- Let's talk about obtaining long term financing,
owner investment, and long term loans.
The permanent financing,
that's the backbone of any company's financing
and here is the key finance question.
Does it matter how I structure my long term financing?
Does it matter how much owner investment I have
and how many loans I have?
Does this financing mix impact the value of my company?
Let's illustrate this with an example
of Lily's Ice Cream Company, a hypothetical example.
Lily has a dream.
She wants to start and operate her own ice cream business
and she has figured out that it'll cost
200 million dollars to make that happen.
Where will Lily get this 200 million dollars?
Let's make some simplifying assumptions here
in this example just to keep it tractable.
We will focus on the long term financing
to buy the big stuff, the land, the buildings
and the equipment.
Lily's capital structure is defined as
the mix between owner investment
and long term borrowing.
Where will she get this 200 million dollars
in long term financing?
And the key question is this.
Does it make any difference
where Lily gets her financing?
Does Lily even care how much she gets from borrowing
and how much she gets from long term investment?
That is the capital structure question.
Does capital structure impact the value of the company?
In the area of corporate finance,
this is the question.
Does capital structure impact value?
To talk about this,
we need to do a little historical discussion.
The first sophisticated analysis of this
was done in 1958 by professors Modigliani and Miller.
They said no, it doesn't make any difference
whether you borrow the money
or whether the money is owner invested.
The financing choice does not impact
the value of the company
so don't worry about capital structure.
Now to derive this result,
professors Modigliani and Miller
made some extreme assumptions.
In their mathematical model,
they assumed that there are no taxes, no bankruptcy costs,
no differences in information among people,
and no frictions that hinder business.
This is the baseline capital structure result,
the Modigliani-Miller therm.
These professors won Nobel Prizes for this powerful result.
Let's think about the real world.
There are frictions, there are transactions costs,
there are income taxes.
The analytical work done after Modigliani and Miller
loosened the assumptions and found that
capital structure does impact the value of a company
when there are costs and frictions
with income taxes being a key factor.
If I borrow money then any payments I make to the people
who provided the capital to the company,
that is who loaned money to the company
are called interest expense.
This is important because interest expense
is reported on my income tax form as a tax deduction
so I pay less in taxes.
If those same providers of capital had given me the money
as an investment, then any money I paid back to them
would be called dividends
and in most countries businesses don't get
a tax deduction for paying dividends.
If the providers of capital are called lenders
then the payments to them, interest,
are tax deductible.
If the providers of capital are called investors,
then the payments to them are dividends
and they're not tax deductible.
This suggests that there should never be
any owner investment.
Whenever a company wants to get money,
the company should borrow the money
because then all the payments to providers of capital
are tax deductible and the company will pay
a lower amount of income taxes.
With respect to a company's capital structure,
we've already talked about the income tax benefit
to borrowing but there are additional benefits to borrowing.
One benefit is that a company with borrowing
must run efficiently and without wasted money
in order to be able to make the mandatory
loan and interest payments.
Companies with higher borrowing have been shown
to have less employee slack.
Things are run more tightly.
Maybe not a pleasant situation to be in as an employee,
but it does increase the value of the company
from the standpoint of the owners
but too much leverage increases the probability
of bankruptcy.
A company going through bankruptcy proceedings
is in a very costly situation in terms of legal fees.
In addition, in a company close to bankruptcy,
company management is distracted.
You're not thinking of long term marketing plans
when you're going through bankruptcy proceedings.
Is there an optimal capital structure?
Yes there is.
I should have some borrowing because of the tax benefits
but not too much because of the increase
in the probability of costly financial distress.