CHAPTER 2

CHAPTER 2: LITERATURE REVIEW
2.1 INTRODUCTION
This chapter reviews the relevant literature on capital structure and firm profitability. It elaborates on the key theories of capital structure and empirical studies that were done globally, regionally and within South Africa. The review helps to situate this study within the existing literature and clarify the contribution within the body of knowledge.
2.2 CAPITAL STRUCTURE THEORIES
2.2.1 The traditional view theory of capital structure
Before Modigliani and Miller (1958) introduced the notion that capital structure is irrelevant, financial theorists believed in the ‘traditional view’ theory of capital structure. This theory posits that a firm should finance its assets through the combination of debt and equity, and chooses an optimum capital structure that maximises the value of the firm. According to the traditional view theory, the optimal capital structure exists when the weighted average cost of capital (WACC) is at its minimum and the value of the firm is maximised (Figure 1). As the firm increases its debt levels above a certain level, the cost of equity rises and the value of the firm starts to reduce. An increase in debt levels exposes the firm to an increase in financial risks making shareholders require a greater rate of return, thus increasing the cost of equity. The theory assumes that the rate of interest on debt is constant while the rate of return required by the shareholders can be constant or can increase gradually. In support of the theory, managers would be required to identify and maintain optimal levels of debt at which their firm’s average cost of capital is minimised whilst the value of the firm or its profitability is maximised.
2.2.2 Modigliani and Miller’s propositions
Modigliani and Miller (1958:261) pioneered the discussion on capital structure when they proposed that capital structure is irrelevant. Their argument (depicted in Figure 2) was based on a restrictive set of assumptions that markets are frictionless, firms and individuals borrow and lend at a risk-free rate, there are no bankruptcy costs, there are no corporate and personal taxes, there are no agency costs, and no information of asymmetry. The Modigliani and Miller (1958:261) theory contends that the value of a leveraged firm (firm which has a mix of debt and equity) is the same as the value of an unleveraged firm (firm which is wholly financed by equity) if the operating profits and future prospects are the same. That is, if an investor purchases shares of a leveraged firm, it would cost him the same as buying the shares of an unleveraged firm. They argue that financial leverage does not affect the market value of the firm. According to this proposition, the value of the firm is determined by its assets and income generated from its business activities. Thus, in a world of frictionless capital markets, there would be no optimal capital structure.
This assumption however does not tally with the real world and the functioning of markets, since no country in the world is tax-free. In addition, many transaction costs are incurred on raising capital. In South Africa and in other countries the world over, various intermediaries charge transaction fees such as brokerage fees, consultation fees, agency fees and even underwriting fees on facilitating transactions. Hence, the analysis of the optimal capital structure in a world of transaction costs would be more realistic and informative.
Figure 2 illustrates that as the cost of equity increases, the debt to equity ratios increase as well, while the WACC remains constant at all levels of gearing. The increase in WACC due to an increase in cost of equity (ke) is offset by the decrease in WACC due to the greater weight in the cheaper cost of debt (kd). Modigliani and Miller (1963:433) reviewed their first position of capital structure irrelevance by incorporating tax benefits as determinants of capital structure in firms. This means that debt finance could be relevant in determining a firm’s profitability because of the interest cost of the debt that is allowable for tax deduction purposes in many countries. Interest payments which are tax deductible reduce company tax amounts that are due for payment to the governments, thereby making a saving for the shareholders. This implies that the tax advantage of debt leads to an increase in return on equity (ROE) and value of the firm. Modigliani and Miller (1963) concluded that debt is relevant if the tax benefit is recognised. They even propose that companies should use as much debt as possible in order to improve company profitability
The introduction of income tax lowers the after-tax cost of debt, thereby reducing WACC with a high level of leverage (figure 3). With the absence of financial distress costs, 100% debt finance will be the best but it is not the reality since excessive debt will lead to financial distress. However, this proposition faced some criticisms because it assumed that personal and corporate borrowings were perfect substitutes. Yet, in practice, corporate companies have a limited liability and have the capacity to borrow funds at more competitive rates than individuals. This proposition also assumes that there are no brokerage costs and no costs associated with financial distress, which is different from the observed practice.
Although Modigliani and Miller’s (1963) propositions had shortcomings, it contributed significantly to the capital structure debate by indicating the conditions under which capital structure could be irrelevant. This provides some insight for practitioners to determine what is required for capital structure to be relevant (Brigham & Ehrhardt, 2005:575). Myers (2001:86) suggests that Modigliani and Miller’s propositions should be viewed as a benchmark to which the debate on capital structure can refer. Major capital structure
theories like the agency theory, trade-off theory, pecking order theory, signalling theory and market timing theory emerged after Modigliani and Miller’s propositions to try to explain how firms are financed.