Explain the relationship between the cost of capital, bond ratings, and the capita budgeting decision making process?
* In the absence of taxes the classic Modigliani and Miller (MM) propositions postulate that the value of a firm is unaffected by the capital structure decisions of the firm. Although the required rate of return on the equity increases with an increase in proportion to debt, the increase is in such a manner that weighted-average cost of capital does not change. The implications of this theory are that the choice of debt-equity mix is irrelevant and has no effect on the value of the firm. However, in reality there are so many imperfections that the capital structure of the firm does have an impact on the cost of capital of the firm. The corporate taxes have differential treatment for interest on debt and dividend payments. Whereas interest paid on debt is a deductible expense for the tax calculation purpose, dividends paid on equity do not enjoy such tax benefits.
Similarly, the financial distress of the firm has an impact on the capital structuring decisions. Financial distress is a situation when a firm is not able to meet its obligations to creditors. A severe situation of financial distress would lead to bankruptcy and liquidation of the business. As the debt level increases, the probability of financial distress increases. The risk of investment in a financially distressed firm increases hence the investors demand higher compensation for bearing the extra risk, which in turn reduces the present value of the firm. The fear of financial distress not only increases the cost of debt but also it affects the confidence level of the stockholders and hence the market value of the levered firm’s stocks and bonds decreases. The bond ratings represent the level of financial distress in a firm. While a good rating would mean low risk of financial distress, a poor bond rating would mean higher risk of financial distress.
As the lenders anticipate that the stockholders might take some sub-optimal decisions while in financial distress there will be issues of agency problems on the part of the stockholders, the creditors try to control the behaviour of the stockholders through various debt covenants and conditions under the debt contract. However, there are additional costs of implementing these conditions.
The Trade-off Theory tries to make a balance or trade off between the benefits of debt and costs of debt. Specifically, it says that firms balance the benefits of debt in terms of tax-shield and costs of debt in terms of financial distress costs and opts for an optimal debt ratio, which maximizes the value of the firm. The optimal debt ratio is the level of debts at which the value of the firm is maximum. Initially when the level of debts is low, the tax benefits of debt over weighs the cost of financial distress, but as the level of debt increases the cost of financial distress increase. Thus, the value of the firm is maximized at an optimal level of debt.
The trade off theory also say that the ability of different firms to take benefits of the debt and their costs of managing the financial distress are different. Based on their abilities the firms may have different target (optimal) debt ratios. The optimal debt ratio is determined by the type of assets and the ability of the firm to use the tax-shield provided by debt. Firms which have more tangible assets which are easy to transfer to others can borrow more as the value of tangible assets is not affected much by the financial distress and these firms can transfer a portions of these tangible assets to meet some of their obligations to the creditors. For example airlines, retailers, and banks, all have high amount of tangible assets and can borrow more. On the other hand, firms, which have more intangible assets, can borrow less. The value of intangible assets such as goodwill, research and development, reputation, etc. can erode sharply under distress and these firms may not have the assets which they can transfer to avoid the default situation. The examples of this type of firms are pharmaceutical companies, high tech firms, and software companies.
Hence, trade off theory provides a basis for selecting the optimal debt ratio for the firms by providing a trade of between the tax benefits and cost of financial distress. The bond rating for a firm reflect the ability of the firm to manage its financial distress costs and hence the investors are willing to invest in a bond at an interest rate which reflects the risk associated with that bond. Hence, Capital structures (capital budgeting decisions) are a result of trade of between the cost of distress (bond rating) and ability of the bond to reduce the cost of capital.