Question

Long-answer: Please briefly explain the benefits and costs of holding debt in a company's capital structure according to different capital structure theories and discuss elements companies should consider when making capital structure decisions in practice

Answer 1

A company's capital structure -- essentially, its blend of equity and debt financing -- is a significant factor in valuing a business. The relative levels of equity and debt affect risk and cash flow and, therefore, the amount an investor likely would pay for the company or for an interest in it.

A) A distribution of stock to shareholders can be a nontaxable stock dividend while a distribution of a debt usually results in dividend income. B) Interest is deductible by the payor while a dividend payment is not deductible.

Companies often use debt when constructing their capital structure because it has certain advantages compared to equity financing. In general, using debt helps keep profits within a company and helps secure tax savings. There are ongoing financial liabilities to be managed, however, which may impact your cash flow.

MODIGLIANI AND MILLER APPROACH
This approach was devised by Modigliani and Miller during the 1950s. The fundamentals of the Modigliani and Miller Approach resemble that of the Net Operating Income Approach. Modigliani and Miller advocate capital structure irrelevancy theory, which suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has a lower debt component in the financing mix has no bearing on the value of a firm.

The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger[1] who considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance. This theory is often set up as a competitor theory to the pecking order theory of capital structure. A review of the literature is provided by Frank and Goyal.[2]

An important purpose of the theory is to explain the fact that corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc.). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.