Capital Structure

Abstract

If capital structure doesn't matter the answers to the following scenarios should be straightforward. Maria Costa has an investment opportunity. For $100 000 she can own her own swimwear fashion design and manufacturing business. Maria is independently wealthy and has the necessary money available in some short-term money market investments. Her accountant has indicated that, rather than using her own savings, there might be a benefit in borrowing some of the money needed for the investment. Should Maria borrow some or all of the $100 000? Are there circumstances where borrowing could make a difference? Maxel Manufacturing Ltd (MML) is a (mythical) Australian company with 1 million issued shares currently trading at $2 each and $1.5 million in debt. The management of MML have identified an investment opportunity with a positive net present value that requires an initial outlay to purchase and install new plant and equipment worth $500 000. Should management borrow the money or issue new equity? What will be the effect on the value of the company? Does the amount of existing debt matter? Michael Moynihan owns shares in MML and has heard the rumours that the company is considering borrowing to finance a new investment opportunity. What will this do to the value of Michael's shares? Can Michael change the outcome of the recapitalisation? ... In this chapter we investigate the mix of debt and equity that is best used to finance a firm's investment opportunities. An obvious extension of the Modigliani and Miller (M&M) proposition outlined on the opening page of this chapter is that capital structure is not important because it doesn't influence the value of the firm. This implies that Maria, the managers of MML and Michael may not have to worry about the questions they are asking. It also implies that this chapter should be very short. The M&M propositions were initially framed in a highly simplified environment that assumed no taxes and no transaction costs. We know, however, that transaction costs and taxation are realities and that recognizing the impact of these realities leads to circumstances where capital structure does become important.