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Part 5 Payout Policy and Capital Structure

CHAPTER

17

Does Debt Policy Matter?

A

firm’s basic resource is the stream of cash flows

produced by its assets. When the firm is financed

entirely by common stock, all those cash flows belong to the

stockholders. When it issues both debt and equity securities,

it splits the cash flows into two streams, a relatively safe

stream that goes to the debtholders and a riskier stream that

goes to the stockholders.

The firm’s mix of debt and equity financing is called its

capital structure. A firm that finances an investment partly

or wholly with debt is said to deploy financial leverage. Of

course capital structure is not just “debt versus equity.”

There are many different flavors of debt, at least two fla-

vors of equity (common and preferred), plus hybrids such

as convertible bonds. The firm can issue dozens of distinct

securities in countless combinations. It attempts to find the

particular combination that maximizes the overall market

value of the firm.

Are such attempts worthwhile? We must consider the

possibility that no combination has any greater appeal than

any other. Perhaps the really important decisions concern the

company’s assets, and decisions about capital structure are

secondary.

Modigliani and Miller (MM), who showed that payout pol-

icy doesn’t matter in perfect capital markets, also showed

that financing decisions don’t matter in perfect markets. Their

famous “proposition 1” states that a firm cannot change its

total value just by splitting its cash flows into different streams:

The firm’s value is determined by its real assets, not by how it

is financed. Thus capital structure is irrelevant as long as the

firm’s investment decisions are taken as given.

MM’s proposition 1 allows complete separation of invest-

ment and financing decisions. It implies that any firm could

use the capital budgeting procedures presented in Chap-

ters 5 through 12 without worrying about where the money

for capital expenditures comes from. In those chapters, we

assumed all-equity financing without really thinking about it.

If MM are right, that is exactly the right approach. If the firm

uses a mix of debt and equity financing, its overall cost of

capital will be exactly the same as its cost of equity with all-

equity financing.

Financing decisions do matter in practice, for reasons

detailed in Chapters 18 and 19. But we devote this chap-

ter to MM because their proposition is the starting point for

all applied capital-structure theory. If you don’t understand

the starting point, you won’t understand the destination.

For example, the after-tax weighted average cost of capi-

tal (WACC) follows from MM’s proposition 1 with one tax

adjustment. If you don’t understand MM, you won’t under-

stand WACC.

MM’s proposition amounts to saying, “There is no magic

in financial leverage.” If you don’t understand MM, you may

fall prey to those who claim to see magic, usually in the higher

average rates of return on equity for firms that borrow aggres-

sively. The would-be magicians don’t realize that the extra

borrowing generates extra financial risk. MM show that the

extra financial risk exactly offsets the higher returns.

In Chapter 18 we undertake a detailed analysis of the

imperfections that are most likely to make a difference, includ-

ing taxes, the costs of bankruptcy and financial distress, the

costs of writing and enforcing complicated debt contracts,

differences created by imperfect information, and the effects

of debt on incentives for management. In Chapter 19 we

show how such imperfections (especially taxes) affect the

weighted-average cost of capital and the value of the firm.