debt are less than the disadvantages of higher cost of equity. So overall cost of capital increases with the leverage and the value of the firm decreases.
Moreover, the cost of debt increases as the proportion of debt increases. At some point, the capital markets will consider any new debt excessive, and therefore much riskier. Increasing debt also increases the cost of equity since the equity becomes riskier. At first, the cost of capital falls it is because the cost of equity is not raising enough to offset the low after-tax cost of debt. At higher debt levels, the higher costs of debt and equity cause the cost of capital to increase. At some point, there will be a minimum cost of capital.
Conclusion
According to the Modigliani and Miller's without tax approach, overall cost of capital continuously decreases as and when debt goes up in the capital structure. Optimal capital structure exists when the firm borrows maximum. In addition, Modigliani and Miller's with tax approach that capital structure is not relevant. Ko is dependent business risk which is assumed to be constant.
Besides that, Traditional approach tells us that Ko decreases with leverage in the beginning, reaches its maximum point and further increases. Modigliani and Miller approach also believes that capital structure is not relevant.
Part B
Introduction
Agency theory
Agency theory is a positive accounting theory that attempts to explain accounting practices and standards. The basic assumption of agency theory is that individuals maximize their own expected utilities and are resourceful and innovative in doing so.
Problems of agency theory
The first problem is the relationship between shareholders and operational manager. A latent agency theory problem arises whenever the manager of a firm owns less than 100% of the firm's ordinary stock. If the owner has a property right to manage the firm, the manager of the owner will presumably to operate. Thus, to enlarge his own welfare, with wellbeing measured in the form of improved personal wealth, more freedom, or perquisites. Nevertheless, if some of the stock had sold to outsiders by the owner-manager after incorporates, a latent conflict of interests may instantly arise. This is because the owner-manager may become less motivated in maximizing profit and wealth of the shareholder. Furthermore, the owner-manager can make a decision to acquire further perquisites, because the shareholders will borne these costs. In spirit, the truth of the owner-manager will neither get all the benefits of the wealth created by his hard work nor borne all the expenses of perquisites will raise one encouragement to take actions that may not in the best interests of other shareholders. The majority of the large corporations, potential agency conflicts are vital, for the reason that great firms' managers are usually hold only a little percentage of stock. Under this condition, maximization the wealth of the shareholder could take a back seat to any amount of conflicting managerial goals.
Let take an example, people have argued that the main objective of some managers seems to expend the size of their company. By establishing a large, quickly growing firm, job security will be increase by managers, because a antagonistic takeover of the entire company is less likely to take place. In addition, managers may desire to increase their own influence and reputation. Moreover, by everything more opportunities, raising basic salaries and increasing bonuses to both middle and lower management shift the executive managers (i.e. CEO, CFO) will gain respect and recognition for their effort from a node suggestion base. Moreover, since most large firms' managers hold only a little percentage of the stock, they have a insatiable appetite for salaries and perquisites has been argued, and that they kindly donate corporate dollars to their favorite charities at the expense of the shareholders.
Obviously, managers can be encouraged to act in the best interests of the stockholders through a set of strong rewards, restrictions, and punishments. However, these tools are most efficient if shareholders can examine all the events taken by managers.
Secondly, potential moral hazard problem in which agents under take disregarded actions in their own benefit. This can be arise because all managerial operations within the company is not possible to be monitored by the shareholders.
In general, to reduce both agency conflicts and the moral hazard problem, shareholders must incur agency cost, which includes all costs borne by shareholders to encourage managers to maximize the firm's stock price rather than act in their own self-interests. There have three major categories of agency costs. First are expenditures to monitor managerial actions, such as regular audits on costs. Next is to structure the organization in a way that will limit undesirable managerial behavior, such as appointing outside investors to the board of directors. Lastly, by impossibly restricting to high costs operations which the shareholders will incur, such as setting requirements for shareholders votes on certain issues on discounting, limit the ability of managers to take timely actions that would enhance shareholder wealth.
If shareholders make no effort to affect managerial behavior, and hence incur zero agency costs, there will almost certainly be some loss of shareholder wealth due to improper managerial decisions. Conversely, agency costs would be very high if shareholders attempted to ensure that every managerial action coincided exactly with shareholder interests. Thus, the optimal balance in agency costs to be borne is the shareholders minds and be viewed like any other investment decision (i.e. agency costs should be incurred as long as each dollar spent returns more than a dollar in shareholder wealth).
There are two extreme positions regarding how to deal with shareholder manager agency conflicts. At one extreme, the firm's manager became sonly responsible to compensate any loss on stock price changes. Agency costs would be very low because managers would have a large incentive to maximize shareholder wealth. However, it would be difficult if not impossible to hire competent managers under these terms, because the firm's earnings stream, and hence mangers' compensation, would be affected by economic events that were not under managerial control. At the other extreme, shareholders could monitor every managerial action, but this would be costly and inefficient. The optimal solution lies somewhere in between, where executive compensation is tied to performance but some monitoring is also done.
Lastly, the agency theory has shareholders and creditors. Creditors have a claim on part of the firm's earnings stream for payment of interest and principal on the debt, and they have a claim on the firm's assets in the event of bankruptcy. However, shareholders have control of decisions that affect the possible risks taken. Creditors lend funds at rates that are based on the firm's risk, which in turn is based on the security of the firm's existing assets and potential future capital structure and assets. These are the primary determinants of the riskiness of a firm's cash flows, hence the safety of its debt.
Now suppose shareholders, acting through management, because a firm to sell some relatively safe assets and invest the proceeds in a large new project that is far riskier than the firm's old assets. This increased risk will cause the required rate of return on the firm's debt to increase causing the amount of the outstanding debt to drop. Most of the benefits will go to the stockholders if the risky project was successful, because the returns from the creditors are fixed at the old, low risk rate. However, the bondholders may have to share in the losses if the project was unsuccessful. Besides that, presume its managers borrow extra funds and use the profits to repurchase some of the firm's great stock in an strive to "leverage up" the return of the shareholders on equity. The price of the debt will possibly reduce, since now there will be more debt backed by an unchanged amount of assets. For both of the riskier asset and the increased leverage situations, shareholders is often to get at the expense of creditors.
On the other hand, if creditors perceive that a firm's managers are trying to take advantage of them, they will either refuse to deal further with the firm or else will charge a higher than normal interest rate to compensate for the risk of possible exploitation. Thus, firms which deal unfairly with creditors either lose access to the debt markets or are saddled with high interest rates and restrictive covenants, all of which are detrimental to shareholders.
In view of all this, it is in the company's best interests to serve their shareholders in the long run with managers operating fairly with creditors. Managers, can be seen as agents of both shareholders and creditors and must perform in a method that respects a fair balance among the interests of the two classes of security holders.
Conclusion
According to the agency problem, it is refers to conflict between principals and agents. For example, managers, as agents, may pay themselves excessive salaries; obtain unreasonably large stock options, and the like, at the expense of the principals, the shareholders. The other limitations and sanctions depend on the actions of the management which would expropriate wealth from any of the other shareholders of the firm, together with its employees, suppliers, customers, and community, will eventually to be the disadvantage of its shareholders.
