Magoosh GRE

“Capital Structure Irrelevance Theorem and Asymmetric Information”

| March 5, 2015

1. Introduction
According to Miller and Modigliani (1958) the capital structure of a firm is irrelevant to the firm’s current investment and financing decisions. The theory is based on the assumption that markets are efficient. This means that investors neither incur transaction costs nor pay taxes when buying and selling securities. In addition, there are no information asymmetries between shareholders and managers (Ross et al., 1999; Myers and Brealey, 2002; Hillier et al., 2010). Empirical evidence suggests that in the presence of market imperfections, the Miller and Modigliani irrelevance theory does not hold. The objective of this paper is to show that under asymmetric information and agency costs, the capital structure of a firm is relevant to its financing and investment decisions. This means that the irrelevance theorem “crucially depends on the assumptions of perfect capital markets even in the absence of taxes and bankruptcy costs”. The rest of the paper is organised as follows: section 2 provides the Miller and Modigliani irrelevance theorem; section 3 provides empirical evidence on the theorem; and section 4 provides conclusions and recommendations.

2. The Miller and Modigliani (MM) Capital Structure Irrelevance Theorem

The capital structure of a firm is the mix of equity and debt that the company uses to finance its investments (Aggarwal et al., 2011: p. 100). The objective of the firm is to figure out the financial leverage or capital structure that minimises the weighted average cost of capital (WACC) so as to maximise the value of the firm. Miller and Modigliani provided two propositions on capital structure: Proposition I without taxes and Proposition II without taxes.
According to Proposition I without taxes, the capital structure of a firm is irrelevant. This means that given certain assumptions, the capital structure of a firm does not matter (Miller and Modigliani, 1958). These assumptions are based mainly on expectations and markets:
– Investors have homogeneous expectations regarding the cash flows from a given asset;
– The trading of assets (bonds and stocks) is undertaken in perfect capital markets. This assumption means that there are no transaction costs, no taxes, no bankruptcy costs, no information asymmetries;
– Borrowing and lending any asset can be done at the risk-free interest rate;
– There are no agency costs, indicating that managers always act in the best interest of shareholders;
– Financing and investment decisions do not interact with each other, which means that changes in operating income are independent of changes in financial leverage.
Proposition II without taxes states that: higher financial leverage results in a higher cost of equity capital (Miller and Modigliani, 1958). This shows that the cost of equity capital is a linear function of the company’s financial leverage (debt-to-equity ratio).
Based on the assumption that there are no costs associated with financial distress and that bondholders have a priority claim to assets and profit relative to shareholders, the cost of debt capital is less than the cost of equity capital (Ross et al., 1999; Myers and Brealey, 2002; Hillier et al., 2010; Aggarwal et al., 2011). An increase in the debt-to-equity ratio results in a proportionate increase in the cost of equity capital. According to MM proposition I, the value of the firm is unaffected by changes in financial leverage. Likewise, proposition I states that the weighted average cost of capital is unaffected by changes in financial leverage. Consequently, proposition II suggests that as the firm gradually switches its funding source from more expensive equity to cheaper debt, the cost of equity capital increases in the same proportion thus offsetting the increased use of cheaper debt, thus keeping the WACC constant.
The weighted average cost of capital is given by (Aggarwal et al., 2011):

(1)
Where
represents the weighted average cost of capital;
is the before-tax marginal cost of debt capital;
is the marginal cost of equity capital;
D is the market value of debt;
E is the market value of equity;
V is the market value of the company which is equal to (D+E); and
Tc is the corporate tax rate.
Ignoring taxes as in Miller and Modigliani Proposition II equation (1) can be re-written as follows:
(2)
Assume that is the cost of capital for an all-equity financed firm. Then according to MM Proposition I (Arggawal et al., 2011):
(3)
Substitute for D+E = V in equation (3). That is:

Therefore,

(4)
Equation (4) suggests that the cost of equity capital exhibits a linear relationship with the debt-to-equity ratio. It can be regarded as a regression equation where the intercept is the cost of capital for an all-equity financed firm and the slope coefficient is the spread between the cost of debt and the cost of equity capital. Equation (4) represents the precise mathematical expression of MM proposition II. It shows that as the financial leverage increases, the cost of equity capital increases. However, this increase in the cost of equity capital does not result to an increase in the weighted average cost of capital. This is because, any reduction in WACC that occurs as a result of the use of cheaper debt is exactly offset by an increase in the cost of equity capital as a result of an increase in the financial leverage (Aggarwal et al., 2011).
Equation (4) above illustrates that as long as there are no taxes, the weighted average cost of capital remains constant while the cost of equity capital increases as the debt-to-equity ratio rises. However, in practice, the interest that firms pay for using debt financing is deductible for tax purposes in most jurisdictions. Consequently, using debt provides the firm with a tax shield that can be used to improve the value of the firm. Assuming that there are no costs to financial distress and bankruptcy, the value of the company is expected to increase as the firm gradually replaces equity with debt financing. The after-tax cost of debt is given by before tax cost of debt multiplied by (1-marginal tax rate). That is (Aggarwal et al., 2011):
After tax cost of debt = before-tax cost of debt (1-Marginal tax rate).
From the foregoing the MM Proposition I with taxes states that the value of the firm with debt is higher than the value of the firm without debt. That is:
(5)
That is, the value of the levered firm ( ) is the sum of the value of the unlevered firm ( ) and the value of the debt tax shield ( ) (Myers and Brealey, 2002; Aggarwal et al., 2011). Introducing corporate taxes also result in a reduction in the WACC. That is (Aggarwal et al., 2011):

Again assume that is the cost of capital for an all-equity financed firm.
Then
(6)
Substitute for D+E = V in equation (6). That is:

(7)

Rearranging equation (7) it can be shown that the cost of equity capital is equal to:
(8)
Equation (8) shows that in the presence of corporate taxes, as the debt-to-equity ratio increases, the cost of equity capital increases but at a decreasing rate. Given that the cost of equity capital is increasing at a decreasing rate while the cost of debt is falling, the WACC decreases as the debt-to-equity ratio increases. In the presence of corporate taxes, the relationship between the cost of equity capital and the debt-to-equity ratio is no longer linear.

3. Empirical Evidence

A number of studies have investigated the MM irrelevance theory proposed above. Most of the studies have argued that the MM propositions I and II are based on unrealistic assumptions. When realities are factored into the model, it can be shown that capital structure decision is in fact relevant.
Jensen and Meckling (1976) argue that the relationship between a firm’s management and its shareholders is analogous to that of the principal-agent relationship where the shareholders represent principals and managers represent agents. The principal-agent relationship is characterised by conflicts of interest and information asymmetries. These aspects are neglected in the MM capital structure irrelevance proposition. Myers (1997) suggests that debt-holders take part in the profits that are generated by positive net present value (NPV) projects. Managers are not particularly happy about this fact and as such tend to forego investment in some positive NPV projects (Myers, 1997; Cheng and Shui, 2007). This in other words means that the manager will prefer to abandon a positive NPV project if faced with financial constraints irrespective of whether the project will contribute to an increase in firm value. The objective is to maintain some financial flexibility that can be used in future. Information asymmetry and conflicts of interest arising as a result of agency problems result in an increase in the cost of raising both internal and external finance for investment projects (Greenwald et al., 1984; Myers, 1984; Myers and Masjuf, 1984). Consequently taking agency problems into account, a firm’s capital structure decision has an impact on both its financing and investment decisions. In addition to agency problems and information asymmetry, a firm’s capital structure is influenced by a number of firm specific factors including size, growth opportunities, tangibility and profitability (Haris and Raviv, 1991).
The level of financial leverage depends on the cost of bankruptcy costs and financial distress. Large firms tend to be highly diversified which means that they face lower bankruptcy and financial distress costs than small firms. Consequently, large firms tend to be highly leveraged than smaller firms. This is consistent with the “static trade-off” model, which suggests that financial leverage and firm size exhibit a positive relationship (Cheng and Shiu, 2007: p. 35). One would therefore expect to observe higher debt in the capital structure of large firms and higher equity in the capital structure of smaller firms. MM propositions I and II therefore fail to take into account the fact that firm size can influence a firm’s financing decision. One possible explanation why larger firms are financed with high debt than smaller firms is the fact that information on large firms is readily available to the market while information on smaller firms is rarely available. Consequently, smaller firms are characterised by higher levels of information asymmetry than larger firms. This casts doubt on the conclusion that in the no tax case, the cost of equity capital is a linear function of the debt-to-equity ratio. Given the higher level of information asymmetry for smaller firms, the cost of equity capital will increase at a higher rate for smaller firms than for larger firms for every increase in the level of financial leverage. The reason for this is that investors would require more from smaller firms than from larger firms. Consequently, the relationship between firm size and leverage is expected to be negative (Cheng and Shiu, 2007: p. 35). Large firms also enjoy economies of scale in issuing capital. Large firms are usually involved in seasoned equity offerings while smaller firms are more likely to be involved in an initial public offering (IPO). A seasoned equity offering is the issue of stocks by a firm that is already listed on the stock market while an IPO is the issue of equity by a firm that is not yet trading on the stock market. The costs associated with issuing an IPO are significantly higher than the costs associated with issuing a seasoned equity offering. Consequently large firms have a higher flexibility of issuing equity than smaller firms. Moreover, larger firms also have economies of scale in issuing debt which are not readily available to smaller firms (Cheng and Shiu, 2007).

Financial flexibility is also a factor that determines a firm’s choice of financing. The pecking order theory argues that firms prefer using internally generated funds first. If internally generated funds are insufficient they turn to debt financing. If debt financing is not sufficient they issue equity capital (Myers and Majluf, 1984). The pecking order theory therefore suggest that firms with high levels of profitability should exhibit lower levels of leverage given that they tend to generate higher levels of internally generated funds. However, this is not necessarily the case. Some studies have argued that firms with high levels of profitability are more likely to be financed by debt. This is because these firms are confident over their ability to generate enough earnings before interest and taxes to cover interest payments and other debt servicing costs than firms with lower levels of profitability. In addition, the tax advantage to debt makes it more advantageous for profitable firms to finance with debt than unprofitable firms. Profitable firms can shield part of their profit from tax by using debt financing rather than equity financing (Myers and Brealey, 2002).
The degree of financial leverage is also influenced by the asset structure. Agency theory suggests that the more tangible the assets of the firm, the lower are the agency costs and the higher is its ability to issue debt (Cheng and Shiu, 2007). When a firm communicates information about its asset structure (mix of tangible and intangible assets), it is more likely for investors to verify the authenticity of the firm’s report by counting observing and valuing its tangible assets than its intangible assets. Information asymmetry therefore reduces as the amount of tangible assets increases, which increases the firm’s ability to take on more debt. Firms with higher proportions of tangible assets in their balance sheets are therefore more likely to issue debt than firms with lower levels of tangible assets. The overall cost of capital is lower for these firms because their financial distress and bankruptcy costs are lower than firms with a higher proportion of intangible assets.
Capital structure is also influenced by country-specific factors such as the degree of investor protection, economic development, taxes and inflation. Countries where investors’ rights are secured tend to have well-developed capital markets. These markets tend to be more efficient than those in countries where investors’ rights are not protected. The manner in which firms are financed in both markets is expected to be different. Investors will be more interested in contributing capital in countries where their rights are more protected than in countries where their rights are less protected. There are two main types of financial systems: bank-based and market based systems. In market based systems (e.g., the U.S and U.K) the rights of equity investors tend to be more protected than the rights of bondholders. Consequently firms in these countries tend to be financed with more equity than debt. In contrast, in bank-based countries (e.g., Germany and Japan) bondholders tend to be more protected than equity investors. Consequently firms in these countries tend to be financed by debt (Utrero-González, 2007; Wald and Long, 2007).
4. Conclusions and Recommendations
The objective of this paper was to determine whether the irrelevance theory of Miller and Modigliani depends crucially on the assumptions of perfect capital markets even if bankruptcy costs and taxes are ignored. Based on the analysis, this appears to be the case. In the absence of perfect capital markets, there would be a high degree of information asymmetry. This means that shareholders would have less information about the companies they are investing in. As a result, the cost of capital would be higher for imperfect capital markets than for perfect capital markets. If markets were in fact efficient, then the MM irrelevance theory will hold because all information available to managers would also be available to shareholders. In this case, whether firms use debt or equity will be irrelevant to their costs of capital and thus to their value.

References

Aggarwal, R., Drake, P. P., Kobor, A., Noronha, G. (2011) ”Capital Structure”, in Corporate Finance, CFA Level II Program Curriculum, vol. 3, Pearson Learning Solutions, pp. 99-132.

Brealey R. A., Myers S. C. (2002). Principles of Corporate Finance. Seventh Edition. Irwin McGraw-Hill.

Cheng S., Shiu C. (2007). Investor protection and capital structure: International Evidence. Journal of Multinational Financial Management, vol. 17, pp. 30-44.

Harris, M., Raviv, A. (1991), “The Theory of Capital Structure”, The Journal of Finance, Vol. 46, No. 1., pp. 297-355.

Hillier, D., Ross, S., Westerfield, R., Jaffe, J. and Jordan, B. (2010) Corporate Finance, Chapters 14, 15 and 16.

Levy A., Hennessy C. (2007). Why does capital structure choice vary with macroeconomic conditions? Journal of Monetary Economics, vol. 54, pp 1545-1564.

Modigliani, F., and M. Miller, (1958), ”The cost of capital, corporation finance and the theory of investment”, American Economic Review, 48, 261-297.

Myers S.C. (1977). Determinants of Corporate Borrowing. Journal of Financial Economics, 5, pp. 147-176.

Myers, S., (1984) ”The capital structure puzzle”, Journal of Finance, 39, 575-592.
Myers, S., Majluf, N. (1984), ”Corporate financing and investment decisions when firms have information that investors do not have”, Journal of Financial Economics, 13, 187-221.

Ross, S.A., Westerfield, R.W., Jaffe, J. (1999). Corporate Finance. 5th Edition. McGraw-Hill International Edition Finance Series.

Utrero-González N. (2007). Banking regulation, institutional framework and capital structure: International evidence from industry data. The Quarterly Review of Economics and Finance, vol. 47, pp. 481-506.

Wald J. K., Long M. S. (2007). The effect of state laws on capital structure. Journal of Financial Economics, vol. 83, pp. 297-319.

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