Debt v. Equity and Capital Structure

Introduction

It is said that one of the most influential and popular theories in the field of economics and corporate finance was serendipitously discovered by two professors who had been assigned to teach a subject that they were not familiar with. The two were Franco Modigliani and Merton Miller, and this contribution and others in the field earned the two Nobel Prizes in Economics in 1985 and 1990 (Jefferson 2001).

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It is said that the two were assigned to give lectures on corporate finance to business students at Carnegie Mellon University. The two were lacking in prior experience in this field, and as such, they found it important to sit down and brainstorm on the content of their lectures. After going through the literature that existed within the field, the two concluded that there were a lot of inconsistencies than there were consistencies (Brealey and Myers 2008). This prompted them to further criticize the material, as a result of which they came up with the theory that they published in the American Economic Review-Journal. Their theory came to be known as the Modigliani-Miller theorem (Brealey and Myers 2008).

This theory is referred to by many analysts in the field as the conventional theory of capital structure (Jefferson 2001). The theory had several assumptions that it used in making an argument about the capital structure of a company. Even though this theorem is taken as the basis of contemporary thinking in the field of capital structure, many analysts regard it just as that; a mere theory. This is given the fact that the theory assumes away significant factors and issues in the capital structure arena.

According to Modigliani and Miller, the way a business enterprise is financed does not affect its value in the market (Viviani 2008). Whether the business is financed through debt, through equity, or a hybrid of the two does not change or affect its value. The assumption is made within a perfect capital market (Romano et al 2001). A perfect market is where there are no transaction or bankruptcy costs and where the business can access perfect information regarding the market and other issues that affect it (Groth 2010).

Also, within a perfect market, businesses and individual borrowers can do so at a uniform interest rate where there are no taxes (Groth 2010). However, it is notable that these conditions rarely exist in the real world. It is a fact beyond doubt that the capital structure of a business does affect the value of the business in the market. For example, in the real and contemporary world, the use of debt in the capital structure holds some benefits to the business. For example, the use of debt leads to a tax advantage, and this leads to the lowering of the cost of capital to the business (Tyerman 2005).

The classical capital structure theory is going to form the basis of this paper. The author is going to look at the benefits and advantages of using debt on a business. The paper will also look at the implications that the use of debt has on the equity holders in the business. This is given that most businesses adopt a mix of equity and debt financing, and as such, the amount of debt will affect the equity holders on several fronts.

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Literature Review

Capital Structure and the Value of Business

According to Lasfer (2010), a business’s capital structure can be conceptualized as the way through which the business finances its assets to support its operations. There are two major options for the company to choose from when it comes to financing. The first is equity, where the business sells shares and interests to investors. The investors do not expect the business to pay back their money. On the contrary, they expect to reap from the profits that are made by the business, and they take this as the return on their investment (Tsuruoka 2004). The other option is for the firm to borrow from financial institutions and other traditional lenders. This debt is paid up together with the interest that it would have accrued.

More often than not, businesses find themselves having to finance their operations from both the debt and equity options. This determines the value of the business both to the investors and to the lenders. For instance, a business may opt to offer 30,000 dollars in equity and 70,000 in debt. In this case, it is said that the firm’s capital structure is 30 percent equity-financed and 70 percent debt-financed (Lasfer 2010).

As earlier indicated in this paper, the irrelevancy of the capital structure in the value of the business exists only within a perfect market (Groth 2010). If this is the case, then the imperfections that are found within the contemporary and real-world render the capital structure some degree of relevance. This is argued by other contemporary theories such as the trade-off theory that acknowledges the existence of bankruptcy costs (Tsuruoka 2004). The other is the pecking order theory that takes into consideration the existence of the costs of asymmetric information to the business and the effects that this information has on the business (Viviani 2008).

The Benefits of the use of Debt in Capital Structure

Several benefits are attached to the use of debt in the business capital structure. Some of these benefits are as analyzed below:

Maintenance of Control

The person or institution that lends money to the business holds no claim over the equity of the firm (Brealey and Myers 2008). As such, the use of debt does not dilute the hold that the business owner has on their enterprise. As such, they can continue making critical decisions that inform the operation of their enterprise without the interference of the debtors (Brealey and Myers 2008).

Control over Profits

By the use of debt, the business is only obligated to pay the principal amount of the lent amount plus the interest that has been accrued. As such, the lending institution or individual holds no claim over the profits that are made by the business, now or in the future (Romano et al 2001). This means that if the business becomes successful in the future, the owners will be looking forward to benefiting from the profits that are made.

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Tax Advantages

This is perhaps one of the major advantages as far as the use of debt in business capital structure is concerned. The interest that the company pays on the loan is usually deducted from the tax returns filed with the authorities (Groth 2010). This is especially so given that the business pays taxes on the profit that remains after the loans and the interests therein have been paid. If the firm makes 10,000 dollars and uses it all to pay the loans and the interests accrued, there will be no taxes to be paid. This lowers the cost of capital, in this case, the debt, to the firm.

Disadvantages of the use of Debt

Financial Burden

The business has the obligation of paying the debt in the future, even though it may not be making any profits. This creates a financial burden on the part of the business and the owners, especially so given that they risk losing the collateral and other securities that might have been placed for the loan (Lasfer 2010).

Raising of Break-Even Point

Tyerman (2005) is of the view that the interest that the loan accrues is a fixed cost that has to be borne by the business. This in effect raises the business’s break-even point in the future (Tyerman 2005). It is especially noted that high-interest costs especially during hard business cycles increase the risk of the business going into insolvency (Tyerman 2005).

Discussion and Analysis

Several factors may inform the firm’s decision in using equity financing as opposed to debt. One of them is the fact that the owner of the business is under no obligation to pay the investors if the company does not make any profits (Lasfer 2010). This is unlike in the case of debt which has to be paid regardless of the financial status or performance of the business. However, one major disadvantage, as this paper revealed, is the loss of control over the business that comes with the use of equity. The investors may demand to even sit on the company’s board of directors, wrenching away the control of the business from the owners.

The use of debt on the business’s capital structure inevitably has implications on the company’s equity holders. For example, if the firm has an excessive debt that is still unpaid, it might be unable to borrow in the future, cutting down on the sources of future capital. This will affect the equity holders since their business will be cash-strapped unless they make additional investments into the business.

If the business has a lot of outstanding debt, the public’s regard for the business is affected. This lowers the price of a stock in the securities market, reducing the value of the shares held by the equity holders. Additionally, too much debt puts the stock of the equity holders at risk. If the business fails because of the debt, the investors will lose everything. The equity holders also get paid dividends after the loan and the interest has been paid. As such, if the debt is huge, the returns on the equity holders’ investment are largely reduced.

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Some benefits come with the use of debt in the capital structure as far as the equity holders are concerned. For example, the debt provides cheap capital for the firm to expand its operations, and the equity holder benefits by having the return on their investment increase.

Conclusion

This paper defined capital structure as the combination of financing that the business uses in its operations. This is the combination of debt and equity as sources of finance, a phenomenon that is referred to as leverage. The classical theory of capital structure states that the capital structure is not relevant to the value of the organization in a perfect market. But given the imperfections of the real and contemporary world, this paper revealed that capital structure does affect the value of the business.

Several advantages and disadvantages are associated with the use of debt or equity in a company. Also, the use of debt has effects on the equity holders in the firm. This ranges from the reduced price of their stock to reduced earnings if the debt is very high. From this discourse, it is obvious that the classical theory of capital structure did a lot of assumptions, assumptions that do not necessarily apply to the real world.

References

Brealey, R A., and Myers, S C 2008. Principles of Corporate Finance. Boston: McGraw-Hill/Irwin.

Groth, J C 2010. Capital Structure: Perspectives. Web.

Jefferson, S 2001. When Raising Funds, Start-Ups Face the Debt vs. Equity Question. Pacific Business News: 34-38.

Lasfer, M 2010. Optimizing the Capital Structure: Finding the Right Balance between Debt and Equity. Web.

Romano, C A., et al 2001. Capital Structure Decision Making: A Model for Family Business. Journal of Business Venturing: 2-8.

Tsuruoka, D 2004. When Financing a Small Business, Compare Options, Keep It Simple. Investor’s Business Daily: 6-9.

Tyerman, R 2005. Debt v. Equity. Web.

Viviani, J L 2008. Capital Structure Determinants: An Empirical Study of French Companies in The Wine Industry. International Journal of Wine Business Research, 20(2): 171-194.

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