In
finance
Finance refers to monetary resources and to the study and Academic discipline, discipline of money, currency, assets and Liability (financial accounting), liabilities. As a subject of study, is a field of Business administration, Business Admin ...
, 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 during a defined accounting period, period of time, often a year. It is a key measure of corporate profitability, focusing on the inte ...
(EPS) are maximized. Managements have an
incentive
In general, incentives are anything that persuade a person or organization to alter their behavior to produce the desired outcome. The laws of economists and of behavior state that higher incentives amount to greater levels of effort and therefo ...
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, in financial management and corporate finance, is concerned with
Aswath Damodaran (N.D.)Returning Cash to the Owners: Dividend Policy/ref>
the policies regarding dividends;
more specifically paying a cash dividend in the pr ...
, the
monetary transmission mechanism
The monetary transmission mechanism is the process by which monetary policy decisions affect the broader macroeconomy through multiple channels including asset prices, money markets, and general economic conditions. Such decisions are implemente ...
, 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 cost ...
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
Stocks (also capital stock, or sometimes interchangeably, shares) consist of all the Share (finance), shares by which ownership of a corporation or company is divided. A single share of the stock means fractional ownership of the corporatio ...
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
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:
# 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:
Combining these two effects, the marginal change in EPS as function of the total number of outstanding shares becomes:
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 or corporate income tax, is a type of direct tax levied on the income or capital of corporations and other similar legal entities. The tax is usually imposed at the national level, but ...
rate
EPS is maximized when substituting one more share for one bond or vice versa leads to no marginal change in EPS or: