Financial Strategy, Second Edition

Section 3

Adding Value through Financing

SECTION OVERVIEW

Janette Rutterford

The last ten or twenty years have seen a radical shift in the approach to corporate finance. In the old days, corporate finance was somehow a given, with industry norms for debt-equity ratios, borrowing limits imposed by banks and little emphasis on adding value through financing. Managers concentrated on investment rather than financing decisions. This approach could be vindicated by the early research into the firm's capital structure and dividend policy by Franco Modigliani and Merton Miller. This showed that, in perfect markets, with no corporate taxes, neither dividend policy nor capital structure could be altered to add value to the firm.

However, once taxes were introduced, the irrelevance proposition broke down. The 1963 paper by Franco Modigliani and Merton Miller, which showed that, once corporate taxes were taken into account, capital structure did matter¹, can be blamed for the dramatic rise in leveraged buyouts² which we saw particularly in the 1980s and 1990s. In the late 1990s, companies reacted to the threat of leveraged buyouts by reorganising their own capital structures through share repurchases, using debt to buy back equity and increasing their leverage as a result. The twenty-first century has seen the rise of private equity funds and venture capital funds, both of which specialise in acquiring companies and, as part of their “value added”, restructuring the capital structure to include ...