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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.
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.
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
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
iii)
K0
= KEU [1 VDt/VG]
= 18% [ 1 (5x0.35)/34.25] = 17.08%