Refresher Reading
Capital Structure
2021 Curriculum CFA Program Level II Corporate Finance
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The most important decision a company makes in pursuit of maximizing its value is typically the decision concerning what products to manufacture and/or what services to offer. The decision on how to finance investments (e.g., in factories and equipment), the so-called capital structure decision, is often seen as less important, even secondary. As we will see in this reading, the importance of the capital structure decision depends on the assumptions one makes about capital markets and the agents operating in it.
Under the most restrictive set of assumptions, the capital structure decision—the choice between how much debt and how much equity a company uses in financing its investments—is irrelevant. That is, any level of debt is as good as any other. The capital structure decision is not only secondary but also irrelevant. However, as some of the underlying assumptions are relaxed, the choice of how much debt to have in the capital structure becomes meaningful. Under a particular set of assumptions, it is even possible to have an optimal level of debt in the capital structure—that is, a level of debt at which company value is maximized.
In this reading, we first discuss the capital structure decision and the assumptions and theories that lead to alternative capital structures. We then present important practical issues for the analyst, such as differences in capital structure policies arising from country-specific factors. We conclude with a summary of key points from the reading.
Learning Outcomes
The member should be able to:
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explain the Modigliani–Miller propositions regarding capital structure;
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explain the effects on costs of capital and capital structure decisions of taxes, financial distress, agency costs, and asymmetric information;
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explain factors an analyst should consider in evaluating the effect of capital structure policy on valuation;
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describe international differences in the use of financial leverage, factors that explain these differences, and implications of these differences for investment analysis.
Summary
In this reading, we have reviewed theories of capital structure and considered practical aspects that an analyst should examine when making investment decisions.
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The goal of the capital structure decision is to determine the financial leverage that maximizes the value of the company (or minimizes the weighted average cost of capital).
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In the Modigliani and Miller theory developed without taxes, capital structure is irrelevant and has no effect on company value.
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The deductibility of interest lowers the cost of debt and the cost of capital for the company as a whole. Adding the tax shield provided by debt to the Modigliani and Miller framework suggests that the optimal capital structure is all debt.
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In the Modigliani and Miller propositions with and without taxes, increasing a company’s relative use of debt in the capital structure increases the risk for equity providers and, hence, the cost of equity capital.
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When there are bankruptcy costs, a high debt ratio increases the risk of bankruptcy.
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Using more debt in a company’s capital structure reduces the net agency costs of equity.
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The costs of asymmetric information increase as more equity is used versus debt, suggesting the pecking order theory of leverage in which new equity issuance is the least preferred method of raising capital.
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According to the static trade-off theory of capital structure, in choosing a capital structure, a company balances the value of the tax benefit from deductibility of interest with the present value of the costs of financial distress. At the optimal target capital structure, the incremental tax shield benefit is exactly offset by the incremental costs of financial distress.
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A company may identify its target capital structure, but its capital structure at any point in time may not be equal to its target for many reasons.
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Many companies have goals for maintaining a certain credit rating, and these goals are influenced by the relative costs of debt financing among the different rating classes.
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In evaluating a company’s capital structure, the financial analyst must look at such factors as the capital structure of the company over time, the business risk of the company, the capital structure of competitors that have similar business risk, and company-specific factors (e.g., the quality of corporate governance, which may affect agency costs).
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Good corporate governance and accounting transparency should lower the net agency costs of equity.
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When comparing capital structures of companies in different countries, an analyst must consider a variety of characteristics that might differ and affect both the typical capital structure and the debt maturity structure. The major characteristics fall into three categories: institutional and legal environment, financial markets and banking sector, and macroeconomic environment.