Financial Management- Capital structure

What is gearing?

•          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

Key question:

•          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.

Simplifying Assumptions

•          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

Traditional approach

•          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 (1^st 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

Example

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:

                                                                     A                               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

NB:

•          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 (2^nd 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

Market Imperfection

•          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.

Conclusions:

•          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.