Modigliani and Miller’s classic contribution to capital structure theory suggest

Question

Modigliani and Miller’s classic contribution to capital structure theory suggests that in the absence of capital market imperfections (no taxes, or distress costs) firm value is independent of its capital structure.

(i) Explain why there might be an optimal capital structure for the firm when these imperfections are taken into account.

(ii) Why might a manager choose to use less debt than that indicated by the position of this optimal debt/equity ratio?

b. Both a dividend payout and a share buyback achieve the result of returning capital back to shareholders. Briefly explain the circumstances under which you might advise a company to use the share buyback mechanism rather than a dividend payout

Explanation / Answer

i) When the market imperfections are taken into account, the cost of capital follows a pattern wherein the cost of capital decreases with increasing leverage till a certain point and reaches a minimum. Post the minimum point, with increasing leverage the cost of capital against starts increasing due to factors such as increase in risk for shareholders, risk of bankruptcy and high debt as well as cost of financial distress. Thus when market imperfections are taken into account, there is an optimal structure wherein the cost of capital is minimum for the firm.

ii) The manager might choose to use less debt because he wants to have a safety margin as the future performance of the company cannot be estimated or predicted accurately. To ensure that the financial manager has got a margin of safety and the debt obligations of the company are manageable from future earnings, he would tend to take less risk and ensure that debt is less than optimal and he would err on the side of conservatism.

b) A sharebuy back mechanism may be useful to reduce the number of outstanding shares and increase metrics such as earning per share and return on equity. Also it is more efficient from taxation point of view as dividend is taxed immediately. While in case of sharebuyback, for an investor, the value of share increases but the taxation happens only when he sells these shares at a profit in the future. Thus tax is deferred.

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