Prof. Dr. Zulfiqar Hasan
Capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities.
Capital restructuring is a corporate operation that involves changing the mixture of debt and equity in a company's capital structure.
It is performed in order to optimize profitability or in response to a crisis like bankruptcy, hostile takeover bid, or changing market conditions.
Motives of Capital Restructuring
- To enhance liquidity.
- To lower the cost of capital.
- To reduce risk.
- To avoid loss of Control.
- To improve Shareholder Value.
Capital Structure Theory
Capital Structure Theory refers to a systematic approach to financing business activities through a combination of equities and liabilities.
- Net Income Approach to Capital Structure Theory
- Net operating income approach
- Traditional approach (intermediate approach)
- Modigliani and Miller approach
- Pecking Order Theory
Modigliani and Miller (MM) Arguments
In a world of no taxes, the value of the firm is unaffected by capital structure.
Modigliani and Miller (MM) have a convincing argument that a firm cannot change the total value of its outstanding securities by changing the proportions of its capital structure. In other words, the value of the firm is always the same under different capital structures.
In still other words, no capital structure is any better or worse than any other capital structure for the firm’s stockholders.
Assumptions of the Modigliani-Miller Model
- Homogeneous Expectations
- Homogeneous Business Risk Classes
- Perpetual Cash Flows
- Perfect Capital Markets
- Perfect competition
- Firms and investors can borrow/lend at the same rate
- Equal access to all relevant information
- No transaction costs
- No taxes
Factors That Influence a Company's Capital-Structure Decision
Business Risk: Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio.
Company's Tax Exposure: Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes.
Financial Flexibility : Financial flexibility is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies typically have no problem raising capital when sales are growing and earnings are strong. The lower a company's debt level, the more financial flexibility a company has.
Management Style: Management styles range from aggressive to conservative. The more conservative a management's approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's earnings per share (EPS).
Growth Rate: Firms that are in the growth stage of their cycle typically finance that growth through debt by borrowing money to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate.
Market Conditions: Market conditions can have a significant impact on a company's capital-structure condition. Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning that investors are limiting companies' access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay.
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