What type of capital structure should a firm choose and why? In your answer, be sure to include capital structure fallacies and their effects on a firm’s decision. Capital structure is the relative proportions of debt, equity, and other securities that a firm has outstanding. When a firm need to raise funds from investors they must choose which type of security to issue. There are typically two different types: financing through equity alone, or financing through a combination of debt and equity (DeMarzo, 2011, p. 451).
When a firm chooses to finance with equity alone, the equity is considered unlevered equity. Unlevered equity is the equity of a firm with no debt. If a firm has no liabilities, the equity holders will receive all of the cash flows generated by the project on day one. When there is no debt, the cash flows of the unlevered equity are equal to those of the project stating on day one. Because the risk of the project equals the unlevered equity, shareholders will earn an appropriated return for the risk they are taking (DeMarzo, 2011, p.
452) If a firm chooses to finance with debt and equity, they are said to have levered equity since they also have debt. Before any payments are made to the equity holders, the promised payments have to be made first. Leverage does increase the risk of the equity of a firm. Investors in a levered equity will require a higher expected return to compensate for its increased risk. Equity is less valuable with leverage, but this does not mean the firm is worse off (DeMarzo, 2011, p. 453).
Franco Modigliani and Merton Miller (of MM Proposition I) state that with perfect capital markets, the value of a firm should not depend on its capital structure. They argue that in the absence of taxes or other transaction costs, the total cash flow paid out to all of the firm’s security holders is equal to the total cash flow generated by the firm’s assets. They state there is no gain or loss from using leverage and the value of a firm is determined by the present value of cash flows from its current and future investments (DeMarzo, 2011, p.
455). There are two capital structure fallacies worth mentioning. Leverage can indeed increase a firm’s expected earnings per share. The first fallacy is that leverage should also increase the firm’s stock price. Adding leverage to a firm will cause the total earnings to fall with interest payments, but it will also cause the number of outstanding shares to fall. This is what causes the increase of earnings per share, but it also causes the risk to increase.
While earning per share increases, the increase is necessary to compensate shareholders for the additional risk they are taking. The effects cancel each other out, and the price per share will stay the same (DeMarzo, 2011, p. 468). The second fallacy is that issuing equity will dilute existing shareholder’s ownership, so debt financing should be used instead. Two things happen when a firm issues equity. The first thing that happens is the market value of its assets grows because more money has been raised. Second, the number of share increase.
As long as the firm sells the new shares at a fair price, there is no gain or loss to shareholders associated with the equity itself (DeMarzo, 2011, p. 469). In conclusion, the owner of a firm should choose the capital structure that maximizes the total value of the securities issued. Sometimes it is best for firms to choose levered versus unlevered and vice versa. According to MM Proposition I, with a perfect capital market, the value of a firm is independent of its capital structure; therefore, the firm’s choice of capital structure is unimportant (DeMarzo, 2011, p. 478).