MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost

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Financial Management MGT201

Lesson 33

MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY

Learning Objectives:

After going through this lecture, you would be able to have an understanding of the following topic:

· Modifications in Miller Modigliani Capital Structure Theory

Modified MM - With Taxes:

In order to apply it in the real world for its use, Miller-Modigliani and some other economists made

some modifications. In order to make this theory applicable in the real world and to account for the

effects of corporate and personal taxes on investment decision and on firm, the effect of taxes was

included in it.

· Modigliani-Miller (With Corporate Tax)

In most countries, a Firm's Interest Payments to Bond Holders are NOT Taxed. But

Dividend Payments to Equity Holders are taxed. This was conclusion after study of

different countries. Most of the firms prefer debt rather than equity.

Based on CORPORATE TAXES, FIRMS should prefer to raise Capital using DEBT

Financing rather than equity as there is saving associated with capital raised through

this source.

From firms point of view interest payments are source of tax savings.

· Modigliani -Miller (With Personal Tax)

In most countries, INVESTORS (bondholders and shareholders) pay a higher Personal

Income Tax on Interest Income from Bonds than on Dividend Income from Equity (or

Stocks).

Based on PERSONAL TAXES, INVESTORS should prefer to invest in STOCKS (or

Equity).

Uncertain Conclusion: Difficult to determine Net Effect of taxes on optimal capital structure. Effects

of corporate taxes and personal taxes are contradictory. But, practically speaking, Corporate Tax Effect

is generally stronger so Based on Taxes alone, Firms should prefer Debt.

Modified MM - With Bankruptcy Cost:

The second major change in MM-theory was to incorporate the effect of bankruptcy costs. In the

real world companies face cash problems, their sales might drop, they face more competition, the

interest rate might go up, their debt servicing charges might go up, they start incurring losses, making

operational cash outflows and this may lead the company to close down or go bankrupt.

· Bankruptcy: when a Firm is forced to close down because of continual Losses and Net Cash

Outflows or Default on Interest Payments.

· Bankruptcy Costs Real Money - Companies Do Not Die in Peace! There are costs associated

with bankruptcy companies have to pay. Fees paid to Lawyers and Accountants, possible

penalties and Legal Claims by Suppliers, Buyers, & Partner Firms, and Loss on Sale of Assets

because Firm is forced to quickly Liquidate its Assets and repay the Debt Holders (such as

Banks) first.

· Even before bankruptcy the THREAT or RUMOR of Bankruptcy can create problems for a

Firm. Suppliers refuse to supply raw materials and cancel Trade Credit facilities. Banks demand

higher Interest Rates. Customers cancel Purchase Orders so sales fall.

· If Firm is EXCESSIVELY LEVERAGED (or has a Lot of Debt) then there is a HIGHER

Chance of Bankruptcy.

· For Certain Types of Firms, Debt is More Likely to Cause Bankruptcy:

Firms with High Operating Leverage or high Fixed Costs

Firms with Non-Liquid Assets that are difficult to sell quickly for cash

Firms whose EBIT (or Earnings) Fluctuate a Lot

Tradeoff Theory of Capital Structure With Tax & Bankruptcy:

Now let us discuss trade off theory. It mixes a couple of changes in pure MM-theory by taking into

consideration both bankruptcy costs and taxes. We will start with a firm of 100% equity capital and see

what happens when a firm starts taking debt and gradually increases the percentage of debt in its capital

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Financial Management MGT201

structure. See the following graph to determine the effect of increasing leverage on the value of firm

measured by its stock value to make trade off theory concepts clear:

Tradeoff Theory Graph

Leverage & Optimal Capital Structure

Slightly Leveraged Firm: Interest Tax

Shield Benefit. Total Return to Investors

Excessively Leveraged Firm:

Rises so Stock Value Rises. Total Return

Threat of Bankruptcy has Real

= Net Income (paid to Shareholders) +

Value of

Costs. Less Investor

Interest (paid to Debt Holders)

Firm or

Confidence and Lower Share

Price.

Price of

Stock

Firm Remains 100%

Equity (Un-Levered)

Financial Leverage =

OPTIMAL Capital

Debt / Assets =

Structure - MAXIMUM

D/(D+E)

VALUE & MINIMUM

WACC

Keep in mind, Value of Firm = Price of One Share x Number of Shares Outstanding

On the Y-axis we have the Value of Firm or Price of Stock and on X-axis the Financial Leverage = Debt

/ Assets = Debt/ (Debt + Equity) in percentage. In the graph 1.0 shows 100% capital is from debt at that

point. Horizontal line represents the case when a firm is 100% equity. It is un levered firm. Here firm

has no debt so its stock value is not sensitive to financial leverage. Now let us take the case of the same

firm if it gradually adds debt to its capital structure.

· When 100% Equity Firm adds a Small Amount of Debt, the Value of its Stock Goes Up at first

because Total Return Increases.

Total Return

= Net Income (paid to Equity Holders) + Interest (paid to Debt Holders).

The line therefore rises initially but then it reaches a maximum point which is the optimal

capital structure. At this point value of firm will be at its maximum. This is the best debt to

equity ratio for this firm at which WACC will be at minimum. After this point firms' debt gets

high and it starts facing high interest costs, chances of loosing creditors and buyers and threats

of bankruptcy. Investors' loose confidence on the share of the firm and the Chances of

Bankruptcy will offset the Initial Benefit and the Stock Value will Fall.

· Decision regarding how much Debt (or Financial Leverage) to take is based on Tradeoff

between the Advantage of Debt & Disadvantage of Debt.

Advantage of Debt over Equity: Interest Payments are Not Taxed. Known as Interest

Tax Saving or Tax Shield or Tax Shelter

Disadvantage of Too Much Debt: Firm becomes more Risky so Lenders and Banks

Charge Higher Interest Rates and Greater Chance of Bankruptcy

· Trade theory tells there is some optimal capital structure or there is some percentage of debt in

capital structure for a firm at a particular date. But it does not give us the exact figure for that. A

range for the Optimal Capital Structure or Debt/Equity Mix can be calculated in theory. This is

where the Firm has Maximum Value and Minimum WACC. Practically speaking it varies

across industries and companies. Optimal D/E can range from 20/80 to 70/30 and keeps

changing with time depending on the firm's financial health and growth strategy.

Signaling Theory of Capital Structure- An Improvement on Tradeoff Theory:

This is another modification of the theory of Miller Modigliani Capital Structure.

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Financial Management MGT201

This theory takes into account the practical fact of the world that NOT all Investors have equal

amount of information. All investors are not rational. A Firm's Owners & Managers (Insiders)

know more about it than Ordinary outside Investors.

· Signaling Theory: "Insiders (Managers & Owners) Know Better"

When Firm's Future genuinely looks Good (i.e. High forecasted Cash Flows, Earnings,

NI, and ROE) then Managers will choose to raise financing through Debt (or Bonds or

Loan) because they do not want to share the Financial Gain with More Shareholders.

Rather They Prefer to Take on Debt and pay a small interest to the Debt Holders. There

is almost no risk of Default.

When Firm's Outlook looks bad, then Managers will choose to raise capital by Issuing

Equity (or Stock) to be able to share the Likely Losses amongst more Shareholders

(Owners). If they took Debt and couldn't repay it, they might Default and be forced to

go Bankrupt.

So mangers are in a better position to decide about the firm.

Signaling Theory Conclusions:

· Practically speaking, Firms should maintain LESS Leverage than the Optimal Level from

Tradeoff Theory.

· Firms Should Save Some Reserve Debt Financing Capacity in case they find a Great Project or

Investment Opportunity. They should finance the Project using Debt for 2 reasons:

they don't have to share the Financial Gains with more shareholders and

they give the Right Signal to the Market of Investors about the good health of their

Firm !

Debt Financing brings Financial Discipline and tighter cash control on some Managers

that waste Shareholders' money

· News of New Equity Financing Signals bad news: It indicates shortfall in cash flows through

profit, Investors will sell stock and Market Price (Po) of Stock will fall. Therefore, Required

ROR (r = DIV/ (Po + g)) will Rise and WACC will Increase. Now more difficult for Projects

and Investments to meet this Firm's Capital Budgeting Criterion by showing positive NPV (=

Sum of Cash Flows / (1+r) t).

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