Shareholders want managers to choose the mix of securities that maximises company value But does this
Introduction In terms of the shareholders, the value of a firm is seen to be the present value of its expected future free cash flows, discounted at its weighted average cost of capital (WACC). ... Capital structure can also affect free cash flows, both by influencing managers in their capital budgeting decisions and also by altering the potential costs associated with bankruptcy and financial distress. ... A capital structure is the composition of a company’s long-term financing. Among the array of financing securities in modern capital markets, debt and equity remain the two most popular for use in configuring a capital structure. ... The article proves, under some controversially set assumptions, that it does not matter how a firm finances its operations, hence capital structure is irrelevant. ... EBIT is not affected by the use of debt Many of these assumptions are obviously unrealistic, but what this analysis attempts to do is isolate the critical variables affecting firm value, under the restrictive conditions of a perfect capital market, so as to then be able to establish a systematic basis for examining the way in which the real world market influences the link between risk and return. ... This imperfection is caused by the costs of actions taken to forestall this contingency, for example, legal and accounting expenses and an actual/expected inability to realise ‘full value’ for assets in a distress sale. ... Therefore the more debt a company uses, the higher its value and stock price. ... Moving past this optimum point, the perceived costs of financial distress exceed the tax benefits; hence the debt ratio lowers the value of the stock. ... Complications have occurred because of a number of measurement difficulties, in particular, the difficulty of classifying hybrid securities. ... These alternative claims can be viewed as hybrid securities, with some of the characteristics of both long-term, fixed-rate, non-convertible debt and common equity. The hybrid securities cannot be treated as simple linear combinations. ... He goes on to say if there is insufficient internal cash flow to finance non-postponable new projects, the theory illustrates that the firm will first draw down its marketable securities, then move to external capital markets. If external capital is needed, Donaldson believed a firm would first choose debt, followed by convertible bonds, only using common stock as a last resort. ... This means firms are reluctant to raise dividends unless they are confident that the higher dividend can be maintained as the firm is reluctant to have to cut them and face upsetting the shareholders. ... The assumption in MM’s original analysis, suggesting that investors have the same information the managers do in regards to the firms prospects (known as symmetric information), was relaxed as the above findings suggest that in actual fact, managers often have better information then outside investors (called asymmetric information). ... Likewise, a firm with unfavourable prospects would want to sell stock, which would mean bringing in new investors to share the losses. ... ” [4] Agency Related Conflicts on Capital Structure Agency problems are well known to occur between managers and shareholders who have conflicting objectives. Such conflicts are particularly likely when the firm’s managers have too much cash at their disposal. Managers are known to use excess cash to finance personal projects or for perquisites such as lavish offices, corporate jets, etc. ... By contrast, managers with limited excess cash flows are less able to make wasteful expenditures. Hence, firms may limit this cash flow by funnelling some of it back to shareholders through higher dividends and/or stock repurchases, as well as altering the capital structure towards more debt financing in the hope that higher debt service requirements will force managers to be more disciplined. This works because if debt isn’t serviced as required, the firm will be forced into bankruptcy, in which case managers will lose their jobs.