Capital Structure

Modigliani and Miller, 1963 v Trade off model - Kraus & Litzenberger, 1973

I hope you have all had a fun week! This week’s post is going to focus on capital structure, with main references to Modigliani and Miller (1958). How much do you know about company’s capital structure? Probably not much, so read on!

What is the most efficient, effective and relevant way for a company to structure its capital? Does it change between companies? Does it depend on the size of the business? Is that even of relevance to the capital structure?

Businesses have the choice to either be financed by debt or by equity, or by a bit of both. What do you think is the best way to finance a company?

Modigliani and Miller theorem (1958), also known as ‘capital structure irrelevance principle’ highly believed that it did not matter if a company was financed with either debt or equity. They believed that the value of the business depends on its risk.  However this was at first a highly rejected theory. Many limitations were found with this theory in 1958: no taxation mentioned, no perfect information is always available and markets were assumed to have strong form efficiency - the theory was not uniform enough to make complete judgements from. However, they realised this and in 1963 Modigliani and Miller added taxation to their theory to make it a normative and unified. The 1963 theory was way more accepted as it was a ‘real world’ approach.

(Modigliani and Miller theorem, 1963).

Surely this would have swayed people to agree with them? Many did, many didn’t. Modigliani and Miller (1963) assume that it doesn’t matter what the gearing (debt/equity) is, what really matters is the firm’s value which is determined solely by business risk.

Modigliani and Miller advice companies to always finance through debt, is this sustainable? High gearing can negatively impact the economy and businesses.

However the trade-off model (Kraus & Litzenberger, 1973) contrary to Modigliani and Miller, assumes that companies choose the amount of debt and equity finance to use by balancing benefits and costs. Do you think this model is better than Modigliani and Miller? I think so. Having both debt and equity finance allows tax benefits, which increased the gearing to a safe level and having half debt, half equity allows a discount rate for potential projects the company may want to invest in.

The trade-off model assumes that weighted average cost of capital (WACC) will initially fall and at some point will hit rock bottom. Decreased WACC = decreased risk. But we must ALWAYS consider financial distress costs. A high level of debt will equal to a high level of financial distress, is this another factor against Modigliani and Miller? At high levels, financial distress cannot be ignored. Particularly when there is uncertainty in supplier’s minds. High financial distress can lead in bankruptcy costs. 

                                 (Trade off model - Kraus & Litzenberger, 1973)                                                

To me I think that the trade-off model represents a more realistic view of capital structure. Modigliani and Miller seems too good to be true, and does not represent the world that we live in which is definitely not a perfect one. Trade off model takes into account that things can change, and that companies should only borrow as much as they can afford (AKA reasonable level).

What do you think? Which model do you think is more sustainable? Thanks for reading this blog post, and I hope you found it interesting! Please leave your comments and opinions below and let me know what you think. Until next week.

Laura