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{{Short description|Theory in finance}}In finance, the capital structure substitution theory (CSS)JOURNAL, Timmer, Jan, 2011, Understanding the Fed Model, Capital Structure, and then Some, 1322703, describes the relationship between earnings, stock price and capital structure of public companies. The CSS theory hypothesizes that managements of public companies manipulate capital structure such that earnings per share (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, the monetary transmission mechanism, and stock volatility, and provides an alternative to the Modigliani–Miller theorem 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.JOURNAL, Zürcher, Ulrik Årdal, 2014, The Effect of Interest Rates on Equity Markets That Allows Share Repurchases,www.cfasociety.org/france/Documents/Quant%20Awards%202014/QuantAwards2014_Ulrik%20Årdal%20Zürcher_Maastricht%20University.pdf,

The formula

The CSS theory assumes that company managements can freely change the capital structure of the company – substituting bonds for stock 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 File:CSS_equilibrium_color.png|thumb|upright=1.5|right|alt=test1|CSS equilibrium conditions: (1) companies fulfilling the equilibrium condition are found on B-B”, (2) companies cannot issue debt with interest rates below ‘Aaa’ rated bonds on line A-A”, (3) high valued companies with E/Pfrac{1-T_{text{C}}}{1-T_{text{D}}}-1Under 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.JOURNAL, Bernanke, B.S., Kuttner, K.N., June 2005, What Explains the Stock Market’s Reaction to Federal Reserve Policy?, Journal of Finance, LX, 3, 1221–1257, 10.1111/j.1540-6261.2005.00760.x, free, 10419/60670, free, 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 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 [1-T] and 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_{text{x,t}}=overline{R_{text{t}}}cdotleft[frac{P}{E}right]_{text{x,t}}cdot[1-T] where overline{R_{text{t}}} 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 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
• Capital structure
• Dividend
• Dividend policy
• Earnings management
• Fed model
• Leveraged recapitalization
• monetary transmission mechanism
• Modigliani–Miller theorem
• Share repurchase
• P/E ratio
• Merton model

References

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External links

• valuemystock.com/screeners/" title="web.archive.org/web/20131117085244valuemystock.com/screeners/">web.archive.org/web/20131117085244valuemystock.com/screeners/
• wealth.barclays.com/content/dam/bwpublic/global/documents/BTH%20docs/In%20Focus/2017/9/in-focus-290917.pdf