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Capital Structure

Capital structure refers to the mix of different types of funds that a company uses to finance its
activities. It varies greatly from one company to another.
A good capital structure is one that results in a lower overall cost of capital for a firm. A lower cost of
capital means that the discounted value of future cash flows generated by the company is higher,
resulting in a higher company value.
Let us assume that companies are financed by just two types of funds, shareholders funds (equity)
and borrowings (debt), and consider the effect on the cost of capital of varying the proportion of
debt in the capital structure. (ACCA, 2000)
Two advantages of borrowing:
1. Cheap direct cost because debt is less risky to the investor
2. Cheap direct cost because interest payments are a tax deductible expense
Two disadvantages of borrowing:
1. Financial leverage causes shareholders to increase the cost of equity because of financial risk
2. Bankruptcy risks arise if borrowing is too high.

Traditional view of capital structure


When a company starts to borrow, the advantages outweigh the disadvantages. The cheap cost of
debt, combined with its tax advantage, will cause WACC to fall as borrowing increases. This increases
the market value of the company.
However, as gearing increases, the effect of financial leverage causes shareholders to increase their
required return because of financial risk. And, at high gearing the cost of debt also rises because of
an increasing chance of the company defaulting on its debt (bankruptcy risk). So at higher gearing,
WACC will increase, thus reducing the market value of the company.
Conclusion of traditional view:
Each company has an optimal capital structure that maximises its value by minimising its WACC.
Company management must find this particular gearing ratio (which is likely to change over time).
Therefore the financing decision is elevated to an importance almost on par with the investment
decision itself.
The main problem with this view is that there is no underlying theory to show how much the cost of
equity should increase because of financial leverage, or how much the cost of debt should increase
because of default risk. It is purely a descriptive theory.

Modigliani and Miller (1958)


Simplifying assumptions:

Perfect capital market


No transaction costs
Borrowing rate = lending rate
No tax
Risk measured entirely by volatility of cash flows

Proposition:
M&M argue that if the capital market is perfect, all companies with the same business risk and same
expected annual earnings should have the same value, regardless of their capital structure.
This is because the value of a company should depend on the present value of its operations, not the
way it is financed. WACC will be the same at all levels of gearing. Thus there is no optimum level of
gearing, and no minimum WACC.
M&M offered a number of formal proofs to their model.
Two assumptions need to be highlighted due to their significant impact on the result:
1. No tax. This is a serious problem because tax exists and one key advantage of debt is the tax relief
on interest payments.
2. Risk in M&M is measured entirely by the variability of cash flows. They ignore the possibility that
cash flows might cease because of bankruptcy.
With these two assumptions, there is just one remaining advantage and disadvantage of borrowing;
cheap debt (from lower risk) and increased cost of equity (from financial leverage) respectively.
M&M show that these effects cancel out exactly: the use of cheap debt gives the shareholders a
higher rate of return, but this is exactly what they need to compensate for the increased financial
risk.
Implications of M&M (1958):
As the value of firms is unaffected by changes in capital structure:
1. It doesnt matter how the firm raises its finance for new investments.
2. Issuing equity to repay debt wont affect the value of the firm.
3. Raising debt to repay shares also has no effect on the value of the firm.

Equations:
1. VG = VU
2. KEG = KEU + D/E x (KEU KD)
3. WACCG = WACCU = KEU

Total risk
Total risk consists of systematic risk and diversifiable risk. We are concerned with systematic risk
since it determines investors expected returns. It can be split into business risk and financial risk.
Business risk is the systematic risk of net cash flows that result from the operation of the companys
assets. Both equity and debt holders bear this risk.
Financial risk is an additional systematic risk, borne by equity holders of a geared company. The cost
of debt is the explicit cost of debt capital. Another cost of debt capital is the implicit cost caused by
financial risk.
The latter arises directly out of the gearing process. It is caused through debt capital having a priority
over shareholders in both the distribution of annual net cash flow and in any final liquidation
distribution.
Interest to debt holders must legally be paid in full by a company before any dividends can be paid.
Therefore financial risk is an increasing function of gearing. This financial risk is systematic in nature
and shareholders require a higher expected return on their capital for bearing it.

Capital structure decisions with tax


K0 = KE x VE/VE+D + KD(1-t) x VD/VE+D
Because interest on debt is tax deductible, this effectively reduces the cost of debt.
Effect of gearing on the value of a firm:
M&M (1963): as a result of taxation, geared firms give higher total returns to investors.
In an efficient market, geared firms should therefore have a higher total value than ungeared firms.
VG = VU + PV of tax shield = VU + VDt (assuming amount of debt is fixed)
Tax shield = present value of tax savings from interest payments.
If the total value of the firm increases with the level of gearing, then its overall cost of capital
(WACC) will go down.
K0 = KEU(1 VDt/VG)

KEU = K0 / (1 Dt/VG)
With taxation the impact on fixed interest costs is reduced. Therefore the risk of equity capital still
increases with extra debt, but not as much as before.
KEG = KEU + [VD(1-t)]/VE x (KEU KD)
Note: Knowing K0 or KEU allows us to calculate the other. Knowing KEG of KEU allows us to calculate the
other.
M&M propositions

II

III

No tax (1958)
Market value of firm is independent of its
capital structure.
A firms WACC is independent of its gearing
ratio.
VG = VU
K0 = KEU
Rate of return expected by shareholders
increases in proportion to the debt/equity
ratio because higher debt leads
shareholders to bear more financial risk.
KEG = KEU + VD/VE x (KEU KD)
Required rate of return for an investment
is a firms WACC and is unaffected by the
type of security used to finance the
investment.
K0 = KE x VE/V + KD x VD/V

Tax (1963)
As gearing increases:
i. the value of the firm increases by the value
of the tax shield.
ii. WACC falls
VG = VU + VDt
K0 = KEU x (1- VDt/VG)
Rate of return expected by shareholders
increases in proportion to debt/equity, but
not so steeply because of the tax shield.
KEG = KEU + [VD(1-t)]/VE x (KEU KD)
Required rate of return for an investment is
the firms WACC.
It depends on project risk and debt capacity.
K0 = KE x VE/V + [KD(1-t)] x VD/V

M+M (1963) Conclusions


The one and only advantage to a company of borrowing is the tax savings resulting from payment of
debt interest.
If a company raises funds by borrowing the government effectively gives the company a free gift in
the form of lower tax payments.
In the M+M (1963) paper, they calculated the advantage of borrowing as the present value of the tax
savings from interest payments (aka the tax shield, VDt).
A geared company is worth more than an ungeared company by the value of the tax shield.
VG = VU + VDt
In theory a company would maximise its total market value by gearing up as much as possible with
just a token of equity to determine ownership.
Under the assumption of tax relief available on debt interest, the total market value of a company is
an increasing function of the level of gearing.

Problems at high gearing


In the real world, gearing up as much as possible is unlikely for several reasons:
1. Agency costs: The principle-agent problem. This relates to external financial control of
management by suppliers of corporate finance. For example, management raise money for
investment in a low-risk project, then invest it in a high-risk project. Debt holders suffer because of
insufficient equity to carry the risk. Thus the expected return for debt holders wouldnt properly
reflect the risk of their investment. As a result, debt suppliers attach very strict covenants to loan
agreements. This constrains management and is an agency cost.
2. Bankruptcy costs: probability of bankruptcy is likely to be an increasing function of a companys
gearing ratio.
VG = VEU + VDt E[bankruptcy]
E[bankruptcy] = probability x cost of bankruptcy
Thus management may restrict the level of gearing because shareholder wealth falls at very high
levels, and management jobs are put on the line if the firm goes bankrupt.
3. Debt capacity: debt capital lent to a business is secured against assets. If a company defaults, the
bank seizes the assets. Assets must be suitable to be used as collateral; quality and ability of secondhand sale are important factors. For example, a company needs to borrow 100k to purchase a new
machine. The bank may only lend 30k against the whole asset 30% debt capacity.
Firms can run out of debt capacity. Therefore high levels of corporate gearing are unusual. Plus it is
good to keep a little reserve borrowing power to avoid paying high costs if finance is required.
Plants and real estate are good assets to use for collateral; they have high debt capacity.
4. Tax exhaustion: where a company has insufficient tax liability to be able to take advantage of all
the tax relief it has available. Debt capital then loses its advantage for a company.
5. Financial distress: even if a company doesnt go bankrupt, the directors may have to manage long
term cash flow problems if borrowing is too high. The main costs here are the waste of management
time and high costs of emergency short term borrowings, which can result in the rejection of
positive NPV projects. Thus cost of equity and debt increases.

Conclusion
The capital structure decision is very complex. The costs of increased gearing are difficult to identify,
thus preventing any general decision advice being formulated.
Although it is clear that gearing up as much as possible is not practical.

Lecture example
Canalot PLC is all equity financed. VU = 32.5m. K0 = KEU = 18%.
Canalot decides to repurchase 5m of equity and replace it with a 13% loan.
EBIT is constant. Corporation tax is 35%.
i)

VG

= VEU + VDt
= 32.5 + 5 x 0.35 = 34.25m

VEG

= VG VD
= 34.25 5 = 29.25m

We see the market value of the company increases with the introduction of gearing.
ii)

KEG

= KEU + [VD(1-t)]/VE x (KEU KD)


= 18% + [(5 x 0.65)/29.25] x (18% - 13%) = 18.56%

iii)

K0

= KEU [1 VDt/VG]
= 18% [ 1 (5x0.35)/34.25] = 17.08%

Capital structure evidence


Read Myers, The Capital Structure Puzzle
Pecking-order theory
Companies prioritise their sources of financing according to the law of least effort, or least
resistance:
1. retained earnings
2. debt
3. equity a last resort.
The capital structure decision is not determined by the trade-off between costs and benefits of using
debt. Instead it is a function of:
1. the amount of financing required for all positive NPV projects
2. the amount of retained earnings available
3. the debt capacity of the company
Therefore, we expect profitable companies to have less debt because of greater retained earnings.

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