Modigliani and Miller’s no-tax model
In 1958, Modigliani and Miller stated that, assuming a perfect capital market and ignoring taxation, the WACC remains constant at all levels of gearing. As a company gears up, the decrease in the WACC caused by having a greater amount of cheaper debt is exactly offset by the increase in the WACC caused by the increase in the cost of equity due to financial risk.
The WACC remains constant at all levels of gearing thus the market value of the company is also constant. Therefore, a company cannot reduce its WACC by altering its gearing (Figure 1).
The cost of equity is directly linked to the level of gearing. As gearing increases, the financial risk to shareholders increases, therefore Keg increases. Summary: Benefits of cheaper debt = Increase in Keg due to increasing financial risk. The WACC, the total value of the company and shareholder wealth are constant and unaffected by gearing levels. No optimal capital structure exists.
Modigliani and Miller’s with-tax model
In 1963, when Modigliani and Miller admitted corporate tax into their analysis, their conclusion altered dramatically. As debt became even cheaper (due to the tax relief on interest payments), cost of debt falls significantly from Kd to Kd(1-t). Thus, the decrease in the WACC (due to the even cheaper debt) is now greater than the increase in the WACC (due to the increase in the financial risk/Keg). Thus, WACC falls as gearing increases. Therefore, if a company wishes to reduce its WACC, it should borrow as much as possible (Figure 2).
Summary: Benefits of cheaper debt > Increase in Keg due to increasing financial risk.
Companies should therefore borrow as much as possible. Optimal capital structure is 99.99% debt finance.
There is clearly a problem with Modigliani and Miller’s with-tax model, because companies’ capital structures are not almost entirely made up of debt. Companies are discouraged from following this recommended approach because of the existence of factors like bankruptcy costs, agency costs and tax exhaustion. All factors which Modigliani and Miller failed to take in account.
Modigliani and Miller assumed perfect capital markets; therefore, a company would always be able to raise funding and avoid bankruptcy. In the real world, a major disadvantage of a company taking on high levels of debt is that there is a significant possibility of the company defaulting on its increased interest payments and hence being declared bankrupt. If shareholders and debt-holders become concerned about the possibility of bankruptcy risk, they will need to be compensated for this additional risk. Therefore, the cost of equity and the cost of debt will increase, WACC will increase and the share price reduces. It is interesting to note that shareholders suffer a higher degree of bankruptcy risk as they come last in the creditors’ hierarchy on liquidation.
If this with-tax model is modified to take into account the existence of bankruptcy risks at high levels of gearing, then an optimal capital structure emerges which is considerably below the 99.99% level of debt previously recommended.
Agency costs arise out of what is known as the ‘principal-agent’ problem. In most large companies, the finance providers (principals) are not able to actively manage the company. They employ ‘agents’ (managers) and it is possible for these agents to act in ways which are not always in the best interest of the equity or debt-holders.
Since we are currently concerned with the issue of debt, we will assume there is no potential conflict of interest between shareholders and the management and that the management’s primary objective is the maximisation of shareholder wealth. Therefore, the management may make decisions that benefit the shareholders at the expense of the debt-holders.
Management may raise money from debt-holders stating that the funds are to be invested in a low-risk project, but once they receive the funds they decide to invest in a high risk/high return project. This action could potentially benefit shareholders as they may benefit from the higher returns, but the debt-holders would not get a share of the higher returns since their returns are not dependent on company performance. Thus, the debt-holders do not receive a return which compensates them for the level of risk.
To safeguard their investments, debt-holders often impose restrictive covenants in the loan agreements that constrain management’s freedom of action. These restrictive covenants may limit how much further debt can be raised, set a target gearing ratio, set a target current ratio, restrict the payment of excessive dividends, restrict the disposal of major assets or restrict the type of activity the company may engage in.
As gearing increases, debt-holders would want to impose more constrains on the management to safeguard their increased investment. Extensive covenants reduce the company’s operating freedom, investment flexibility (positive NPV projects may have to be forgone) and may lead to a reduction in share price. Management do not like restrictions placed on their freedom of action. Thus, they generally limit the level of gearing to limit the level of restrictions imposed on them.
The fact that interest is tax-deductible means that as a company gears up, it generally reduces its tax bill. The tax relief on interest is called the tax shield – because as a company gears up, paying more interest, it shields more of its profits from corporate tax. The tax advantage enjoyed by debt over equity means that a company can reduce its WACC and increases its value by substituting debt for equity, providing that interest payments remain tax deductible.
However, as a company gears up, interest payments rise, and reach a point that they are equal to the profits from which they are to be deducted; therefore, any additional interest payments beyond this point will not receive any tax relief.
This is the point where companies become tax - exhausted, ie interest payments are no longer tax deductible, as additional interest payments exceed profits and the cost of debt rises significantly from Kd(1-t) to Kd. Once this point is reached, debt loses its tax advantage and a company may restrict its level of gearing.