Traditional views on capital structure point to the existence of an optimal capital structure. Critique the analysis of the traditional views on capital structure in light of the competing views offered by Modigliani and Miller along with their assumptions.

Capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. Stewart C. Myers argues that there is “no magic” in leverage and there is nothing supporting a presumption that more debt is better. He adds that debt maybe better than equity in some cases, worse in others or it may be no better and no worse. Thus, all financing choices are equally good. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20bn dollars in equity and $80bn in debt is said to be 20% equity financed and 80% debt financed. The firm's ratio of debt to total financing, 80% in this example is referred to as the firm's leverage. There are many views on capital structure including the traditional views as well as the competing views offered by Modigliani and Miller.

Traditional views on capital structure point to the existence of an optimal capital structure. An optimal capital structure is simply a mix of debt and equity which maximizes the value of the firm or minimizes the cost of capital. According to the traditional views on capital structure, changes in capital structure benefit the stockholders if and only if the value of the firm increases. Conversely, these changes hurt the stock holders if and only if the value of the firm decreases. This result holds true for capital structure changes of many different types. Thus, managers should choose the capital structure that they believe will have the highest firm value because the capital structure will be most beneficial to the firm’s stockholders. Apart from that, a change in the debt–equity ratio affects the value of the firm because it would change the risk shareholders bear. Under the traditional views, the fundamental principle is that individuals require higher returns in compensation if the risk they bear rises. If a rise in the debt–equity ratio increases risk, firms should offer shareholders higher return and it is important to realize that an increase in the debt–equity ratio increases the firm’s cost of capital. Thus, all corporations should determine their capital structure bearing that in mind. In the article by Stewart C. Myers, the author points out that the search for optimal capital structure is like the search for Truth or Wisdom and that it is impossible to completely attain either goal but progress has been seen in the past few years.

Apart from the traditional views on capital structure, there are competing views offered by Modigliani and Miller along with their assumptions. The Modigliani-Miller(MM) theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it assumes away many important factors in the capital structure decision. Modigliani and Miller (1958) demonstrated that the firms overall cost of capital cannot be reduced as debt is substituted for equity, even though debt appears to be cheaper than equity. The reason for this is that as the firm adds debts, the remaining equity becomes more risky. As this risk rises, the cost of equity capital also rises as a result. The increase in the cost of the remaining equity capital offsets the higher proportion of the firm finance by low-cost debt. In fact, MM prove that the two effects exactly offset each other, so that both the value of the firm and the firm’s overall cost of capital are invariant to leverage. In addition, MM say that there is no “optimal” debt-equity ratio and the amount of debt issued by the firm is irrelevant.

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There are two propositions that MM have pointed out. MM Proposition 1 focuses on the value of the firm and states that the value of the levered firm is the same as the value of the unlevered firm. Basically, the market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate appropriate to its risk class. Thus, each firm’s cost of capital is constant regardless of the debt equity ratio. Before MM, the effect of leverage on the value of the firm was considered complex and convoluted. MM showed a blindingly simple result: If levered firms are priced too high, rational investors will simply borrow on their personal accounts to buy shares in unlevered firms. This substitution is called homemade leverage. As long as individuals borrow (and lend) on the same terms as the firms, they can duplicate the effects of corporate leverage on their own and can earn a higher return on equity without changing his/her risk profile. Apart from the first MM proposition, MM Proposition 2 focuses on expected return on equity of a company with various capital structures and states that the expected return on equity increases linearly as the amount of debt increases-provided that the debt remain risk free. But if increases debt levels increase the cost of debt, this also causes the rate of increase in the expected return on equity to decline. This is shown in figure 1.

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Since the sum of the returns to debt and equity must equal the total return generated by the asset of a company, it is possible to write the return on assets as follows:

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Thus proposition II shows mathematically that the expected return on equity increases as the amount of financial leverage increases, unless the expected return on debt rises. This rise in expected return on debt will only happen when the debt holders fell they have lent more than can be justified at the risk free rate.

Thus, a higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. These propositions are true assuming the following assumptions: no taxes exist, no transactions costs exist and individuals and corporations borrow at the same rate. Propositions 1 and 2 are based on a number of simplifying assumptions and in the real world, those assumptions are not valid. However, the theorem is still taught and studied because it tells us something very important. That is, if capital structure matters, it is precisely because one or more of the assumptions is violated. It tells us where to look for determinants of optimal capital structure and how those factors might affect optimal capital structure.

On the other hand, MM conclusions are changed when real world conditions differ from their assumptions. One important real world phenomenon is the existence of corporate and personal taxes which treat different forms of income differently. In this situation, MM Proposition 1 states that because corporations can deduct interest payments but not dividend payments, corporate leverage lowers tax payments and the firm’s value increases with leverage. The key concept for understanding the impact of corporate taxation is the ‘present value of the interest tax shield’ or, in other words, the present value of the tax saving that is obtained through the firm having to make interest payments to its debt-holders. Apart from the first MM proposition, MM Proposition 2 states that the cost of equity rises with leverage because the risk to equity rises with leverage. If we consider the impact of corporate taxes alone, the conclusion would be to observe 100% debt in the capital structure of firms. Thus the existence of taxes combined with the ability to reduce taxable incme by the amount of interest expense results in increased cash flowing out of the company with more debt. This implies that having debt results in a higher value to the owners.

In 1977, Miller suggested that the important result is not solely how much money flows out of the company, but how much the owners retain after being taxed on cash received from the company.. If the personal tax rate is higher that the corporate rate, it is clear that income at the personal level due to equity is more favorable than income from holding debt. On the other hand, if the personal tax rate is lower than the corporate rate, it would be better if personal income was derived by holding debt in lieu of equity.

This further consideration of the tax issues involved in maximizing shareholders’ wealth leads to an examination of the ‘clientele’ effect. Some shareholders prefer a capital structure with more equity while others prefer one with more debt. The choice depends on the tax structure of the shareholders. It is also possible that owners will have to pay tax on their equity income, further complicating the analysis.
Therefore, each individual investor will assess which particular capital structure best suits their needs making it impossible to formulate a general rule for an ‘optimal’ structure. (Dividend is partially influence by clientele effect)

According to the above information, it is clear that the choice of capital structure boils down to taxes, risks and asset type. These three factors give managers a framework for thinking about optimal capital structure and will enable managers to make good decisions that will improve the long run performance of the company. In the article “The Search for optimal capital structure”, Stewart C. Myers, argues that there is no presumption that borrowing is a good thing, even if debt is kept to “moderate” levels. He adds that there is a moderate tax advantage to corporate borrowing for companies that are reasonably sure they can use the interest tax shields. However, the costs of possible financial distress may limit borrowing. These costs are particularly valid for risky firms and for firms whose value depends on intangible assets. In addition, growth firms should borrow less, other things equal.
Conclusion

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References

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