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 doesn’t’ matter how the firm raises its finance for new investments.

2. Issuing equity to repay debt won’t 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 company’s 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

No tax (1958) Tax (1963)I Market value of firm is independent of its

capital structure.A firm’s WACC is independent of its gearing ratio.VG = VU

K0 = KEU

As gearing increases:i. the value of the firm increases by the value of the tax shield.ii. WACC fallsVG = VU + VDtK0 = KEU x (1- VDt/VG)

II 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)

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)III Required rate of return for an investment

is a firm’s WACC and is unaffected by the type of security used to finance the investment.K0 = KE x VE/V + KD x VD/V

Required rate of return for an investment is the firm’s 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 wouldn’t 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 company’s 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 second-hand 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 doesn’t 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.