I don’t normally venture in to discussions of financial topics but I have recently taken a course on Corporate Finance and whilst it isn’t my normal cup of tea it was quite interesting and I learned a lot! In today’s article, I therefore want to summarise some concepts around capital structure and discuss the various theories I learned which go some way to explain observed differences in leverage ratios of companies (although, there is no universal theory of debt, there are instead theories which may apply in different circumstances).

To start, the capital structure of a company refers to how it finances its operations and growth. This can either be financed through (i) retained earnings (previous profits the company made which were not returned to shareholders), (ii) equity (issuing ownership of the company’s future profits and current resources in return for money) and, (iii) borrowing (promising to repay money in the future with added interest).

The overarching question that I will try to explain (although, not fully) is what induces a firm to choose a certain level of leverage (the amount of debt it has) and how to choose between the various sources of finance described above.

It is an observed fact that the cost of debt is usually lower than the cost of equity, so naturally one would assume that firms which have more debt must have lower costs of repayment and therefore make more profit than firms which finance with equity. However, surprisingly, the Modigliani-Miller theorem states that in a perfect world (these assumptions will be outlined below), a firm’s financing decisions do not affect the firm’s enterprise value. In other words, if we consider two companies which are perfect twins except for the fact that one has a leverage of 70% (i.e. it is 70% financed by debt and 30% financed by equity) whilst the other has a leverage of 30%, the theorem states that both companies would have the same economic value. Due to this irrelevance, the Modigliani-Miller theorem is also known as the capital structure irrelevance principle. But this sounds odd: if debt is cheaper than equity, surely the firm which has more debt should be worth more than the firm with more equity? The insight from Modigliani-Miller, which explains why common-sense does not hold, is that the firm with more debt has to pay an even higher cost of equity to offset the additional risk that being laden with debt imposes. Indeed, the increased costs of equity used to offset higher debt levels, exactly offsets the cheaper cost of debt financing. Consequently, financing with debt does not allow the overall cost of capital to fall, so financing by debt or equity does not affect the enterprise value. (of course, this result can be shown mathematically but I want to focus here on the explanation alone)

The Modigliani-Miller theorem only holds with certain assumptions: the absence of taxes, bankruptcy costs, agency costs and asymmetric information. In reality, it is clear that these assumptions do not hold, which makes the MM theory great on paper but less relevant in practice!

Obviously, the assumption of no taxes does not hold in reality. When we look at most tax structures across the world, it is often the case that interest payments of debt are tax-deductible. Therefore, there is a tax shield on a part of debt and there is an additional benefit from using debt rather than equity. In this case, we would expect companies to increase debt levels to benefit from this tax deduction, which would allow them to have a higher enterprise value relative to a lower-debt company.

This leads to the trade-off theory of capital structure: firms balance the tax advantages of additional debt against the costs of possible financial distress, including the costs of bankrupty or re-organisation and to the agency costs that arise when the firm’s credit-worthiness is in doubt. Note that the costs of bankruptcy are not just direct but include indirect costs such as staff leaving during periods of uncertainty, loss of customers who are concerned they may not be able to return goods if the company goes under, and suppliers may only supply if they are paid up-front.

This theory would therefore predict more moderate levels of borrowing, which is more realistic. A firm benefits from having greater levels of debt as a result of the tax shield it gains from this but this is offset by the fact that higher levels of debt can bring greater risks as a company nears bankrupty. This theory would therefore also predict that more financially stable companies (those in mature industries) would have higher levels of debt than upstart companies which may be more likely to find themselves in financial distress. The theory correctly explains why high-tech growth companies, whose assets are usually risky and mostly intangible (and therefore, who have a relatively high cost of financial distress), normally use relatively little debt.

The final theory I want to discuss is the pecking order theory. Under this strand of thinking, firms have a preference over the choice of capital structure and would rather finance using (1) internal retained earnings, (2) issue debt, (3) issue equity.

We can think of the trade-off theory as balancing the need for tax-shield cheaper financing with concerns of moral hazard, in the sense that managers who are under the control of shareholders may have an incentive to make big bets on borrowed money at the detriment of bondholders. On the other hand, the pecking order theory can be thought of as balancing the need for finance against concerns of information asymmetry, in the sense that managers (who tend to know most about their firm’s future prospects, risks and value) choose their mode of funding based on the information it reveals to the market. Financing through internal funds reveals the least information whilst issuing equity reveals the most. The reason why asymmetric information favours debt over equity is that if equity is undervaleud then it makes sense to invest with debt, whilst if equity is overvalued then issuing equity signals this overvalue to shareholders which would drive down the share price thus eliminating the advantage of an equity issue. As a result, debt is more likely to be issued than equity, unless the company runs out of capacity to issue further debt.

In reality, none of the theories presented above are perfect and can completely explain the patterns of capital structure we see in reality. The Modigliani-Miller theorems are nice on paper but have unrealistic assumptions which do not apply in real life. The trade-off theory cannot account for the empirical correlation between high profitability firms tending to have low debt ratios (instead, it would predict the opposite, with high debt-levels to ebnefit from interest tax shields on the high profit firm activities). Finally, the pecking order theory is better at explaining observed reality but often fails for small firms where the issue of information asymmetry should be larger (see Frank and Goyal (2018)). Overall, we have some theories which can explain parts of capital structure but do not provide unambiguous explanations for capital structure.