Signals by Capital Structure of Companies

Franco Modigliani

Merton Miller

The modern capital structure was formed in 1958 by F. Modigliani and M. Miller, they were important contributors of capital structure in corporate finance. They proposed irrelevance theorem which means that it does not matter how the companies finance their capital. The main sources of companies that finance their capital is by issuing debt or equity. The debt can be obtained from Banks and equity is when the capital is raised by issuing shares or selling the stake of the company. The irrelevance theorem focused on the capital structure without tax, when there is tax it does matter on how the company finance their capital, which was published in 1963. 

Why capital structure is very important for investors?

Every company pays tax which reduces the profit therefore companies would rather finance their capital by debt because debt is tax deductible and dividend payments are not. The investors should be aware of the capital structure of companies because it can be vital information on giving signals.

Signals by Capital Structure

• Risky debt

When company has high debt it increases the risk of the company because high debt gives extra power to managers, therefore it increases the chance of investing in bad projects. High debt reduces the ability to pay the debt of the company. Usually it takes long time for projects or businesses to give high return but the banks have their system where debts must be paid according to the given time regardless of the ability of company to make fast return or not. High debt also reduces the companies ability to acquire additional debt when needed. The ideal debt in capital structure is the optimal debt level which is usually calculated by debt to equity ratio. 

• Power management

There are some managers who cares about their self interest, when the company has too much equity it reduces the power of the manager. When we say manager it is usually the CEO for established companies and it usually the entrepreneurs for new businesses. One of the good example is Apple inc when Steve Jobs was fired by his own company because he did not own enough equity in the company therefore he did not have that much power. Having too much equity is also bad for the company because it reduces the motivation of the managers to work harder. The managers that are really good at adding value to the company sometimes held back because of power allocation and also lack of motivation. ​

• Self interested Managers 

The self interested managers are the managers that wants to increase the equity of the company so that they can increase their monetary rewards. The study that was publish by Jensen and Meckling (1976) demonstrated that the managers can increase their spending for their private use. The value of the company reduces every time when the managers spends money for their personal use therefore if the company is owned by managers then he will not be able to increase his personal spending because the value of the company will reduce dramatically. The managers can share the cost of their personal spending when the company has 50% equity which will reduce the value by little compared if the managers owned all the equity. In other words managers can spend more for the same reduced value. 

Conclusion

In conclusion on the ideal capital structure of company is always depends on the managers of the company. Increasing debt can increase the risk of company being bankrupt due to redirection in ability to payback their debt. To much of equity can also signal that the manager might not be motivated and instead they might use too much of the companies money for their personal use. They might also try to increase their equity by investing too much in new projects. It is best for the investors to learn corporate finance to understand how the corporate finance can increase or reduce the value of the company.