Capital structure substitution theory
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finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fina ...
, the capital structure substitution theory (CSS) describes the relationship between earnings, stock price and
capital structure In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt (borrowed funds), and preferred stock, and is detailed in the ...
of public companies. The CSS theory hypothesizes that managements of public companies manipulate capital structure such that
earnings per share Earnings per share (EPS) is the monetary value of earnings per outstanding share of common stock for a company. It is a key measure of corporate profitability and is commonly used to price stocks. In the United States, the Financial Accounting ...
(EPS) are maximized. Managements have an incentive to do so because shareholders and analysts value EPS growth. The theory is used to explain trends in capital structure, stock market valuation,
dividend policy Dividend policy is concerned with financial policies regarding paying cash dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's una ...
, the monetary transmission mechanism, and stock volatility, and provides an alternative to the
Modigliani–Miller theorem The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is an influential element of economic theory; it forms the basis for modern thinking on capital structure. The basic theorem states that in the absence of taxes, bankruptcy costs ...
that has limited descriptive validity in real markets. The CSS theory is only applicable in markets where share repurchases are allowed. Investors can use the CSS theory to identify undervalued stocks.


The formula

The CSS theory assumes that company managements can freely change the capital structure of the company – substituting bonds for
stock In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
or vice versa – on a day-to-day basis and in small denominations without paying transaction costs. Companies can decide to buy back one single share for the current market price P and finance this by issuing one extra corporate bond with face value P or do the reverse. In mathematical terms these substitutions are defined as \left frac\right_ = -P_ where D is the corporate debt and n the number of shares of company x at time t. The negative sign indicates that a reduction of the number of shares n leads to a larger debt D and vice versa. The earnings-per-share change when one share with price P is repurchased and one bond with face value P is issued: # The earnings that were ‘allocated’ to the one share that was repurchased are redistributed over the remaining outstanding shares, causing an increase in earnings per share of: E/n # The earnings are reduced by the additional interest payments on the extra bond. As interest payments are tax-deductible the real reduction in earnings is obtained by multiplying with the tax shield. The additional interest payments thus reduce the EPS by: P\cdot R\cdot -Tn Combining these two effects, the marginal change in EPS as function of the total number of outstanding shares becomes: \left frac\right_ = -\frac+\frac where * E is the earnings-per-share * R is the nominal interest rate on corporate bonds * T is the
corporate tax A corporate tax, also called corporation tax or company tax, is a direct tax imposed on the income or capital of corporations or analogous legal entities. Many countries impose such taxes at the national level, and a similar tax may be imposed at ...
rate EPS is maximized when substituting one more share for one bond or vice versa leads to no marginal change in EPS or: \frac=R_\ -T/math> This equilibrium condition is the central result of the CCS theory, linking stock prices to interest rates on corporate bonds.


Capital structure

The two main capital structure theories as taught in corporate finance textbooks are the
Pecking order theory In corporate finance, the pecking order theory (or pecking order model) postulates that the cost of financing increases with asymmetric information. Financing comes from three sources, internal funds, debt and new equity. Companies prioritize their ...
and the
Trade-off theory The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger ...
. The two theories make some contradicting predictions and for example
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and
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conclude: ''"In sum, we identify one scar on the tradeoff model (the negative relation between leverage and profitability), one deep wound on the pecking order (the large equity issues of small low-leverage growth firms)..."''. The capital structure substitution theory has the potential to close these gaps. It predicts a negative relation between leverage and valuation (=reverse of earnings yield) which in turn can be linked to profitability. But it also predicts that high valued small growth firms will avoid the use of debt as especially for these companies the cost of borrowing (''R_ '') is higher than for large companies, which in turn has a negative effect on their EPS. This is consistent with the finding that ''"…firms with higher current stock prices (relative to their past stock prices, book values or earnings) are more likely to issue equity rather than debt and repurchase debt rather than equity"''.


Asset pricing

The equilibrium condition can be easily rearranged to an
asset pricing In financial economics, asset pricing refers to a formal treatment and development of two main Price, pricing principles, outlined below, together with the resultant models. There have been many models developed for different situations, but cor ...
formula: P_=\frac The CSS theory suggests that company share prices are not set by shareholders but by bondholders. As a result of active repurchasing or issuing of shares by company managements, equilibrium pricing is no longer a result of balancing shareholder demand and supply. In a way the CSS theory turns asset pricing upside-down, with bondholders setting share prices and shareholders determining company leverage. The asset pricing formula only applies to debt-holding companies. Some companies are offering stock screeners based on the CSS theory. The asset pricing formula can be used on a market aggregate level as well. For the S&P 500 composite index, data from Shiller can be used for composite earnings level, and Federal Reserve Economic Data can be used for the interest rate on corporate bonds (BAA) and an estimate of corporate tax rate (by looking at the ratio of corporate profits and corporate profits after tax). The resulting graph shows at what times the S&P 500 Composite was overpriced and at what times it was under-priced relative to the Capital Structure Substitution theory equilibrium. In times when the market is under-priced, corporate buyback programs will allow companies to drive up earnings-per-share, and generate extra demand in the stock market. In times when the index was under-priced relative to the model equilibrium, repurchase programs will be stopped and demand is reduced. Not surprisingly the index was overpriced in the period around the tech bubble. What may come more as a surprise that the market is currently (June 2018) not over-priced relative to the model as earnings are high and corporate interest rates are low. In order to reach equilibrium conditions the index would have to gain ~20% or about US$4.9 trillion in market capitalization.


Fed model equilibrium

In the US, a positive relationship between the forward earnings yield of the
S&P 500 The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices. As of D ...
index and government bond yields has been present over specific time periods, namely 1921 to 1929, and 1987 to 2000; for most other periods, and markets, the relationship fails. This relationship is known as the Fed model, which states an equality between the one year forward looking E/P ratio or earnings yield and the 10-year government bond yield. The CSS equilibrium condition suggests that the Fed model might be misspecified: the S&P 500 earnings yield during 1987 to 2000 was not in equilibrium with the government bond yield but with the average after-tax interest rate on corporate bonds. The CSS theory suggests that the Fed equilibrium was only observable after 1982, the year in which the
United States Securities and Exchange Commission The U.S. Securities and Exchange Commission (SEC) is an independent agency of the United States federal government, created in the aftermath of the Wall Street Crash of 1929. The primary purpose of the SEC is to enforce the law against market ...
allowed open-market repurchases of shares. However, the CSS theory cannot explain why the Fed model relationship breaks down for all other periods, such as 2000 to 2019.


Dividend policy

It can be shown that repurchasing has a disadvantage over dividends for companies with a debt-equity ratio above \frac>\frac-1
Under the assumptions described above, low valued, high leveraged companies with limited investment opportunities and a high profitability are expected to use dividends as the preferred means to distribute cash. From the earnings payout graph it can be seen that S&P 500 companies with a low earnings yield (=highly valued) on aggregate changed their dividend policy after 1982, when SEC rule 10b-18 was introduced which allowed public companies open-market repurchases of their own stock.


Monetary policy

An unanticipated 25-basis-point cut in the federal funds rate target is associated with a 1% increase in broad stock indexes in the US. The CSS theory suggests that the monetary policy transmission mechanism is indirect but straightforward: a change in the federal funds rate affects the corporate bond market which in turn affects asset prices through the equilibrium condition.


Corporate tax

One unexpected result of the CSS theory is possibly that a change in
corporate tax A corporate tax, also called corporation tax or company tax, is a direct tax imposed on the income or capital of corporations or analogous legal entities. Many countries impose such taxes at the national level, and a similar tax may be imposed at ...
rate does not have an influence on share prices and/or valuation ratios. As earnings per share are a corporation’s net income after tax, both the numerator and the denominator of the CSS asset pricing formula contain the after-tax factor -Tand cancel each other out.


Beta

The CSS equilibrium condition can be used to deduct a relationship for the beta of a company x at time t: Beta_=\overline\cdot\left frac\right\cdot -T where \overline is the market average interest rate on corporate bonds. The CSS theory predicts that companies with a low valuation and high leverage will have a ''low'' beta. This is counter-intuitive as traditional finance theory links leverage to risk, and risk to ''high'' beta.


Assumptions

* Managements of public companies manipulate capital structure such that earnings-per-share are maximized. * Managements can freely change the
capital structure In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt (borrowed funds), and preferred stock, and is detailed in the ...
of the company – substituting bonds for stock or vice versa – on a day-to-day basis and in small denominations. * Shares can only be repurchased through open market buybacks. Information about share price is available on a daily basis. * Companies pay a uniform corporate tax rate T.


See also

* Beta (finance) *
Capital asset pricing model In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio. The model takes into accou ...
*
Capital structure In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt (borrowed funds), and preferred stock, and is detailed in the ...
*
Dividend A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a portion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-in ...
*
Dividend policy Dividend policy is concerned with financial policies regarding paying cash dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's una ...
* Fed model *
Leveraged recapitalization In corporate finance, a leveraged recapitalization is a change of the company's capital structure, usually substitution of debt for equity. Overview Such recapitalizations are executed via issuing bonds to raise money and using the proceeds to bu ...
* monetary transmission mechanism *
Modigliani–Miller theorem The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is an influential element of economic theory; it forms the basis for modern thinking on capital structure. The basic theorem states that in the absence of taxes, bankruptcy costs ...
*
Share repurchase Share repurchase, also known as share buyback or stock buyback, is the re-acquisition by a company of its own shares. It represents an alternate and more flexible way (relative to dividends) of returning money to shareholders. When used in coord ...
* P/E ratio *
Merton model The Merton model, developed by Robert C. Merton in 1974, is a widely used credit risk model. Analysts and investors utilize the Merton model to understand how capable a company is at meeting financial obligations, servicing its debt, and weighing ...


References


External links

* https://web.archive.org/web/20131117085244/http://valuemystock.com/screeners/ * https://wealth.barclays.com/content/dam/bwpublic/global/documents/BTH%20docs/In%20Focus/2017/9/in-focus-290917.pdf {{DEFAULTSORT:Capital Structure Substitution Theory Finance theories Financial capital