Introduction
Since 1958, when Modigliani and Miller showed that the capital structure that a firm follows is irrelevant if perfect market conditions could exist, studies have been done on the matter capital structures and their benefits. With the existence of a perfect market being hard to be realized, scholars have come up with theories that firms ought to choose depending on the tax benefits, costs of bankruptcy and also the agency costs which might be involved depending on the structure. However, irrespective of the capital structure followed, they are always determined by the following factors: size and profitability of the business, liquidity as well as the promising future growth opportunities.
There exists three types of business financing and they are: debt financing, equity financing, and finally using a hybrid of either. With Modigliani and Miller (1958) having put the irrelevance of preferring one form of financing to the other, the big question that remained to economic and finance experts was how best one could optimize the financing methods to ensure the benefits enjoyed were maximum.
Debt financing involves borrowing of capital from an external body with a promise to pay at a certain agreed date as well as with an interest rate above. The interest is usually fixed as it is not determined by the productivity of the debt thus no matter how the capital behaves, the interest rate remains fixed and in accounting, most of the times interest is treated as an expense for tax purposes and therefore it is tax deductible.
Literature Review
According to Hecht (n.d) how a firm organizes its source of capital (how it obtains the money required for start up and operating) describes the capital structure. Different corporations adopt different capital structures in order to meet both the internal and external needs for a good shareholder return. To find the optimal capital structure, one has to find that combination which minimizes the total capital cost for the corporation.
No matter how the above factors interact, the form of capital structure which the firm uses has to offer some incentives over other forms. There is an assumption that choosing debt as a method of financing offers a positive tax incentive. The incentive is said to occur because “Corporations make interest payments out of pre-tax income but make equity payments after corporate income taxes have been paid” (Pattenden 2006 p.69). However, what many do not understand is the fact that the incentives offered by a debt form of financing can only be enjoyed in a classical form of economy which rarely exists with few countries such as United States of America. Most of the world economies exhibit what is commonly known as a fully integrated system whereby,
“Tax system shareholders receive a tax credit for taxes paid at the corporate level with their dividends, which is equivalent to the corporation paying dividends out of pre-tax income. Therefore, under a full imputation tax system, there is no tax incentive to finance with debt” (Pattenden 2006 p.69).
With many arguing for and against use of debt as bringing a tax advantage the question that rings in ones mind is whether it really brings an advantage of tax advantage or not.
The impact of tax on the capital structure that a company chooses has been argued by scholars using two different aspects. The first aspect is that of the tax deductibility of the debt while the other aspect is in the way in which taxes influence the decision of the firm’s security holders. Prasad, Green and Murinde (2001) while quoting Modigliani and Miller states that on realizing that their perfect market assumptions needed modifications in order to allow the inclusion of corporate taxes, they (the two) developed a model which included taxes as a heterogeneous character. This realization was due to the fact that the two realized that debts offer shelter from taxes since the interest is deductible before taxable profits are calculated.
In that connection, if taxes were incorporated, the Modigliani and Miller values showed that most of the firms increased their values by increasing their rate of borrowings or simply by financing their ventures through debts. However, it is important to note that debt owners are subject to taxation on their securities and this affects their after tax returns. King in his book public policy and corporation (1977) notes that the marginal tax rate applicable to securities depended on the system under which the taxes were collected as well as the existing official rates.
Following the assumptions of Modigliani and Miller that taxes are the only factors that influence choice of a capital structure, thus becoming heterogeneous (Miller 1977), the author notes that as long as debts seems profitable, companies will continue issuing them until at the margin where the corporate tax savings will equal the personal tax loss and since the company or the firm cannot be able to contain the two rates simultaneously, the tax structure thereby determines the aggregate level at which the company should stop (Prasad Green and Murinde 2001).
Ghaugan (2007) argues that the relationship between capital structure and valuation is influenced by the effects of the debt in the value of the firm: whereby the value can increase the tax savings as long as the firm can survive on debts but also in contrast is that it reduces the survival probability of the firm depending on how the firm is faring. It is important to note that if the firm increases most of the times, debts increases the value of the firms which have low risk since as the maturity of the debt approaches, the optimal leverage also falls.
For a firm to benefit from tax advantage, the debts are usually higher subject to higher personal tax than its equity. This means that for the investors who prefer equities to transfer to debts, an incentive in the form of price reduction has to be offered in order for them to switch as a result, the overall advantage of tax is reduced further (Kochhar 1997).
Other than offering a tax advantage, debt financing offers the entrepreneur some degree of freedom as compared to equity financing since debt obligations are limited to the loan repayment period after which the lender cannot claim anything from the business. This form of financing also tends to be cheaper for small firms in the short run but expensive in the long run.
Analysis and Discussion
Debt financing is a form of business financing where the owner borrows funds from an external body which he is supposed to repay with an interest above. This form of financing is advantageous to the investor since the risks involved are limited to the loan repayment period. However, one advantage of debt financing is the fact that it reduces taxes liability to the firm. The complexity of how debt financing relieves the firm is complex and as covered by different scholars is quite an issue of discussion.
From the discussion by Modigliani and Miller initial position was where the company debts were free of risk and thus tax advantages were irrelevant. The position was later shifted when tax benefits were entered in the scene and from then, the costs of debt have been considered to be smaller than those of the equities because governments subsidize the expenses with interests.
By the government giving a tax advantage on the interests paid, it gives a company operational profit in the amount expended while paying the interests. With tax waivers on the interest paid, the profit of the company is usually larger compared to the profits of the investor who used similar amount of equities since they are not tax exempted but due to the risks involved with debt financing in the short run, an optimal capital structure is often determined by the combination which minimizes the costs to the company.
Conclusion
The three forms of capital structures through which a firm can source for capital are debt and equity financing as well as a hybrid of the two methods. The advantages of debt financing include the fact that the liability to the debt is not dependent on the performance of the capital but it is limited to loan repayment agreements. Another advantage of debt financing is the fact that the government exempts the firm from the taxes incurred on the interest thus giving a firm much giver than the equities.
While there are advantages and disadvantages of using either method, a good investor is he who combines the two methods of financing to find an optimal level through which capital costs are completely minimized.
Reference List
Ghaugan, P. A. 2007. Mergers, Acquisitions, and Corporate Restructurings. 4th Edition. New York, John Wiley and Sons.
Hecht, H, R. Not Dated. Capital Structure. Web.
King, M.A., 1977. Public Policy and the Corporation. London, Chapman and Hall, UK.
Kochhar, R. 1997. Strategic Assets Capital Structure and Firm Performance. Journal of Financial and Strategic Decisions. Vol. 10, No. 3. pp 23-36 Volume 10 Number 3.
Miller, M.H. 1977. Debt and Taxes. Journal of Finance, Vol. 32, pp. 261- 275.
Modigliani, F. and Miller, M.H. 1958. The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review, 48, pp. 261-297.
Pattenden, K. 2006. Capital Structure Decisions Under Classical and Imputation Tax Systems: A Natural Test for Tax Effects in Australia. Australian Journal of Management, Vol. 31, No.1 pp 67-92.
Prasad, S., Green, J. C and Miranda, V. 2001. Company Financing, Capital Structure, and Ownership: A Survey and Implications for Developing Economies. Web.