Debt and Equity in capital structure

                Today I will talk about debt and equity in capital structure which is taught in Week 6 lecture. In the business world, many companies are facing tough decision between debt and equity. However, both debt and equity have different ways in raising company’s capital with different costs. Many companies prefer debts more than equity. Why? One of the reasons is that the issuing and transaction costs for debt are lesser than ordinary shares. Besides that, lenders require a lower rate of return than ordinary shares because debt is less risky than ordinary shares and it has tax advantages as well. Since debts has a lot of advantage to a company, why company do not go for a 100% debt instead. Well, this is because that if a company choose to go for full debt will cause financial distress risk to the company. A higher level of debt will leads to an increase in gearing level and a decrease in the overall cost of finance that will cause the risk of the company increase at the same time. This will cause the company become financially distressed as its WACC increased and shareholders will start to demand for a higher return to compensate the higher risk of the debts. Meanwhile, too much debt is not a good thing to a company because a company still has to pay the interest even if the profits are low or high. Therefore, a company has to balance the percentage between debt and equity.  

The diagram above shows the changes of WACC between debt and equity. The WACC will falls initially because debts has tax advantage but if it go beyond the optimal debt-equity ratio, it begins to rise because of the financial distress cost.

                I have found an article which talk about European Central Bank that has recently launched its quantitative easing programme. Unfortunately, this programme failed to stimulate lending due to lack of investment from many firms. In Europe, many blue-chip companies have recently issued debt at a lower rate. However, with the cheap credit and low interest rates, many companies in Europe are still reluctant to take on more debt (Financial Times, 2015). According to Marc Zenner, the co-head of corporate advisory at JPMorgan say that a debt with low cost does not mean that its hurdle rate is low as well. It is just a slow process from QE and cheap money to get more companies to invest more. It is quite true that corporate boards seldom adjust the hurdle rate and so the impact of borrowing costs will not pass on immediately. Companies have to bear in mind that they have to repay all these debts to lenders on its maturity. So, even if the interest rate is low or cheap credit, it is not necessarily to take more debt because it may cause higher risk to the company.   

               According to Modigliani& Millar (1958) theory, it says that a company’s capital structure has no impact on the WACC. Thus, there is no optimal structure exists and a company’s value are purely depends on business risk where it can perfectly measurable by shareholders. In Modigliani & Millar(M&M) theory, it has make few assumptions like there is no taxation, no transaction costs, a perfect capital markets with perfect information available to all and there are no costs of financial distress and liquidation. In real world, this theory can be easily debate because all these assumptions are not possibly happen. Thus, M&M revised their theory to take tax into account. However, you might feel that M&M theory does not really make sense in the real world but it does help some manager to make decision on capital structure.