Capital structure theories

Debt is cheaper than equity. Every calculation in this lesson has said so — 6.37% against 16% for MBS, 3.42% against 11.00% for MP Co. The obvious conclusion is that a company should borrow as much as it can, and the whole argument about capital structure is over whether that conclusion is right.

It matters because of what the cost of capital does. A company is worth the present value of its future cash flows, so lowering the rate those cash flows are discounted at raises the value of the business — without changing the business at all.

• If WACC can be reduced by changing the mix of debt and equity, then there is an optimal capital structure, and finding it is part of a finance director’s job.
• If WACC cannot be reduced that way, the mix is irrelevant and value comes only from investing in positive-NPV projects.

Four positions have been argued, and they are best read as one conversation rather than four separate theories. Each answers the objection raised against the one before it.

The traditional or relevance view says capital structure matters, and that there is a level of gearing at which WACC is at its lowest and the company at its most valuable.

The argument runs in three stages as debt is added.

So the graph of WACC against gearing is a U. The bottom of it is the optimal capital structure, and because the lowest WACC gives the highest present value, that same point is where the value of the company peaks.

The theory’s weakness is that it never says where the bottom is. It asserts that shareholders under-react to modest borrowing and then over-react to heavy borrowing, and offers no way to identify the turn other than looking at what comparable companies do.

Modigliani and Miller answered that in a perfect capital market the capital structure is irrelevant. The benefit of cheap debt is exactly cancelled by the increase in the cost of equity that the borrowing causes, so WACC is constant at every level of gearing and the value of the company never moves.

The mechanism is precise rather than approximate. Borrowing makes the shareholders’ returns more volatile, because interest is a fixed claim that has to be met before anything reaches them — the same amplification the interest cover working showed. Shareholders price that additional risk exactly, and they price it by the amount that removes the gain.

It rests on a set of assumptions that are named as assumptions, not hidden: no taxation, no transaction costs, no costs of financial distress, and investors who can borrow personally on the same terms as companies. That last one carries the argument — if a shareholder wanting the effect of gearing can simply borrow and buy more shares, they will not pay a company a premium for doing it on their behalf.

The conclusion follows directly, and it is the point of the theory rather than a technicality: a company cannot become more valuable by rearranging how it is funded. Value comes from investing in projects with positive NPVs. Financing decides who owns the value, not how much of it there is.

Drop the assumption of no taxation and the conclusion reverses. Interest is tax deductible, so a geared company hands less of its cash to the government than an identical ungeared one — and that saving is real value that belongs to the investors.

This is the same tax shield the APV step calculated, doing the same work at the level of the whole company rather than one project. WACC now falls continuously as gearing rises, and the theory’s logical conclusion is that a company should be financed almost entirely by debt.

No company is. Something the theory has left out must bite before that point, and it does: the costs of financial distress.

• Direct costs — legal and professional fees, and assets sold at whatever they will fetch rather than what they are worth.
• Indirect costs, which are usually the larger. Suppliers withdrawing credit, customers going elsewhere in case the company cannot honour a warranty, good staff leaving before they are pushed.
• Management time spent negotiating with lenders instead of running the business.

Distress costs are negligible at low gearing and grow rapidly at high gearing, because what is really growing is the probability of getting into distress at all. So the compromise view: the tax shield pulls WACC down, distress costs push it up, and the optimum is where the next kwacha of tax relief is just outweighed by the next kwacha of expected distress cost.

That lands in the same place the traditionalists started from — a U-shaped WACC curve with an optimum somewhere in the middle — but by a route that names what is on each side of the trade-off. It is the position most finance directors actually work from.

The pecking order theory describes what companies do rather than what an optimum would require. Observed behaviour is that firms fund themselves in a fixed order of preference, taking the next source only when the one before it is exhausted.

The order is not driven by cost of capital at all. It is driven by resistance — the least difficult source first. Retained earnings need nobody’s permission. A share issue needs a prospectus, underwriters, months of work and a discount to get it away.

The deeper explanation is information. Managers know more about the company’s prospects than investors do, so investors read a share issue as a signal that management thinks the shares are currently overvalued — and mark the price down on the announcement. Debt sends no such signal, because a lender is repaid the same amount either way.

This is descriptive, and it does not fit alongside the others as a rival account of the optimum. A company following the pecking order is not aiming at a target gearing level; its gearing is simply the residue of a series of funding decisions taken in order of least resistance. That fits Zambian unquoted and family-owned companies particularly well, where a share issue would mean admitting outsiders to the ownership and is often not on the table at any price.