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Critique on Optimal Capital Structure and Capital Structure Decisions by Firms in the UK.

Byline: Syed Shabib ul Hasan and Abdur Rehman Zaki

The concept of leverage and capital structure is very vital for investment and finance. It has always remained a contentious matter among financial analysts and academia whether there is any possibility of an optimal way to finance an investment proposal or not. The question posed is if any possibility of such a mix exists, as it can make a significant difference on how investment proposals are viewed. A number of studies have been done on the issue that if a project is being financed with one mix of securities as against the other, would it affect the market value of the investment or not? For the sake of discussion, if it does, the organization would then definitely like to manipulate the market value of its shares through its financing policy. Under such circumstances, the organization would adopt a policy on the financing mix which can increase the value of its shares by the maximum.

The academia has worked extensively in this area and is still searching for the right financing mix that fits all kind of scenarios. Thomas W Killian (2005) also highlighted that the type of capital to be issued is very much a function of matching capital needs with the type of capital that most efficiently and cost effectively meets those needs.1 While various approaches have been put forward by studies from time to time, the authors of this paper aspire is to look into the Modigliani & Miller (M&M) approach and to see how it can be applied in an actual setup. However, the traditional approach has not been ignored. The authors have also made an attempt to highlight the impact on the total valuation of the firm and the cost of its capital when the ratio of debt to equity varies.

The Conventional Approach to valuation and use of leverage assumes that there is a possibility of optimal capital structure and the firm can increase its total value through the sensible and meticulous use of leverage. The approach suggests that a firm can increase its total value through leverage, using a lower cost of capital, and even though the investor may elevate the required rate of return on equity, the increase would not entirely counteract the benefit of using a cheaper source of funding.2 The conventional stance further argues that as more leverage is applied, the investor starts greater disciplining of the firm's required return on equity until in due course it compensates the use of cheaper debt financing. Furthermore, it was also argued in one of the later deviations of the conventional approach, that the required return on equity rises at an increasing rate with leverage, whereas the rate on debt rises only after significant leverage.

Initially, the weighted average cost of capital drops with leverage as the increase in the required return on equity does not entirely offset the cheaper debt financing and consequently, the weighted average cost of capital falls with restrained use of leverage.3 However if the use of debt continues to accelerate, then after some time the increase in the required return on equity is more than what is offset by the use of cheaper debt financing in the capital structure. The weighted average cost of capital would be further pushed up once the cost of debt financing starts to climb up as a result of the higher level of leverage being used by the firm. Hence the conventional approach can easily be seen as supporting the contention that optimal capital structure exists, and at the point where the weighted average cost of capital is at its lowest.

The Modigliani & Miller Approach presented more than half a century ago, made use of behavioural support to argue for the autonomy of the total valuation and the cost of capital of the firm from its capital structure.4 Since they advocated the idea of relating the cost of capital to the concept of leverage in using operating income, Modigliani and Miller (1958)5 could easily be branded as the pioneers of contemporary literature on corporate capital structure. Their study was directed towards critically evaluating the conventional approach which assumes that an optimal capital structure can be relied upon and the firm can increase its total value through the judicious and rational use of leverage. In their significant and influential work on the effects of capital structure on the firm's value they arrived at the conclusion that provided there is a perfect financial market, capital structure is irrelevant.

In other words, the firm's value is independent of its optimal capital structure.6 Modigliani & Miller (1963)7 had even gone one step further and tried to illustrate how firms could utilize debt financing to allow them to pay lower taxes than they would have to if equity financing were used and thus attain optimal capital structure through saving on tax. Regardless of all the disparagement and controversy arising from their proposition, empirical work by Hatfield, Cheng and Davidson (1994)8 supported the M&M theorem.

However Myers and Majluf (1984)9 had a different perspective. They developed the pecking order model, arguing that managers would seek to finance projects internally, however, if retained earnings are insufficient, they would opt for debt rather than equity finance, because debt providers, with a prior claim on the firm's assets and earnings, are less liable than equity investors to errors in valuating the firm. Managers would only opt for equity finance as a last resort in this model. Under such circumstances, corporate gearing will reflect a company's need for external funds and there will not necessarily be any target or optimal level of gearing.

Furthermore, they reiterated that targeting a particular gearing would also be difficult because of market imperfections such as information asymmetries between lenders and borrowers that affect the decision making or the agency cost issue between a company's managers, and shareholders and sometimes creditors, based on differing incentives. Drobetz and Fix (2003)10, have tested leverage forecasts of the trade-off and pecking order models using Swiss data and pointed out that at an aggregate level, the gearing of Swiss firms is relatively on a lower side; however the outcome is based on how the leverage is defined. The data they said, reflected that the more profitable firms use less leverage, which confirms the pecking order model but works against the trade-off model.

They found support for both the trade-off model and a complex version of the pecking order model by claiming that firms with more investment opportunities apply less leverage. Claiming that gearing is very closely related to the tangibility of assets and the volatility of a firm's earnings, they concluded that Swiss firms tend to maintain target leverage ratio. The findings of Drobetz and Fix are vigorously applicable to many alternate estimation techniques.

The critical evaluation of the M&M model in an economy like UK

Academic researchers are often criticized for generally basing their research on some simplified assumptions, that are hard to implement in real life situations. The classic M&M theory is no exception. Critics have argued that the theory being based on idealized situations fail as soon as these are applied in the real world situations. When M&M called for perfect market conditions, they made a simplified assumption. The approach assumed that the market is perfect and the individuals or investors can borrow unlimited amounts at same rate of interest. The investors freely decide to sell infinitely divisible securities, as there is a perfect flow of information and investors are well informed about the market. Furthermore, despite the fact that debt is a cheaper source of funding, an increased debt level would increase the financial risk of the firm and the expectations of the equity holder would go up, thereby making the average cost of capital constant for all levels of leverage.

There is no benefit in debt financing other than reducing corporate income tax, due to tax shield on interest payments of debt. There are no taxes either personal or corporate and all investors are price takers.

A bird's eye view definitely gives the impression that the M&M model has serious flaws, but to see the real value of the model requires special glasses. The real value of the original M&M model can be gauged by assuming the presence of a tax environment where taxes represent another claim on the firm's cash flow. In the UK, like in most of the economies around the world, interest payments are tax deductible thereby reducing tax liability where there is additional borrowing. This implies that firms can reduce their tax liability by borrowing more. The additional savings can then be paid out to shareholders as dividends who in turn can reinvest the proceeds in order to earn more returns. However the extent of this benefit also depends on the tax regime faced by shareholders. This makes the debt financing option as more tax efficient for the company and its shareholders than equity financing.

Barclay et al (1995)11 and Myers (2001)12 had pointed out that, in issues of corporate gearing; firms would like to aim for targeted or 'optimal' gearing levels that balance the tax benefits of additional debt against the expected costs of the financial distress the probability of which increases as indebtedness rises. Now since taxes are reduced as leverage increases and vice versa, the benefit of tax benefit from leverage is only important to firms that are in tax paying position, however firms that have substantial tax shield from other sources, like depreciation, will have less benefit from leverage. Furthermore, the higher the tax rate, the greater the incentive to borrow; so if a firm is highly leveraged some of its tax burden will be shifted towards debt servicing. But under such circumstances there are greater chances of bankruptcy, and its cost will come into play.

As the firm chooses to have high debt to equity ratio it has to alter its behavior to attempt to stave off the event itself. These costs become large when bankruptcy actually happens.

Now these items only represent the change in the direction and proportion of the cash outflows with the total cash flow remaining the same.

Cash flow a = payments to share holders + payments to lenders (base case)

Cash flow b = payments to share holders + payments to lenders + taxes + bankruptcy cost + payment to any other claimants of the cash flow of the firm.

Thus the essence of the M&M intuition and theory is that the value of the firm depends upon the total cash flow of the firm. The firm's capital structure just cuts that cash flow into segments without altering the total cash flow. This signifies that the shareholders and creditors are not the only ones who can claim a segment.13 In an ideal scenario, the total market value of all the securities issued by the firm would be governed by the earning capacity, and the exposure to risk of its underlying real assets. The total market value would be detached from how the mix of securities, issued to finance those assets was divided into debt and equity instruments.14

The argument that the firm can enhance the total value of its investment by increasing the proportion of debt instrument, because yields on debt instrument are generally significantly lower than that on equity capital was actually targeted. M&M. reiterates that there is no magic in leverage - nothing to support a presumption that more debt is beneficial. Debt is better than equity in certain cases, but worse in others. At times, all financing choices are equally good.15

The point remains that what should a firm do to develop an optimal capital structure, though such a capital structure represents an ideal situation. The value of the firm diminishes as its overall risk increases, because the expected value of the interest tax shield declines and the expected bankruptcy costs rises. The expected value of the interest tax shields declines, because greater risk decreases the probability that a firm will be able to exploit those shields in any given period. The expected bankruptcy costs increase, because the probability of default for the firm rises. There may be a reversal of the situation if a firm seizes any opportunity to reduce its risk. Since the value of interest tax shields, (the condition being that the firm is able to use them), increases with leverage, the impact of a change in risk on the value of interest tax shields is magnified when a firm has more leverage.

The greater a firm's leverage, the greater the potential decline in the value of the tax shields that will ultimately be realized from the existing debt. Thus interest tax shields are more beneficial to firms with relatively high and stable taxable income compared to firms with large accumulated tax loss from previous years and uncertain future prospects. For a consistent generation of income, firms have to consider the quality and the type of assets it holds.

So in a broader perspective, the choice of capital structure should be looked at from three perspectives: i) tax shield advantage, ii) risk undertaken and, iii) the quality and type of assets. This indicates that a low risk firm with consistency in profitability, few intangible assets and robust growth opportunities, ought to find a relatively high debt to equity ratio less attractive. A company with doubtful potential for growth ought to avoid debt financing, especially if it has other ways of shielding its income from taxes.16

To illustrate the value of the original M&M concept, let us take the example of the tax environment in the United Kingdom, where taxes represent another claim on a firm's cash flow. As pointed out earlier, like most other economies, interest payments in the UK are tax deductible, thereby reducing firms' tax liability when borrowing additionally. The additional savings can then be paid out to shareholders as dividends who in turn can invest the proceeds in to earn more returns. However the extent of this benefit depends to a considerable extent on the tax regime faced by shareholders. Thus apparently, the debt financing option is more tax efficient for the company and its shareholders than equity financing.

The contemporary scenario representing a high level of corporate capital gearing among companies in the United Kingdom makes it interesting to study the relationship between the theories of capital structure and the practical aspect of it and also to explore the empirical relationship between gearing and an array of financial characteristics. Peter Brierley and Philip Bunn (2005) analyzed the data in aggregate and suggested that the sharp use in gearing between 1999 and 2002 cannot solely be explained by an increase in its long-run equilibrium level, according to a model where that equilibrium is determined by the trade-off between the tax benefits of debt and the risks of financial distress. There are several factors not captured by that model that could have contributed to a sustainable increase in gearing.17

Analysis of the past information on the UK companies clearly reflects that gearing levels are persistent, related positively to company size and inversely correlated to growth prospects and intangible assets. Prior to 1995, highly profitable companies had low gearing, but this pattern has changed since 1995 as more profitable firms have increased their debt.

However on balance it seems that gearing has been above a sustainable level, causing firms to adjust their balance sheets by paying lower dividends and issuing more equity and probably by investing less than they otherwise would have done. As antidote for gearing being above the long-run equilibrium level companies try to adjust their gearing back towards intent level over time, but that process usually is prolonged. Nevertheless, the initial stabilization and subsequent unpretentious fall in gearing, besides the corporate sector maintaining a financial surplus over this period, supports this interpretation, as does the fact that gearing levels tend to be persistent, with the degree of persistence declining over time. However, the behavior of management needs further assessment as many studies contend that incentives for managers to take risks increase significantly with firm leverage, because wealth transfers between stockholders and debt holders increase with leverage.18


Other things being equal a rapid growth in borrowing increases the possibility of the corporate sector finding its difficult to service its debt. The fact is that corporate capital structure cannot be fully explained by any one theory, especially because the theories are not mutually exclusive.

The records of UK quoted firms for the past thirty years suggest that gearing has been persistently negatively related to growth opportunities and the importance of intangible assets in balance sheets. Furthermore, an inverse relationship between gearing and profitability is also apparent over most of this period. However, this relationship appears to have weakened after 1995, as less profitable firms have scaled back gearing and more profitable firms have increased it. The relationship between gearing and company size appears to be largely positive, especially in the recent past when rises in gearing have been concentrated among large companies.

Observations do not support that investment spending will be cut back solely in response to balance sheet pressure at the aggregate level, although empirical studies at the firm level have shown stronger support for this possibility. Nevertheless this equilibrium in gearing has been relatively stable over the past decade and the shift to a more stable, low inflation, low interest rate macroeconomic environment may have increased the actual level of gearing more than studies have suggested. Low interest rates allow firms to remain above their equilibrium gearing for longer, given that the costs of servicing high debt levels are likely to be relatively low.


1 Thomas W Killian, "Designing an Opimal Capital Structure", US Banker 115, no. 9 (2005): 56.

2 James C. Van Horne, Financial Management & Policy (New York: Prentice Hall, 2005), 236.

3 Ibid.

4 F. Modigliani, and M. H. Miller, "The Cost of Capital, Corporation Finance and the Theory of Investment", American Economic Review 48, (1958): 268.

5 Ibid.

6 Ravi M. Kishore, Financial Management (New Delhi: Taxmann Publications (Pvt.) Ltd., 2009), 83.

7 F. Modigliani, M. H. Miller, "Corporate Income Taxes and the Cost of Capital: A Correction", The American Economic Review 53, no. 3 (1963): 435.

8 Gay B. Hatfield, T.W. Louis Cheng, and Wallace N. Davidson, "The Determination of Optimal Capital Structure: The Effect of Firm and Industry Debt Ratios on Market Value", Journal of Financial and Strategic Decisions (1994): 84.

9 S. C. Myers, and N. S. Majluf, "Corporate financing and investment decisions when firms have information that investors do not have", Journal of Financial Economics 13, (1984): 198.

10 Wolfgang Drobetz & Roger Fix, "What are the Determinants of the Capital Structure? Evidence from Switzerland," Swiss Journal of Economics and Statistics (SJES) 141, no.1, (2005): 75-78.

11 M. J. Barclay, C. W. Smith, and R. L. Watts, "The determinants of corporate leverage and dividend policies", Journal of Applied Corporate Finance 7 (1995): 9.

12 S. C. Myers, 'Capital structure', Journal of Economic Perspectives 15 (2001): 87.

13 Denzil Watson and Anthony Head, Corporate Finance: Principles and Practice (London: Prentice Hall, 2007), 199.

14 Stephen A. Ross, Randolph W. Westerfield and Bradford D. Jordan, Fundamentals of Corporate Finance (New York: McGraw-Hill International, 2007), 494.

15 F. Modigliani, and M. H. Miller, "The cost of capital, corporation finance and the theory of investment", American Economic Review 48 (1958): 268.

16 S. C. Myers, "Capital Structure", Massachusetts institute of technology: Massachusetts, 45.

17 Peter Brierley and Philip Bunn, "The determination of UK corporate capital gearing", Quarterly Bulletin London 45, no. 3 (2005): 358.

18 Robert Parrino, R. Poteshman, and Michael S Weisbach, "Measuring Investment Distortions when Risk-Averse Managers Decide Whether to Undertake Risky Projects", Financial Management 34, no. 1 (2005): 28.
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Publication:Pakistan Journal of European Studies
Date:Jun 30, 2013
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