Blog 4.

Trade off theories vs Modigliani and Miller.

Using trade off theories within an organisation can bring many benefits to a company. The Trade off theory of capital structure can be defined as “The taxation of corporate profits and the existence of bankruptcy penalties are market imperfections that are central to a positive theory of the effect of leverage on the firm's market value.”(Kraus, 1973). However some could argue that using the methods of Modigliani and Miller are more relevant to modern day organisations.The Modigliani and Miller theory believes that a company’s WACC remains unchanged at all levels of gearing (Watson & Head, 2016)

There are three different methods a firm can use when financing a business according to Modigliani and Miller, they can borrow money, spend the profits that they have saved and use the insurance of shares. In its simplest form is based on the idea that with certain assumptions in place, there is no difference between a firm financing itself with debt or equity (Chen, 2014).

Debt is generally considered a cheaper way to raise finance within an organisation compared to other options such as raising money through shareholders as lenders usually require a lower rate of return than ordinary shareholders in exchange for some kind of security or collateral. Along with debt interest can be offset against pre-tax profits before the calculation of the corporation tax bill, thus reducing the tax paid. Finally issuing and transaction costs associated with raising and servicing debt are generally less than for ordinary shares. Financial distress can occur from borrowing too much money and not being able to pay it back, therefore putting the organisation at risk. Indirect examples of the risks brought from financial distress are uncertainties in customers minds and loss of staff morale therefore leading to struggles in recruiting talented people. Some direct examples of risks that can occur to a company from being in financial distress are a different number of fees such as lawyer fees and management fees. Any risk brought to any company can have significant effects, a great example of  how getting to deep in debt can have significant effects is relating it to the retail store British Home Stores (BHS). 

       The demise of BHS, which employs 11,000 people, is the biggest failure on the high street since Woolworths in 2008 (Butler, 2016). The financial distress that the company was put in through the lack of cash flow and the increasing prices of rent for their stores meant that the group is very unlikely to meet all contractual payments. The directors therefore have no alternative but to put the group into administration to protect it for all creditors. Using BHS as an example using the theories brought to our attention from Modigliani and Miller the company did not benefit from using debt to fund the company as there was a lack of funds within the organisation. 

       The theory of Modigliani and miller making such unrealistic assumptions on taxes and in this case assumptions on the cost of bankruptcy mean that this theory is difficult to relate to modern day companies. This theory was published in 1958 therefore meaning it could be considered out of date, this isn't helped by the most recent version of this theory was released in 1963. In 1963 M&M revised their paper to take tax into account. They were heavily criticised for ignoring tax in their 1958 paper, as taxation has a measurable benefit on using debt in particular to finance an entity.

     

      According to the updated Modigliani and Miller theory as you increase the Gearing you will reduce the WACC due to the tax benefit of debt, as you can see from the diagram to below. 

       From the lecture i learnt that The Trade-Off Model indicates that up to a point, gearing will increase shareholder wealth. Therefor beyond this point is starts to become too risky, as the impact of the increase in cost of equity starts to outweigh the impact of the extra debt. Resulting in the WACC rising and thus share price falls. 

       In conclusion i believe both models are great ways to determine the effectiveness of the capital structure of organisations however they both bring their disadvantages, many factors need to be taken into consideration such as the amount of tax that is relevant to their company and the debts they are taking out and the level of finance they can raise through shares and shareholders. 

   Bibliography

Butler, G. R. (2016). BHS collapses into administration as rescue deal fails. The Gaurdian .

Chen, J. (2014, April 14th). Modigliani-Miller Theorem (M&M). Retrieved from https://www.investopedia.com/terms/m/modigliani-millertheorem.asp.

Kraus, A. &. (1973). A state‐preference model of optimal financial leverage. The Journal Of Finance, 12.

Watson, D., & Head, A. (2013). Corporate finance: principles and practice. Pearson.

Wikipedia, t. f. (2019). Retrieved from https://en.wikipedia.org/wiki/Trade-off_theory_of_capital_structure.