Impact of Debt Financing on EBIT of Firm–Introduction Part 1

In finance, capital structure refers to the way a corporation finances its assets. A firm can be financed by 100% equity or with some mix of equity and debt. It is an important decision, how the assets of a firm are financed i-e what should be the financing mix? Should the firm be financed with 100 equity or with some mix of equity and debt? The finance literature on the subject of capital structure is extensive but yet to come up to any definite answer.

Equity in finance is defined as the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. Debt imply intent to pay a fixed periodic payment and pay back an amount owed by a specific date, which is set forth in the repayment terms. It has a claim ahead of equity on the earnings of the firm.

Does capital structure choice of a firm matter? In financial literature related to the question of financing mix of a firm, we find five major strands of research viz.

1. Tax Based Theories
2. Agency Costs Theories
3. Signaling Theories
4. Pecking Order Theories
5. Information Asymmetry Theories

 Modigliani Miller (1958) argued that under certain assumptions value of the firm is independent of how its assets are financed i-e its capital structure. Later in (1963) they revised their famous MM proposition by saying that the existence of tax subsidies on interest payments would cause the value of the firm to rise with the amount of debt financing by the amount of the capitalized value of the tax subsidy. For value of the firm to increase in case of debt financing because of larger cash inflows due to tax subsidy is only possible when EBIT of the firm remains the same no matter how the assets are financed. So, essentially they argued that EBIT of the firm would be independent no matter how the capital is divided among equity and debt. Jensen and Meckling (1976) argued that the firm is not an individual. It is a legal fiction which serves as a focus for a complex process in which the conflicting objectives of individuals (some of whom may “represent” other organizations) are brought into equilibrium within a framework of contractual relations. In this sense the “behavior” of the firm is like the behavior of a market, that is, the outcome of a complex equilibrium process. If the behavior of the firm is “the outcome of complex equilibrium process” – balancing act of value maximization of different stakeholders given the positive monitoring and bonding costs then it cannot be said that its operations are independent of its choice of capital structure. They further argued that Modigliani-Miller theorem is based on the assumption that the probability distribution of the cash flows to the firm is independent of the capital structure. It is now recognized that the existence of positive costs associated with bankruptcy and the presence of tax subsidies on corporate interest payments will invalidate this irrelevance theorem precisely because the probability distribution of future cash flows changes as the probability of the incurrence of the bankruptcy costs changes, i.e., as the ratio of debt to equity rises. The existence of agency costs provide stronger reasons for arguing that the probability distribution of future cash flows is not independent of the capital or ownership structure. They went on to assert that debt carries covenants that limit management’s ability to take optimal actions on certain issues and that would reduce the profitability of the firm. In general the revenues or the operating costs of the firm are not independent of the probability of bankruptcy and thus the capital structure of the firm. As the probability of bankruptcy increases, both the operating costs and the revenues of the firm are adversely affected, therefore, its EBIT of the firm cannot be independent of how it is financed. Stephen A. Ross (1977) advocated that implicit in the irrelevancy proposition is the assumption that the market knows the (random) return stream of the firm and values this stream to set the value of the firm. What is valued in the marketplace, however, is the perceived stream of returns for the firm. Putting the issue this way raises the possibility that changes in the financial structure can alter the market's perception. Value of a firm will rise in case of debt financing because it will signal to the market that EBIT of the firm would be sufficient enough to meet its obligations. The reason was that any change in financial structure of the firm changes its perception in the market about its earnings stream and when leverage is increased, it is perceived in the market that the firm has expectations of strong earnings stream. So, in his opinion, if the firm decides to finance future expansion or change its financial structure with debt, it is because that firm expects a strong earnings stream and so the value of the firm would increase. Stewart C. Myers (1984) argued that optimal debt ratio in capital structure is determined by tradeoff of benefits and costs of debt financing by holding constant the firm’s assets and investment plans. Benefits of debt are interest tax shields whereas costs include various costs of bankruptcy and financial distress. If there were no adjustment costs then each firm’s debt-to-value ratio should be its optimal ratio. But there are adjustment costs and time lag as the firms move toward their target debt ratio that is why there is observable dispersion in debt ratios in cross section of data. He cited a study by Donaldson (1961) that states “Management strongly favored internal generation as a source of new funds even to the exclusion of external funds except for occasional unavoidable ‘bulges’ in the need for fund.” He further cited Donaldson “Given that external finance was needed, managers rarely thought of issuing stock.” This behavior of managers is due to asymmetric information and costs of financial distress. Because of asymmetry of information, managers are unwilling to issue equity if market undervalue new issue of equity. If the firm does seek external funds, it is better off issuing debt than equity securities. The general rule is, "Issue safe securities before risky ones." What if the managers' inside information is unfavorable, so that any risky security issue would be overpriced? In this case, wouldn't the firm want to make /\N as large as possible, to take maximum advantage of new investors? If so, stock would seem better than debt (and warrants better still). The decision rule seems to be, "Issue debt when investors undervalue the firm, and equity, or some other risky security, when they overvalue it.” If the manager with superior information acts to maximize the intrinsic value of existing shares, then the announcement of a stock issue should be bad news, other things equal, because stock issues will be more likely when the manager receives bad news. On the other hand, stock retirements should be good news. The news in both cases has no evident necessary connection with shifts in target debt ratios.It is assumed that EBIT of the firm is independent from source of financing. It does not matter as far as EBIT is concerned how the new investment opportunity is financed. It is a matter of perception in the market due to asymmetry of information that changes the value of the firm. Stewart C. Myers and Nicholas S. Majluf (1984) argued that because of asymmetry of information new stockholders assume that  management acts in the interests of 'old' (existing) stockholders. If managers have inside information there must be some cases in which that information is so favorable that management, if it acts in the interest of the old stockholders, will refuse to issue shares even if it means passing up a good investment opportunity. That is, the cost to old shareholders of issuing shares at a bargain price may outweigh the project's NPV. Investors, aware of their relative ignorance, will reason that a decision not to issue shares signals 'good news'. The news conveyed by an issue is bad or at least less good. This affects the price investors are willing to pay for the issue, which in turn affects the issue-invest decision. Under these circumstances, a firm with ample financial slack - e.g., large holdings of cash or marketable securities, or the ability to issue default-risk-free debt - would take all positive-NPV opportunities. The same firm without slack would pass some up and if external financing is required will prefer debt to equity. This model also assumes that EBIT of a firm is independent of its choice of financing mix, it is the discount rate that varies with the perception of investors about a particular choice of financing mix.