If you are pursuing a career on ACCA, then at some point you will study about the Modigliani and Miller theory, their theory basically ponders over the question of using debtor equity to finance the operation of the business. If you are not yet at the level of taking FM or AFM, then this article will give you some insight and if you are preparing for these subjects then this article will most likely serve as a revision of this theory.
This theory looks at the age-old question of choosing either debt or equity to finance the operation of the business. Which one should be used? What do you think? Students generally think that it is better to issue shares because they do not increase the leverage, right? This is what I used to think too. It is, right? Is it wrong? Let’s see.
What is Cost?
If you want to understand if a company should issue shares or take debt, then you must first understand the criteria for doing so. Everything in this world has a cost. When you buy an apple you pay its cost, when you sleep your opportunity cost is your productive time, when you work your cost is your leisure time. Similarly, there is a cost with issuing shares and there is a cost with incurring debt.
This is called the cost of capital. Now every company wants to minimize its cost of capital because when the cost of capital goes down, the margin of making profit increases. This is simple enough right. So naturally, all companies want to minimize their cost of capital. The decision of using either debt or shares depends on the cost of capital attached to each of the choices.
So, if the debt is cheaper, then a company will use debt and if shares are cheaper then a company will issue shares to finance its operations.
Now let us look at the costs of issuing a share. Whenever any company decides to issue new shares, there is an issuance cost, which is a small percentage of the total cost. But this is not the cost we are worried about. There are other costs too. For example, with every new share issued a company has to pay a dividend on each new share. So the cost of a new share, is its dividend. In addition to the dividend, it must also be seen that the dividend is paid on after-tax profits. So dividend payments are not tax-exempt. Why is this important? This you will understand in just a little bit.
So we have seen the cost of issuing new shares, now let us look at the cost of taking on debt. Whenever a company takes debt, it is a straight forward process, the loan carries negligible transaction costs but the real cost of debt is its interest charge. But there is an interesting point here. While dividends are not exempt from tax, interest payments are exempt for tax purposes. This means that when you work out the cost of both issuing new shares and the cost of debt, the cost of debt will be lower than that of issuing new shares because the effect of tax savings will reduce it.
This is what Modigliani and Miller concluded. They argued that if you take a hypothetical scenario where tax is not applicable then in such a case cost of shares will be less but this is a hypothetical scenario and when you look at real-world tax is a reality and when you take taxation into consideration then it turns out that cost of taking debt is always going to be lower than that of issuing new shares because of tax savings on interest charged on debt. So this begs another question.
Why don`t companies take as much debt as possible? Well, the answer is that debt is cheaper than shares yes, but it is only safe to take debt to a certain limit. Companies look at their interest cover ratio for this. As long as they have a healthy interest cover ratio, they keep on taking debt but when they see that a red line is getting closer and any debt beyond this red line will reduce the interest cover ratio thus making it difficult for the company to pay back the interest and loan, then the company will stop taking more debt and issue shares from that point onwards.
There is also another issue and it is of leverage. As a company keeps on taking more debt, its leverage increases, it becomes highly geared and while this means that the financing is being done at a lower cost but the stakeholders and investors generally do not like very highly geared companies. A highly geared company means that it has got too much debt to repay and this makes it risky in case of a default. So this is what managers have to look at as well. Even if a debt is cheaper, it is not always the best choice if your investors are going to take this as a risky sign.
Gearing levels are also affected by industry standards, industry regulations and banks. For example, a bank may ask the company to keep its gearing at 60% or lower otherwise it will not issue further credit, similarly, a company may feel safe to have to gear up to 70% but if the industry standard is at 55% it will not be wise to go higher than the industry average.
Similarly, there is an issue with share issues. Before every new issue of shares, the directors have to see the dilution effect on the earning per share. More shares mean that current shareholders will receive less dividend in future because the profit will have to be divided among more shareholders.
So these are the issues that the directors of a company must keep in mind before taking on new debt or shares. Under normal conditions, directors will always prefer to take on the debt first and then issue shares.