Capital Structure Theories and Company Market Value

Executive Summary

MM Proposition has for decades been used to explain the connection between firms’ market value and capital structure. The first proposition (Proposition I) states that the market value is independent company capital structure, whereas proposition II holds that a firm’s total cost of equity is the sum of cost of capital and the risk premium charged. Other than MM propositions, there several other theories that explain how a capital structure could affect a firm’s market value. Among the theories includes the Trade-off Theory, which states that firm managers determine the respective share of debt and equity in the capital structure. Firms may change both sources proportion on need by need basis. The Pecking Theory holds where firm managers determine the capital structure by prioritizing sources of finance. The priority is inside resources, especially retained earnings or budget reallocations. Internal sources are especially useful when firms are dealing with short-term projects that need immediate financing. Such projects usually require less resources that happen to be readily available within companies. Approaching creditors or shareholders for resources could paint a bad image on the management. The next priority of sources of capital include debt and equity. Debt is however considered for two major reasons. First, the process of requesting banks and other creditors for funds is less laborious compared with equity. Secondly, debt is more effective in dealing with short term capital needs. Equity becomes vital when firms are faced with funds to finance long term projects whose return on investment would take longer, especially considering that creditors are less patient in waiting for payment compared to shareholders who can wait for long term share in company profits. Both equity and credit are therefore used when internal sources provide funds too little to meet demand. The Life Cycle Theory of Finance states that firms apply some preferences in ways they raise capital. Both Life Cycle of Finance and Pecking Theory work almost similarly given the preferences that go in the capital sourcing processes.

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Introduction

Regular investigation of company’s capital structure provides a clear picture of how well companies can wade through business cycles. Owing to the importance of this matter, concurrent sections of this paper shall deal with ways and means used by firms to sustain a decent capital structure. This will be attained though thorougher investigation of MM propositions that have for decades been bench marks for such analysis. The second part of the paper shall analyze three theories of finance that are used to investigate how firms’ market structure could be affected by respective capital structured.

MM Propositions

MM’s Proposition One holds that firms’ market value is completely independent of the capital structure (SSB 2). This is achieved through various assumptions. First, MM ignores the presence of taxes in a firm, which helps in eliminating debt bias. The second assumption ignores the presence of bankruptcy costs that push companies to choosing equity as the most preferred financing option. Third, MM ignores the presence of costs involved in enforcing debt contracts. The fourth assumption holds that companies have various investment options, which help reduce external pressure on respective capital structures. Proposition Two holds that the cost of equity for a levered firm is the sum cost of capital and risk premium (Cheremushkin 52). However, managers in companies tend to just look cost of capital at face value without consideration of the risk premium to be faced. The main assumption used in Proposition II is that managers have information regarding the risk premium being faced by their companies.

Assuming proposition I is correct, management should set respective firms’ borrowing level by trading off the benefits of the two sources of finance, that is, debt and equity. Financing with debt would help in the process of reducing the amount of tax payable through deductions. For example, a company that makes US$ 6 million in profits but pays US$ 1 million in loan payment and interest sees respective taxable income decrease to US$5 million. On the other hand, the bankruptcy costs that come with debts and therefore hinder business operations should be considered. Some advantages of equity should also be considered. This includes the management having greater discretion in choosing forms of investment. Most importantly, the chosen form of financing should be the one providing greatest return on investment. Understanding MM propositions enable managers to develop strategies that aid in getting enough capital to sustain companies in both short and long run. This is in consideration that the chosen financing strategy can have a great impact on company market value, a fact testified by the three theories discussed in subsequent sections of this analysis.

Trade Off Theory

Given that equity and debt are the two major ways of financing company operations, management regularly embark on investigating the best option of the two. In this regard, the Trade Off Theory helps in explaining not only the best option but also how management can mix both options. According to the theory, it is possible for companies to consistently change their debt equity ratio as organisational financial position requires. This is achieved through the understanding on the respective levels that each of the options can be used. Managers tend to apply each option up to the optimal level, then start integrating the other. This means starting to decrease the use of one option at it point of diminishing return, whereas increasing application of the other. Managers keep replacing the optimum option until proper results are reached. In case it was debt that reached the optimum level, the managers embark on introducing equity as from of financing until the persisting dangers vanish.

The Trade Off Theory helps the management in comparing benefits and costs of each of the option on respective firms’ market value. The balancing of equity and debt that is provided in the theory helps companies to escape the exposure to bankruptcy costs that comes with this form of financing. Escaping the bankruptcy threats would help in safeguarding company market value. For listed companies, this means reducing chances of their stocks being affected. Unaffected share prices would mean less effect on the overall market capitalization. Company market value would also be enhanced by the proper balance of the two financing options. For instance, the right amount of debt would enable management to reduce taxes through interest deductions. This would have a positive impact on respective company’s bottom line. Having the two measures well balanced will therefore lead to untainted company market value.

By understanding the balance between equity and debt, managers in small and medium-sized companies can develop the right mix to see respective establishments grow. This will especially be helpful at the initial operation of the said establishment. The long-run market value of respective companies shall therefore be on good footing. This theory explains the benefits of balancing the use of the two financing methods in the initial stages of company operations. Indeed, the management of small companies starts gaining the necessary experience in dealing with financing needs, which leads to mastering the art of employing methods in the best ways possible. In addition, it becomes possible for these companies to develop financing mechanisms that would maintain company operations in the long run (Campbell &Kelly 422). Continuing with this tradition helps the management as the small and medium-sized establishments increase in size and therefore guard the market value. While they are still small, the well-maintained market value serves as magnets attracts outside investors and buyouts, a fact that compounds the value of the company in its respective market.

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The theory thus concludes that the best way to maintain market value in companies is by balancing the use of the two financing methods. When this happens, respective companies can adjust the source of capital depending on the market and organizational needs. Being exposed to the two methods leaves managers in respective companies well exposed to forms of financing. By becoming effective at their capacities, respective companies benefit immensely. Setting a good tradition in switching financing methods in accordance to situation demands helps means that exit of long-serving managers will not affect company performance, the reason being that new ones would have learned the trick in earnest. Other than developing successful ways of balancing sources of financing, management in respective companies should also embark on exploiting the source that would lead to long-run benefits to their companies’ market value. However, the management should also consider that the best method is not a silver bullet for all company financing needs, which means that even the measureless regarded as important should be kept closed. Managers use the trade-off theory’s debt-equity ratio to plan on the most appropriate financing method. For example, a company with an optimal ratio of 0.5 embarks on financing through equity when the ratio starts approaching that level.

Pecking Order Theory

This theory states that companies choose sources of financing starting from internal sources to external ones, depending on the convenience and ease of getting funds. In this regard, internal sources come first because of the ease of getting funds. Indeed, it would be more convenient for managers to decide to use some portion of capital to invest in capital equipment or meet some other obligation. On the other hand, going to the banks to ask for loans or to shareholders for more capital would take much time and effort. The internal sources are also favored when the undertaking requiring extra financing requires fewer funds. It, therefore, becomes more natural for the company to use internal savings to deal with little demands. Going to the bankers for such little amount of funds would harm the company’s market value. Investors and other observers would wonder why the company is borrowing for small projects, which could lead to a mentality of poor performance. This could greatly downsize company market value to a low level. For this reason managers in companies needing cash to embank on raising cash for small projects from internal sources. This could mean cutting budgets for some projects while increasing allocation for other activities that will have a greater return on investment. However, this internal source of capital has some limits, especially when the project in need of finance is huge. Management thus embarks on sourcing funds from outside the company. This involves talking to banks regarding loans and the capital market regarding bonds or shares sales. Before expressing interest to the market, individual companies ensure that the project to be undertaken is attractive enough, which helps convince providers of funds guaranteed return on investment. The lack of decent return on investment means that the providers of capital (investors and financiers) would not be cooperative. At the same time, lower return on investment would lead to reduced interest from capital providers, which will result in lower market value. In the case of companies quoted in respective stock markets, the value of their stock could either increase or decrease depending on the number of funds needed and the purpose that necessitated company actions. Should it appear that the company intends to invest in some lucrative projects, then interest on quoted company shares would become more attractive to investors and thus result in to increase in company market value. At the same time, companies that seem to borrow money and invest in a project deemed to be less attractive will see the value of their quoted share decline, and so will be the overall market value.

After exhausting internal sources of funds, managers start sourcing for funds from external sources. At this point, companies have the option of getting funds from either creditor seek more shareholder funds. Creditors’ funds are more attractive when the project being undertaken is a short-term one or the return on capital will be higher and achievable in the short run. The higher return on investment would mean that the company will be able to pay back creditors. After paying the creditors, companies are reaping returns from the investment that was done using the load monies. Having paid the loans, respective companies’ market value would have had a positive impact. Paying the creditors on time also has a positive effect on companies’ market value. This rises from the creditworthiness that comes with the trust generated from respective creditor companies. The company’s creditworthiness provides more opportunities for getting even bigger loans to be used for further investment. Having more sources of capital will provide respective companies in embarking on projects that would have been deemed impossible to undertake without a large number of resources. Since the increased creditworthiness would provide avenues of getting more cash for investment projects, the long-run market value is set to be on an upward scale. In addition, using borrowed money well would result to companies better companies increasing their internal resources to the point where borrowed money will not be needed. Respective companies would therefore increase the ability to finance projects through cheap internal means.

Exhausting internal and creditor sources of finance would result in people embarking on asking for investor funds. The investor funds become more important when companies are dealing with projects requiring more sources of finance and would take longer before return on investment is achieved. Companies can hardly get enough finances for such big projects from internal means. Equally, the return on investment could take longer than creditors would be willing to wait for their funds. companies are therefore left with the option of asking shareholders for more resources. For instance, companies preparing to take over rivals would largely choose to ask investors for funds rather than approach bans. For companies that are already listed in various stock exchanges, they could take the approach of asking investors for more funds through a rights issue or issuing more common stocks. Companies that are not yet listed might choose to go for an initial public offer. This latter route is usually taken by medium-sized companies.

Compared to the Trade-off Theory, the pecking theory is said to be more effective in explaining the way companies adjust their market value through financing strategies (Zoppa, 16). This raises from how companies prioritize sources of funds. By looking for solutions from internal sources, companies benefit from the tendency of looking for internal solutions. Getting used to this habit enables the managers to always consider the long-run effect of their current business decisions. This contrasts with Trade-off Theory’s aspect of relying on one measure of finance, even it means using debt in most cases. Pecking theory has the management consider internal solutions before running to investors and bankers for financing, which only happens when internal measures have been completely exploited.

By focusing on internal measures of financing, managers are well placed in investigating the efficiency of various company operations. Their goal thus becomes to look into ways of allocating capital from areas of low return to projects that would have a higher return on capital. In this regard, companies can increase resource allocation. It is in respective resource allocation that management gets to understand their companies’ comparative advantages and thus embark on exploiting them to the fullest. This would lead to increased productivity in the companies, which will have an impact on profits. More profits would provide respective companies with more funds that can be re-invested for the continuation of the cycle. In the end, companies will end up increasing their profitability and hence the overall market value. This cycle of events will lead to the company having their stocks attract more attention in the market, thus increasing demand, which will raise company capitalization to new levels. Pecking order theory thus helps companies in the process of developing capital raising strategies depending on specific needs. This is achieved by setting targets on the maximum amount of funds sourced from the three main sources. For example, managers can decide that funds for projects requiring between US$ 20-50 million would be generated from within, whereas those requiring US$50-100 million would be sourced from banks and anything above US$ 100 million from shareholders.

Life Cycle theory of Finance

The theory addresses preferences undertaken by individuals in dealing with respective financial lives, as well as preferences undertaken by respective companies in allocating capital to different areas of production. In the theory, companies look at the overall impact of the organization and each of the sub-projects allocated capital. Looking at both micro and macro effects on capital structure helps in designing allocation that would lead to a greater impact on organizational market value. Understanding what goes on at the lower spectrum of company activities would lead to better management of invested capital, a fact that leads to increased productivity profitability. This profitability has a positive impact on the market value. To an extent, this theory works similarly to the pecking theory, especially when it comes to developing internal solutions to organizational problems that hinder better productivity. The theory has a heavy reliance on the way capital is allocated and used at the lowest level of operation. In this regard, it becomes possible for companies to develop long-term solutions to efficient capital allocation. Having better allocation of capital from various sources helps in increasing productivity, profitability, and therefore the market value.

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The life cycle theory has a diversification of sources of funds as the best way to mitigate capital allocation and investment risk (Fluck 67). The reliance on different sources of capital helps in achieving specific goals of aligning capital in ways beneficial respective company’s market value. Just like Trade-off Theory, the Life Cycle Theory addresses the importance of borrowing capital from various sources and mix their use. This helps companies to deal with the challenge of relying on one measure when it is reliable and when it is not. Mixing of different sources of financial aid in balancing exposure to negative consequences. Despite the heavy emphasis on diversification of capital sources, respective companies can still understand the best source that serves them well. This arises from the increased use of internal measures before embarking on the process of looking for finance from outside sources. In addition, companies can easily deal with the challenge of changing the sources of financing depending on the situation at hand and the market situation. In this regard, it becomes possible to deal with various challenges by mixing funds. As a result of relying on different capital sources, companies’ market value keeps changing on regular basis depending on the source in use, and with respect to the balance of the finance sources being applied. The market value of companies taking this measure is therefore not constant. Instead, it keeps changing in line with the balance of sources of funds. Listed companies are therefore subject to regularly changing the market value in accordance with the movement of shares in respective stock markets.

The theory further suggests managers in charge of sourcing for capital weigh the value of capital against the riskiness involved. This results in the selection of capital structure that best meets company needs in both the short and long run. The involved parties would have provided their companies with a capital structure including only finance sources that would have greater benefits to company operations in both the short and long run. Considering the risk involved with the source of capital means that a cost-benefit analysis is undertaken before embarking on getting capital and applying it to the company. In this regard, respective companies would have the greater benefits of increasing the efficiency of capital. As repeatedly mentioned in this analysis, efficiency in capital results in better application balance in the structure and produces positive effects on market value. Life cycle theory is not keen on putting limits on the number of funds generated from various sources. Instead, the life cycle has an emphasis on diversification. For instance, a company that needs to raise US$ 100 million would usually mix the sources ($10 from within, 50 from banks, and 40 from shareholders).

Conclusion and Recommendations

This analysis has established the effectiveness of MM propositions in the company market structure. Proposition One, which states that company market value has no connection with market structure has been proved to be effective and correct. The proposition uses several assumptions in explaining the relationship between firms’ capital structure and market value. The assumptions include ignoring the presence of taxes, and the costs that come with bankruptcy and debt financing. The other MM assumption holds that firms’ cost structure is determined by the number of funds injected and the accompanying risk premium. The second part of the analysis has used three theories to explain how capital structure affects a company’s market value. The trade-off Theory established that companies establish their capital structure by ensuring the balance between equity and debt. Both sources of capital can be used at the same time. Companies can also choose one option that meets their needs best. In Pecking Order Theory, companies prioritize sources of capital starting from internal sources (from profits), then creditors, and finally debtors. Life Cycle Theory seems to combine the just mentioned two theories to determine the most preferred source of funds. All three theories explicitly explain the impacts on companies’ market value. Managers tasked with the responsibilities of arranging for finances are therefore provided with various theoretical frameworks to follow in their day-to-day financing activities. Though the theories are widely used in many business establishments, managers should adhere to negative externalities that could accrue from theory applications. It is therefore important to ensure a clear understanding of the theories’ strengths and weaknesses. There are various limitations to each of the theories described above. First, MM happens to ignore bankruptcy costs in its analysis despite businessmen and institutions setting firms’ leverage in accordance to possibilities of bankruptcies (Cheremushkin 52). Pecking order limitation rises from its ignorance of taxes agency costs and operational inefficiencies when senior management becomes immune to market discipline as a result of excessive financial cushion. The trade-off theory suffers the limitation of being unable to explain why small firms usually rely on bank debt, whereas bigger firms only use bank credit as the first option but emphasize on equity.

References

Campbell, Donald and Kelly, Jelly. ‘Trade off Theory’. Economic Review. 84 (2): 422-426.

Fluck, Zsuzsanna. Life Cycle Theory of Financing. Stern School of Business: New York, 2004.

Cheremushkin, Sergei. MM Propositions. Mordovian State University: Russia.

SSB. Capital Structure. University of Maryland: College Park, 2007.

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Zoppa, Adrian. Pecking Order Theory. Routledge: New York, 2001.

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