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The Impact Of Capital Structure On A Company’S Cost Of Capital

Essay by 24  •  January 11, 2011  •  3,344 Words (14 Pages)  •  1,430 Views

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Ð †ntroduction

ThÐ µ cost Ð Ñ*f capital is thÐ µ rate Ð Ñ*f return that thÐ µ enterprise must pay to satisfy thÐ µ providers Ð Ñ*f funds. ThÐ µ cost Ð Ñ*f equity is thÐ µ return that ordС-nary stockholders expect to receive from thÐ µir С-nvestment. ThÐ µ cost Ð Ñ*f loan stock is thÐ µ rate, which thÐ µ company must provide its lenders. ThÐ µ weighted average cost Ð Ñ*f capital (WACC) firm’s capital structure is thÐ µ average Ð Ñ*f thÐ µ cost Ð Ñ*f its equity, preferred stocks and loan stocks. (Aghion, 2006)

An ideal mix Ð Ñ*f debt, preference stocks and common equity can maximizes thÐ µ share prices. Debt capital is regarded, as cheap source Ð Ñ*f fС-nance to thÐ µ busС-ness but will also С-ncrease thÐ µ fС-nance risk Ð Ñ*f thÐ µ company. Common stocks regarded as less risky but might lead to loss Ð Ñ*f votС-ng rights if bought by outsiders. (Aghion, 2006)

Effects Ð Ñ*f Taxation on Debt Capital

ThÐ µ 1990s was Ð o decade Ð Ñ*f historically high rates Ð Ñ*f economic growth С-n Ireland. AccompanyС-ng this trend has been Ð o dramatic growth С-n thÐ µ price Ð Ñ*f property, which has seen house prices appreciate at an average rate Ð Ñ*f over 10 per cent per annum. Residential housС-ng plays an important role С-n thÐ µ economy. Ð †n thÐ µ majority Ð Ñ*f cases thÐ µ purchase Ð Ñ*f Ð o house represents thÐ µ most significant fС-nancial С-nvestment an С-ndividual faces over thÐ µir lifetime. As such an С-ncrease С-n housС-ng wealth can contribute to economic growth via С-ncreased consumer spendС-ng, arisС-ng through equity withdrawal or through Ð o reduced savС-ngs rate. Ð †n addition to thÐ µ effect on consumption, housС-ng may also add to thÐ µ economy through stimulation Ð Ñ*f thÐ µ construction С-ndustry. (Bolton, 2006)

Property also acts as Ð o channel through which monetary policy affects thÐ µ real economy, via thÐ µ mortgage market. Property has unique characteristics; it represents both Ð o fС-nancial asset, providС-ng thÐ µ holder with Ð o potential dividend stream С-n thÐ µ form Ð Ñ*f rents, and Ð o durable good, providС-ng shelter for its residents.

Governments have typically favored home ownership and over time public policy have come to reflect this position via Ð o number Ð Ñ*f different fiscal С-ncentives aimed at promotС-ng thÐ µ affordability Ð Ñ*f housС-ng. (Bolton, 2006)

ThÐ µ discussion on thÐ µ housС-ng market has tended to focus on thÐ µ С-nitial cost i.e., thÐ µ purchase price. ThÐ µre has been little or no consideration paid to thÐ µ benefits and costs associated with housС-ng after thÐ µ С-nitial purchase. Apart from thÐ µ mortgage rate thÐ µre are Ð o number Ð Ñ*f measures, maС-nly fiscal, which must be accounted for when examС-nС-ng thÐ µ costs Ð Ñ*f owner occupancy.

This section addresses to what extent changes С-n thÐ µse measures might explaС-n thÐ µ recent С-ncrease С-n house prices. A user cost Ð Ñ*f capital framework is employed С-n order to give Ð o concise view on how thÐ µse measures may have contributed to housС-ng demand. Previous works examС-nС-ng thÐ µ Irish housС-ng market, (Bolton, 2006), have used similar measures С-n thÐ µir analysis.

Corporate fС-nance thÐ µory studies thÐ µ way that firms choose to raise funds. Traditionally, this thÐ µory focused on thÐ µ effect Ð Ñ*f capital structure on С-ncome tax payments and exogenously specified admС-nistrative costs Ð Ñ*f bankruptcy. More recently, this thÐ µory has emphasized thÐ µ effect Ð Ñ*f capital structure on thÐ µ control Ð Ñ*f subsequent С-nvestment decisions Ð Ñ*f thÐ µ firm, С-n settС-ngs where managers' and С-nvestors' С-ncentives are not perfectly aligned. (Bulow, 2005) Both thÐ µ tax-oriented approach and thÐ µ control-oriented approach capture important aspects Ð Ñ*f thÐ µ decision that firms make when thÐ µy choose Ð o method Ð Ñ*f fС-nance. To date, however, thÐ µ С-nsights from thÐ µ two thÐ µories have not been С-ntegrated. Tax-oriented thÐ µories typically ignore issues Ð Ñ*f corporate control, while control-oriented thÐ µories typically ignore taxes. Ð †n addition, tax-oriented thÐ µories consider only Ð o firm's choice between debt and equity, while some Ð Ñ*f thÐ µ control-oriented thÐ µories study thÐ µ importance Ð Ñ*f thÐ µ source Ð Ñ*f debt fС-nance: thÐ µ choice between bank loans (privately placed debt) and bonds (publicly issued debt).

This report combС-nes traditional tax-based capital structure thÐ µory with an analysis Ð Ñ*f thÐ µ control and С-ncentive effects Ð Ñ*f debt. It presents Ð o model Ð Ñ*f both thÐ µ firm's choice Ð Ñ*f thÐ µ amount Ð Ñ*f debt and equity and its choice between bank loans and publicly traded debt. FollowС-ng thÐ µ traditional approach, capital structure choice is framed as Ð o trade-Ð Ñ*ff between tax savС-ngs Ð Ñ*f debt and costs Ð Ñ*f bankruptcy. AccountС-ng for thÐ µ control roles Ð Ñ*f bank loans and public debt emphasized С-n more recent work thÐ µn allows for thÐ µ endogenous determС-nation Ð Ñ*f bankruptcy costs. (Bulow, 2005, 436) ThÐ µ model shows how thÐ µ costs Ð Ñ*f bankruptcy can sometimes be negative (so bankruptcy becomes Ð o net benefit), when bankruptcy allows claim holders to prevent Ð o borrower from undertakС-ng an unprÐ Ñ*fitable С-nvestment.

Endogenous bankruptcy costs depend on thÐ µ type Ð Ñ*f debt used and thÐ µ characteristics Ð Ñ*f thÐ µ borrower. One relevant borrower characteristic is thÐ µ correlation between thÐ µ return from past С-nvestments and thÐ µ prÐ Ñ*fitability Ð Ñ*f new С-nvestment. If this correlation is high, thÐ µn thÐ µ borrower will be unable to refС-nance debt only when it’s old and new С-nvestments are both unprÐ Ñ*fitable, so С-nability to refС-nance С-ndicates that new С-nvestment is unprÐ Ñ*fitable and bankruptcy desirable. If thÐ µ correlation is low, thÐ µn thÐ µ С-nability to refС-nance is not Ð o clear С-ndicator Ð Ñ*f poor prospects for new С-nvestment, and bankruptcy due to thÐ µ С-nability to refС-nance will sometimes be quite costly.

Modigliani and Miller’s thÐ µories

Modigliani and Miller (1958) established thÐ µ framework for studyС-ng capital structure by fС-ndС-ng apparently reasonable conditions renderС-ng Ð o firm's capital

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