18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.1 LEARNING OBJECTIVES Discuss

18 CAPITAL STRUCTURE

Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002

OHT 18.1

LEARNING OBJECTIVES

• Discuss the effect of gearing, and differentiate business and financial risk

• Describe the underlying assumptions, rationale and conclusions of Modigliani and Miller’s models, in worlds with and without tax

• Explain the relevance of some important, but often non-quantifiable, influences on the optimal gearing level question



OHT 18.2

DEBT FINANCE IS CHEAPER AND RISKIER (FOR THE COMPANY)

• Lenders require a lower rate of return than ordinary shareholders

• Debt interest can be offset against pre-tax profits before the

calculation of the corporation tax bill, thus reducing the tax paid

• Issuing and transaction costs associated with raising and servicing debt are generally less than for ordinary shares

Exhibit 18.1 At low gearing levels the risk of financial distress is low, but the cost of capital is high; this reverses at high gearing levels

High Low

Gearing level

finance (if thereturns to equityare constant or do notrise much with gearing*)

Risk of the companybecoming financiallydistressed

HighLow

HighLow

Overall cost of

Note: This assumption is considered in the text.



OHT 18.3

WHAT DO WE MEAN BY ‘GEARING’?

• Operating gearing• Financial gearing

Note: Gearing and leverage are used interchangeably.

Exhibit 18.2 A firm’s financial gearing can be measured in two ways

Overall perspective on debt levels

Capital gearing Income gearing



OHT 18.4

CAPITAL GEARING

Capital gearing (1) = Long-term debtShareholders’ funds

Capital gearing (2) = Long-term debt

Long-term debt + Shareholders’ funds

Capital gearing (3) = All borrowing

All borrowing + Shareholders’ funds

Capital gearing (4) = Long-term debtTotal market capitalisation



OHT 18.5

INCOME GEARING

Interest cover = Profit before interest and tax Interest charges

The inverse of interest cover is called income gearing.



OHT 18.6

INCOME GEARING



OHT 18.7

THE EFFECT OF GEARING

The introduction of interest-bearing debt ‘gears up’ the returns to the shareholders.

Example: Harby plc• Three different capital structures• £10m of capital being raised

1 All equity – 10 million shares sold at a nominal value of £12 £3m debt (carrying 10 per cent interest) and £7m equity3 £5m debt (carrying 10 per cent interest) and £5m equity

Exhibit 18.6 Probabilities of performance levels

Customer responseto firm’s products

Income beforeinterest*

Probability (%)

Modest success £0.5m 20

Good response £3.0m 60

Run-away success £4.0m 20



OHT 18.8

Exhibit 18.7 The effect of gearing

Customer response Modest Good Run-away

Earnings before interest £0.5m £3.0m £4.0m

All-equity structureDebt interest at 10% 0.0 0.0 0.0Earnings available for shareholders £0.5m £3.0m £4.0mReturn on shares £0.5m £3.0m £4.0m

= 5% = 30% = 40%£10m £10m £10m

30% Gearing (£3m debt, £7m equity)Debt interest at 10% £0.3m £0.3m £0.3mEarnings available for shareholders £0.2m £2.7m £3.7mReturn on shares £0.2m £2.7m £3.7m

= 3% = 39% = 53%£7m £7m £7m

50% Gearing (£5m debt, £5m equity)Debt interest at 10% £0.5m £0.5m £0.5mEarnings available for shareholders 0.0 £2.5m £3.5mReturns on shares £0.0m £2.5m £3.5m

= 0% = 50% = 70%£5m £5m £5m



OHT 18.9

Exhibit 18.8 Changes in shareholder returns for ungeared and geared capital structures

All-equity structure

50% debt, 50% equity structure

0.50 1.0 2.0 3.0

10

30

50

Earnings before interest, £m

Returns to shareholders (%)

Ret

urns

to s

hare

hold

ers

(%)



OHT 18.10

EXPECTED RETURNS AND STANDARD DEVIATIONS FOR HARBY PLC

All equity

Return, R (%) Probability, pi Return Probability

5 0.2 130 0.6 1840 0.2 8

27 Expected return, R = 27%

Return, R(%) Expected return, R Probability (R – R)2 pi

5 27 0.2 96.830 27 0.6 5.440 27 0.2 33.8

Variance 2 = 136.030% Gearing Standard deviation = 11.7% Return, R(%) Probability, pi Return Probability

3 0.2 0.629 0.6 23.453 0.2 10.6

34.6 Expected return, R = 34.6%

Return, R(%) Expected return, R Probability (R – R)2pi

3 34.6 0.2 199.7139 34.6 0.6 11.6253 34.6 0.2 67.71

Variance 2 = 279.04 Standard deviation = 16.7%

Exhibit 18.9 Expected returns and standard deviations of return to shareholders in Harby plc



OHT 18.11

EXPECTED RETURNS AND STANDARD DEVIATIONS FOR HARBY PLC

50% Gearing

Return, R (%) Probability, pi Return Probability

0 0.2 050 0.6 3070 0.2 14

44 Expected return, R = 44%

Return, R(%) Expected return, R Probability (R – R)2 pi

0 44 0.2 387.250 44 0.6 21.670 44 0.2 135.2

Variance 2 = 544.0

Exhibit 18.9 Expected returns and standard deviations of return toshareholders in Harby Plc

Standard deviation = 23.3%



OHT 18.12

BUSINESS RISK AND FINANCIAL RISK

• Business risk is the variability of the firm’s operating income, that is, the income before interest• Financial risk is the additional variability in returns to shareholders that arises because the financial structure contains debt

Exhibit 18.10 A company has responsibilities to a number of interested parties

Gearing Expected return Standard deviation Business risk Remaining total (%) to shareholders (total risk) (%) risk due to

(%) (%) financial risk*(%)

0 (all equity) 27 11.7 11.7 0

30 34.6 16.7 11.7 5

50 44 23.3 11.7 11.6



OHT 18.13

THE VALUE OF THE FIRM AND THE COST OF CAPITAL

C1

WACCwhere: V = value of the firm; C1 = cash flows to be received one year hence; WACC = the weighted average cost of capital.

The value of the firm, V, is the combination of the market value of equity capital, VE (total capitalisation of ordinary shares), plus the market value of debt capital, VD.

V = VE + VD

V =



OHT 18.14

DOES THE COST OF CAPITAL (WACC) DECREASE WITH HIGHER DEBT LEVELS?

The firm’s cost of capital depends on both the return needed to satisfy the ordinary shareholders given their opportunity cost of capital kD and the return needed to satisfy lenders given their opportunity cost of capital kD.

WACC = kE WEkD WD

where: WE = proportion of equity finance to total finance;

WD = proportion of debt finance to total finance.Assume:• the cost of equity capital is 20 per cent• the cost of debt capital is 10 per cent• the equity and debt weights are both 50 per cent • the overall cost of capital is 15 per cent

WACC = 20%

The firm is expected to generate a perpetual annual cash flow of £1m. The total value of the firm is:

C1 £1m WACC 0.15

V = = = £6.667m



OHT 18.15

DOES WACC DECREASE WITH HIGHER DEBT LEVELS?

Scenario 1 The cost of equity capital remains at 20 per cent

If shareholders remain content with a 20 per cent return, the WACC decreases: WACC = kE WEkD WD

WACC = 20% 0.3 + 10% 0.7 = 13%The value of the firm increases:

C1 £1m WACC 0.13

Scenario 2 The cost of equity capital rises due to the increased financial risk to exactly offset the effect of the lower cost of debt

In this case the WACC and the firm’s value remain constant. WACC = kE WE + kD WD

WACC = 26.67% 0.3 + 10% 0.7 = 15%

V = = = £7.69m



OHT 18.16

DOES WACC DECREASE WITH HIGHER DEBT LEVELS?

Scenario 3 The cost of equity capital rises, but this does not completely offset all the benefits of the lower cost of debt capital

Assume that equity holders demand a 22 per cent return at a 70 per cent gearing level: WACC = kE WE + kD WD

WACC = 22% 0.3 + 10% 0.7 = 13.6%

C1 £1m WACC 0.136

Scenario 4 The cost of equity rises to more than offset the effect of the lower cost of debt

Assume that a return of 40 per cent is required by shareholders: WACC = kE WE + kD WD

WACC = 40% 0.3 + 10% 0.7 = 19%

C1 £1m WACC 0.19

V = = £7.35m=

V = = = £5.26m



OHT 18.17

MODIGLIANI AND MILLER’S ARGUMENT IN A WORLD WITHNO TAXES

Proposition 1The total market value of any company is independent of its capital structureThe assumptions1 There is no taxation.

2 There are perfect capital markets, with perfect information available to all economic agents and no transaction costs.

3 There are no costs of financial distress and liquidation (if a firm is liquidated, shareholders will receive the same as the market value of their share prior to liquidation).

4 Firms can be classified into distinct risk classes.

5 Individuals can borrow as cheaply as corporations.



OHT 18.18

MODIGLIANI AND MILLER’S NO-TAX CAPITAL STRUCTURE ARGUMENT

An example: Pivot plc

• £1m capital needed to buy machines, plant and buildings• The required return on that level of systematic risk for an all-equity firm is 15 per cent• The expected annual cash flow is a constant £150,000 in perpetuity• This cash flow will be paid out each year to the suppliers of capital• Consider three different finance structures:

Structure 1 All equity (1,000,000 shares selling at £1 each).Structure 2 £500,000 of debt capital giving a return of 10 per cent per annum. Plus £500,000 of equity capital (500,000 shares at £1 each).Structure 3 £700,000 of debt capital giving a return of 10 per cent per annum. Plus £300,000 of equity capital (300,000 shares at £1 each).



OHT 18.19

Exhibit 18.12 Pivot plc capital structure and returns to shareholders

Structur e 1 Structur e 2 Structure 3

£ £ £

Annual cash flows 150,000 150,000 150,000

less interest payments 0 50,000 70,000

Dividend payments 150,000 100,000 80,000

Return on debt, kD 0 50,000/500,000 = 10% 70,000/700,000 = 10%

Return on equity, kE 150,000/1m = 15% 100,000/500,000 = 20% 80,000/300,000 = 26.7%

Price of each share, 15p 20p 26.7p

d1 0.15 = 100p

0.20 = 100p

0.267 = 100p

kE

WACC 15 1.0 + 0 = 15% 20 0.5 + 10 0.5 = 15% 26.7 0.3 + 10 0.7 = 15%

(kEWE + kDWD)

Total market value of

debt, VD 0 500,000 700,000

Total market value of

equity, VE 150,000 100,000 80,000

0.15 = 1m

0.2 = 0.5m

0.267 = 0.3m

Total value of the firm,

V = VD + VE £1,000,000 £1,000,000 £1,000,000



OHT 18.20

Exhibit 18.13 The cost of debt, equity and WACC under the MM no-tax model

Returns to shareholders (%)Return %

15

10

Debt/Equity

kE

kD

WACC

Ret

urn

%



OHT 18.21

WACC

If the WACC is constant and cash flows do not change, then the total value of the firm is constant: V = VE + VD = £1m C1 £150,00 WACC 0.15

Exhibit 18.14 Value of the firm under the MM no-tax model

Returns to shareholders (%)Return %Value £m

Debt/Equity

V

Val

ue £

m

V = = = £1m



OHT 18.22

MODIGLIANI AND MILLER’S ARGUMENT IN A WORLD WITH NO TAXES

Proposition 2The expected rate of return on equity increases proportionately with the gearing ratio

Proposition 3The cut-off rate of return for new projects is equal to the weighted average cost of capital – which is constant regardless of gearing



OHT 18.23

THE CAPITAL STRUCTURE DECISION IN A WORLD WITH TAX

Exhibit 18.15 MM with tax

Exhibit 18.16 Value of the firm, MM with tax

Returns to shareholders (%)Return %Value £m

15

7

Return %

Debt/Equity

kE

kD (1 – T)WACCR

etur

n %

Returns to shareholders (%)Return %Value £mReturn %Value

Debt/Equity

V

Val

ue



OHT 18.24

FINANCIAL DISTRESS

Financial distress: where obligations to creditors are not met or are met with difficulty

Exhibit 18.18 Costs of financial distress

Indirect examples Direct examples

Lawyers’ fees.

Accountants’ fees.

Court fees.

Management time.

Uncertainties in customers’ mindsabout dealing with this firm – lostsales, lost profits, lost goodwill.

•

Uncertainties in suppliers’ minds aboutdealing with this firm – lost inputs,more expensive trading terms.

•

If assets have to be sold quickly theprice may be very low.

•

Delays, legal impositions, and the tangles of financial reorganisation mayplace restrictions on managementaction, interfering with the efficientrunning of the business.

•

•

•

•

•

Management may give excessiveemphasis to short-term liquidity, e.g.cut R&D and training, reduce tradecredit and stock levels.

•

Loss of staff morale, tendency to examine possible alternative employment.

•

To conserve cash, lower credit termsare offered to customers, whichimpacts on the marketing effort.

•

• Temptation to sell healthy businesses asthis will raise the most cash.



OHT 18.25

Exhibit 18.20 The cost of capital and the value of the firm with taxes and financial distress, as gearing increases

Debt/Equity

Value of geared firm withtax effect only considered

Optimal gearing level

Debt/Equity

k E

kDAT

WACC

Value of firm with taxesand financial distress costs

Costs of financial distress

Val

ueR

etur

n %



OHT 18.26

SOME FACTORS INFLUENCING THE RISK OF FINANCIAL DISTRESS COSTS

1 The sensitivity of the company’s revenues to the general level of economic activity

2 The proportion of fixed to variable costs

3 The liquidity and marketability of the firm’s assets

4 The cash-generative ability of the business



OHT 18.27

Exhibit 18.21 The characteristics of the underlying business influences the risk of liquidation/distress, and therefore WACC, and the optimal gearing level

Characteristic Food retailer Steel producer

Sensitivity to economic Relatively insensitive to Dependent on generalactivity economic fluctuations economic prosperity

Operational gearing Most costs are variable Most costs are fixed

Asset liquidity Shops, stock, etc., easily sold

Assets have few/no alternative uses. Thinsecondhand market

Cash-generative ability High or stable cash flow Irregular cash flow

Likely acceptable HIGH LOWgearing ratio



OHT 18.28

OTHER FACTORS AFFECTING LEVELS OF DEBT (1)

1 Agency costsAgency costs are the direct and indirect costs of ensuring that agents act in the best interest of principals.

2 Borrowing capacityLenders prefer secured lending, and this often sets an upper limit on gearing.

3 Managerial preferencesManagers have a natural tendency to be cautious about borrowing.



OHT 18.29


4 Pecking order for financingFirms prefer to finance with internally-generated funds.• A firm first of all tries to finance investments by using the store of previous years’ profits• If still more funds are needed, firms will go to the capital markets• Debt market is called on first• Only as a last resort will companies resort to raising equity finance.

Reasons:

1 The stock markets perceive an equity issue as a sign of problems2 Managers are following a line of least resistance3 Ordinary shares are more expensive to issue than debt capital, which in turn is more expensive than simply applying previously generated profit



OHT 18.30


5 Financial slack

6 Signalling

7 Control

8 Industry group gearing



OHT 18.31

IDEAS ON DEBT FINANCE

• Motivation

• Reinvestment risk

• Operating and strategic efficiency



OHT 18.32

Exhibit 18.25 WACC is U-shaped and value can be altered by changing the gearing level

Debt/Equity

WACC

Major influences:– financial distress/bankruptcy cost– agency costs

Major influences:– lower cost of debt– tax relief on debt

Debt/Equity

Other factors

by other factors. In the listbelow, the direction of the effectis indicated by an arrow.

tends to argue forlowering debt level

tends to argue forraising debt level

uncertain

1 Borrowing capacity

2 Managerial preference

3 Pecking order

4 Financial slack

5 Signalling

6 Control

7 Industry group gearing

8 Motivation

9 Reinvestment risk

10 Operating and strategic efficiency

Firm

’s v

alue

Ret

urn

%

The debt-equity ratio can also be affected

Documents

18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.1 LEARNING OBJECTIVES Discuss