In a world of no taxes, transaction costs or other frictions, companies can generate no benefits for their shareholders by using any specific amount of debt relative to equity.
This statement means that the capital structure decision – how much debt to use relative to equity – is irrelevant. Companies should not waste time trying to figure out what is the best level of debt. This result is a direct consequence of the efficiency of financial markets. If markets are competitive and efficient, then we know that investors cannot earn abnormal returns from trading securities. It follows that companies cannot earn abnormal returns from issuing securities. Regardless of what combination of debt and equity is used, the shareholders do not benefit.
One of the strongest arguments supporting this point is the fact that with respect to the buying and selling of securities, companies cannot do anything for their shareholders that the shareholders cannot do for themselves. If a company without any debt issues some debt, it has effectively put its shareholders in the position of being borrowers. If the shareholders wanted to be borrowers, they could have simply borrowed on their own. If shareholders of companies with debt wanted to reduce their debt, they could reduce their personal borrowings. Thus, with respect to issuing securities, anything companies do on behalf of their shareholders could be done directly by the shareholders.
Some argue that debt is cheaper than equity so it should be preferred. Indeed it is true that the cost of debt is less than the cost of equity. But using debt increases the risk to the shareholders. Hence, its lower cost raises the cost of equity, and the effects cancel out.
An alternative way of looking at this point is to think of the company as a pie. Creditors get an agreed-upon piece of the pie, and the shareholders get what is left. To benefit the shareholders, the company should try to make the pie larger. The creditors get the same size piece, so the excess goes to the shareholders. But slicing the pie a different way, i.e., using more or less debt, has no effect on the shareholders.
To make the pie larger, companies should focus on their asset decisions, which is the capital investment decision. We have already demonstrated that positive-NPV projects benefit the shareholders. Financial market efficiency and its consequence – the irrelevance of the capital structure decision – are simply statements that mean that it is impossible for a company to generate positive NPVs by selling and buying its own securities.
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Last updated: January 9, 2011