MODULE 25.2: CAPITAL STRUCTURE THEORIES

Expected number of questions: 2

LOS 25.c: Explain the Modigliani-Miller propositions regarding capital structure.

LOS 25.d: Describe optimal and target capital structures.

1. Asymmetric information exists because managers have superior knowledge about future prospects vs shareholders/creditors.
2. Higher when business is complex or financial reporting is opaque ⟶ investors face more uncertainty. Investors price this uncertainty as higher required returns on both debt and equity.
3. Investors infer management's private information from financing choices (signaling). Issuing debt signals confidence: fixed interest obligations imply expected stable cash flows. Issuing equity signals pessimism: markets infer management thinks stock is overvalued. Therefore, equity financing is penalized more heavily than debt under asymmetric information.
4. Agency costs of equity arise from conflicts between managers and shareholders. Managers without ownership stake don't fully bear costs of overpaying themselves or mismanaging risk (too safe or too reckless). Shareholders anticipate this conflict and impose controls (monitoring, incentives, governance). Even after controls, some conflict remains ⟶ net agency cost of equity.
5. Agency costs of equity are related to conflicts of interest between managers and owners. Managers who do not have a stake in the company do not bear the costs associated with excessive compensation or taking on too much (or too little) risk. Because shareholders are aware of this conflict, they take steps to reduce these costs. The result is called the net agency cost of equity.
6. Free cash flow hypothesis: excess cash invites wasteful spending or self-serving projects by managers.
7. Use of Debt forces managers to be disciplined, because commits cash to interest and principal payments, reducing free cash flow available for misuse.
8. Pecking order theory is built on asymmetric information between managers and investors. Financing choices act as signals about management's private view of firm value. - Internal funds are preferred: no external scrutiny, no signal.

1. MM Proposition I — No Taxes (Capital structure irrelevance)

2. “Pie” intuition: operating earnings determine total pie; slicing between debt and equity does not change the total value when assumptions hold.

   • Equity gets riskier as leverage increases; the cheaper cost of debt is exactly offset by a higher cost of equity, keeping WACC unchanged.

   • Relationship (no taxes): \(r_e = r_0 + (D/E) × (r_0 − r_d)\).

   • Interest is tax‑deductible while dividends are not, so debt creates a tax shield and reduces WACC. In the simple taxed world (ignoring distress and personal taxes), firm value is maximized at very high leverage.

   • Note on personal taxes (Miller view): differing investor tax rates on interest vs dividends can reduce the net advantage of debt.

   • Expected costs rise with leverage and include: direct bankruptcy costs (legal/admin) and indirect costs (lost customers/suppliers/employees, foregone investment, distraction), plus agency costs of debt (conflicts with debtholders during distress).

   • Probability of distress increases with operating leverage, financial leverage, and weak governance/management.

   • Firm value initially increases (WACC decreases) with more debt due to the tax shield, but beyond a point higher expected distress costs dominate.

   • Optimal/target leverage is where WACC is minimized and firm value maximized; depends on business risk, tax rate, asset collateral, governance, and industry norms.

   • Definition: the long‑run mix of debt, preferred, and equity the firm aims to maintain; use market‑value weights when estimating WACC.

   • If not disclosed, estimate using: (i) current market weights, (ii) trend‑adjusted weights if leverage is moving, or (iii) industry averages. Managers often track book‑based constraints for ratings/covenants.