• The mixture of debt finance relative to equity finance that a company uses to finance its business operations
• Gearing ratios assess financial risk:
• Debt/equity ratio: D/E
• Capital gearing: D/(D+E)
• Market values preferred to book values
• Should D include short-term debt?
Implications of High gearing
• Increased volatility of equity returns arises with high gearing since interest must be paid before paying returns to shareholders.
• Increased risk of bankruptcy also occurs.
• Stock exchange credibility falls as investors learn of company’s financial position.
Short-termism moves managers’ focus away from maximisation of shareholder wealth
Optimal capital structure
• Does the mix of debt and equity finance used by a company affect its weighted average cost of capital?
• Is there a mix of debt and equity that will minimise the average cost of capital?
• Minimum cost of capital will maximise market value of company and hence maximise shareholder wealth.
• No taxes exist.
• Financing choice is between ordinary shares and perpetual debt.
• Capital structure changes incur no cost and entail replacing debt with equity or vice versa.
• All earnings are paid out as dividends.
• Business risk is constant over time.
Earnings and hence dividends are constant
• Cost of equity increases as gearing increases due to rising financial risk and, later, bankruptcy risk.
• Cost of debts rises at high levels of gearing due to bankruptcy risk.
• As company starts to replace expensive equity with cheaper debt, WACC falls.
• As gearing continues to increase, cost of equity and cost of debt increase, offsetting the benefit of cheap debt.
Miller and Modigliani 1 (1st Proposition)
• Capital markets are assumed to be perfect.
• No risk of bankruptcy so cost of debt curve is flat.
• Linear increase in cost of equity due to increasing financial risk.
• As company gears up and replaces equity with debt, benefit of cheaper debt is exactly balanced by the increasing cost of equity.
No optimal capital structure is found
Assume you own 1% of B’s shares:
(1) Sell your shares for £77.27
(2) Borrow £30 to copy B’s gearing
(3) Buy 1% of A’s shares (surplus of £7.27)
• Return on B’s shares: 11% × £77.27 = £8.50
• Return on A’s shares: 10% × £100 = £10
• Less interest: £30 × 5% = £1.50 leaves £8.50
• Same return but you now have £7.27 surplus
Arbitrage proof using companies A and B:
Net income 1000 1000
Interest at 5% Nil 150
Earnings 1000 850
Divide by cost of equity 10% 11%
MV of equity 10 000 7 727
MV of debt Nil 3 000
Total market value 10 000 10 727
• Selling will cause B’s share price to fall and buying will cause A’s share price to rise.
• Return on B’s shares will rise and return on A’s shares will fall.
• WACC of A (10%) will fall and WACC of B (9.3%) will rise, and WACCs will converge until any arbitrage opportunity is eliminated.
• The claim that identical business risk will have an identical WACC is shown to be true.
Miller and Modigliani II (2nd Proposition)
• M&M adjusted their first model to reflect the tax deductibility of interest payments.
• Tax efficiency implies that gearing up by replacing equity with debt gives benefit of a tax shield, increasing the value of company.
• Cost of debt curve falls from before-tax to after-tax level, so WACC curve slopes downwards.
This implies an optimal capital structure does exist: i.e. gear up with as much debt as possible
• M&M relaxed assumption of perfect capital market by considering corporate taxation.
• If we relax perfect market assumption further by considering bankruptcy risk, an optimal capital structure emerges.
• Companies have to balance the tax efficiency of debt with the risk of bankruptcy.
• Traditional approach: Optimal Capital Structure (OCS) exists
• Miller and Modigliani I: no OCS is found
• Miller and Modigliani II: OCS is 100% debt
• Market imperfections: OCS exists
In practice, rather than one optimal capital structure existing for each firm, a range of optimal capital structures may exist.