Capital structure — MM, tradeoff, pecking order — Financing Module 2

Modigliani-Miller's 1958 result is the Big Bang of corporate finance theory. They proved that, under specific simplifying assumptions, the value of a company is independent of how it's financed. The proof is elegant: an investor can replicate any capital structure by borrowing or lending at the personal level. If two companies differ only in financing, arbitrage equalises their values.

MM Proposition I (no taxes)

text

  V_levered  =  V_unlevered

The value of a leveraged firm equals the value of an all-equity firm
with identical operating cash flows.

Why: investor can replicate leverage by borrowing personally.
  Buy 10% of unlevered firm with 10% personal borrowing
     = same payoff as buying 10% of levered firm.
If prices differ, arbitrage forces equality.

Assumptions:
  ─ No taxes
  ─ No bankruptcy costs
  ─ No information asymmetry
  ─ Perfect markets (no transaction costs)
  ─ Investors can borrow at the same rate as firms

In 1958, this was radical. It said: capital structure doesn't matter.

MM I: the starting point. Provocative precisely because real-world deviations from its assumptions are how capital structure gains relevance.

Tradeoff theory — relaxing assumptions

Each MM assumption that fails creates real-world implications. The two most consequential:

Taxes (added by MM 1963): interest is tax-deductible; equity dividends are not. So debt has a tax shield equal to debt × tax rate. A company with $100m of debt at 10% interest and 30% tax rate saves $3m/year in taxes. Capitalised, this is a real value transfer from government to shareholders. Pure MM with taxes says: maximise debt.
Distress costs: at high leverage, the probability of financial distress rises. Distress imposes direct costs (lawyers, restructuring fees, asset sales at fire-sale prices) and indirect costs (customers won't pay deposits, suppliers won't extend credit, key employees leave). These offset the tax shield.

The tradeoff curve

Optimal leverage is where the marginal tax shield from one more dollar of debt equals the marginal expected distress cost. Below optimal: more debt is value-accretive. Above optimal: more debt destroys value. The exact optimum depends on the business — stable cash flows tolerate high leverage (utilities, REITs); volatile cash flows can't (early-stage software, mining, biotech).

The pecking order

Myers and Majluf (1984) observed something different: companies don't seem to optimise toward an optimal capital structure. They follow a pecking order:

First choice: internal funds (retained earnings).
Second choice: debt (when internal funds insufficient).
Last choice: equity (only when debt isn't available or affordable).

Why? Information asymmetry. Managers know more about the company than investors. When managers issue equity, the market assumes they think the stock is overvalued (why else would they sell?). Equity announcements typically cause stock prices to fall by 3-5%. To avoid this, managers prefer financing that doesn't send a negative signal — internal funds (no signal), then debt (modest signal), then equity (worst signal). The pecking order explains why profitable companies often have low leverage despite the tax shield — they fund internally and never bother with capital markets.

Reconciling the theories

Tradeoff theory predicts companies optimise toward a target leverage. Pecking order predicts companies just follow available cash. Reality has elements of both: companies have target capital structures (proving they think about tradeoffs) but deviate from them temporarily based on cash availability (proving they follow pecking order in the short term).

Exercise

A Kenyan SACCO with 30% effective tax rate is considering taking on KES 500m of additional bank debt. Annual interest cost would be 14% = 70m. (1) Compute the annual tax shield. (2) The SACCO's CFO worries that the additional leverage would raise the cost of equity from 15% to 17% due to higher distress risk. The SACCO has KES 5bn of equity. What's the value impact on equity capital? (3) Net effect: should they take the debt?