Grainger & it's 'realistic' capital structure?

Welcome back followers! I hope my last post was an interesting one for you guys. Today I am bringing you something different... Grainger & there new capital structure? Is it realistic?

Capital structure refers to the way a corporation finances its assets through some combination of equity or debt securities. A firms capital structure is the composition or structure of its liabilities. Debt and equity are ways which companies can raise capital but really companies have to think which is the best way to finance the company?

 Debt is usually cheaper than equity:

- Lower risk

- Tax relief on interest.

Therefore we might expect that increasing proportion of debt finance would be a good idea and reduce WACC (weighted average cost of capital).

But hold on...

Increasing levels of debt makes equity more risky right?

- Fixed commitment paid before equity = finance risk.

So really increasing gearing (proportion of finance in the form of debt) increases the cost of equity and that would increase WACC!

Modigliani and Miller, 1958 created a theory of Capital Structure in a perfect market.

Capital Structure shows how a company's assets are built out of a debt and equity.

The theory of business finance in a modern sense starts with the Modigliani and Miller (1958) capital structure irrelevance proposition. Before Modigliani and Miller, there was no generally accepted theory of capital structure. Modigliani and Miller strongly believed that it does not matter if a company was financed with debt or equity. Their view based on the belief that the value of a company depends upon the future operating income generated by its assets. Therefore, the total value of the firm will not change with gearing, and neither will its WACC? Agree or disagree? People have argued that the M&M theorem does not provide a realistic description of how firms finance their operations, and it has been said that it provides reasons why financing matters. What do we all think about the M&M theory? Do we believe it is a realistic approach?

Grainger debuted its new capital structure this week. Supposedly promising higher returns? Its debt capitalization ration jumped to 31% from 12% but remains relatively low. The company beat second-quarter earnings expectations, though it lowered its per-share 2015 earnings view for the second time since January. Grainger issued $1 billion debt last month? So has Grainger reduced risk for the company? or made equity more risky? I personally feel the company has used the capital structure rather than the M&M theory. Debt is seen to lower risk as lenders require a lower rate of return. Can we see Grainger pleasing lenders?

A number of practical criticisms were levelled at M&M's no tax theory. Since debt interest is tax-deductible the impact of tax could not be ignored. M&M therefore revised their theory. In 1963, M&M modified their model to reflect the fact that the corporate tax system gives tax relief on interest payments. Can we say that Grainger is increasing innovation as this is the effect that tax relief has! M&M said the value of a company is independent of its capital structure. Also the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm. If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance.

Kraus & Litzenberger 1973 Trade Off Theory:

Equity is seen to be a higher risk therefore shareholders demand higher returns, making equity more expensive. the marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimising  its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. This is when Kraus & Litzenberger 1973, trade off model comes in. This theory assumes that companies choose the amount of debt and equity finance to use by balancing benefits and costs. This theory provides a classic statement of the theory that optimal leverage reflects a trade-off between the tax benefits of debt and the deadweight costs of bankruptcy. The theory assumes WACC (weighted average cost of capital) will not always be standing. According to the trade off theory the present value of the resulting gains from choosing debt over equity, the so called tax shield, increases a firms value, (Baker & Martin, 2011).

Kraus and Litzenberger 1973 model

So guys lets wrap this up. Which theory shows a realistic view of capital structure? Personally, the trade off model (Kraus and Litzenberger) seems more fair to me. The trade off model thinks into the future and sudden changes that may happen whereas Modigliani and Miller does not take in real world aspects. The essential point made by M&M is that a firm should be indifferent between all possible capital structures. Should company use as much debt as possible what do you guys think? I believe that as gearing increases so does the possibility of bankruptcy? Do we want that? hmm...

Modigliani and Miller or Kraus and Litzenberger?

It's a wrap!

RS.

Comment below with your views & questions!