Chapter 12 - The Cost of Capital & Capital Structure

Question 1

What is capital structure?

Answer 1

Capital structure is the composition of the company’s equity and liabilities in its financial statements that show how the company, or its overall operation, is financed. The key objective of a company is to maximise the value of the company and should be considered when designing its optimal capital structure.

Question 2

What is cost of capital and what are its two main uses?

Answer 2

A company’s cost of capital is the rate of return required by the providers of capital for making an investment in the
company.
<br></br> Rate of return that could have been earned by putting the money elsewhere<br></br>
The financial manager uses cost of capital when:
* designing a balanced and optimal capital structure
* evaluating new project or investment options

Question 3

What is cost of equity?

Answer 3

The cost of equity is the return investors expect to achieve on their shares in a company. The rate of return an investor requires is based on the level of risk associated with the investment. Equity shareholders are the last investors to be paid out of company profits, as well as the last to be paid on the winding up of a company.

Question 4

2 MAIN METHODS OF DETERMINING COST OF EQUITY

Answer 4

• capital asset pricing model
• dividend valuation model

Question 5

Capital asset pricing

Answer 5

The capital asset pricing model (CAPM) was developed by Sharpe (1964) and Lintner (1965) as a means to measure the
cost of equity. The model studies and establishes an equilibrium relationship between the expected returns from each
security and its associated risks. It can be used to assess risk in individual company shares or a portfolio of securities.
The cost of equity capital obtained under CAPM is called the risk-adjusted discount rate (RADR). Once the market
portfolio has been established, the required rate of return for any security can be calculated using this model provided
the beta factor (explained in section 3.4) is known.

Question 6

Risk associated discount rate (RADR)

Answer 6

The risk inherent in a project depends on the type of activity involved. Higher risk does not necessarily make a project
unattractive.<br></br>
The RADR is the rate used to discount a risky asset or investment such as real estate. It represents the required
periodical returns by investors to compensate for the higher risk involved. The higher the risk involved in the project, the
higher the discount rate. The cash flows from riskier assets will be discounted at a higher rate. This adjusted discount
rate is typically referred to as expected rate of return. It forms the basis for CAPM.<br></br>
The RADR is based on the risk-free rate (RFR) (such as a short-term interest rate from government securities or a fixed
deposit rate) and a risk premium for the riskier assets. <br></br><br></br>
RADR = RFR + risk premium
Where:
RADR = Risk-adjusted discount rate
**RFR = Risk-free rate**
<br></br>
The formula for calculating RADR is simple and it incorporates risk in the expected rate of return. The real challenge
occurs when measuring the risk premium. The quantification of risk involves good amount of subjectivity and detailed
analysis of asset classes. The approach to dealing with higher risk projects is to use a higher rate, effectively adding a
premium for the market risk.

Question 7

di

Unsystematic risk

Answer 7

Unsystematic risks are risk factors specific to a particular company or industry which can be eliminated or diversified
away in a large portfolio of shares. These risks are not impacted by political and economic factors. Examples include
weak labour relations, adverse press reports and strikes. These are different for different companies; they might even
cancel each other out in some circumstances. Studies have shown that if the portfolio consists of 15 to 20 shares, then
most of the unsystematic risk tends to be diversified.

Question 8

Systematic risk (market risk)

Answer 8

Systematic risk (or market risk) relates to the markets and the economy. It is largely caused by macroeconomic factors
and affects all the shares in the market. It is unavoidable and cannot be diversified. An example may be an economic
recession affecting both the markets and the economy of the country. The level to which each share will be affected will
differ, although it is known that all shares will be affected.
<br></br>
The degree of systematic risk is different in different industries. For instance, the food retailing sector faces lower
systematic risk in comparison to the hospitality sector, as food is a necessity. Irrespective of a recession, people will still
require their daily essentials. It is possible for an investor to select shares with a low systematic risk. Thus, investors
need to select shares that will provide returns over and above its risk-free rate of return.

Question 9

Measuring systematic risk

Answer 9

Sharpe and others used regression analysis to study the relationships between the excess returns (in excess of the
RFR) earned on a share and the stock market portfolio. It is summarised in Figure 12.2.
The outcomes are summarised as follows.
* There is a direct correlation between the excess returns earned on a share and the stock market. In other words, in
times of boom or recession, individual shares tend to perform in line with the market movements.
* The gradient of the regression line is termed beta (ß).
* The greater the ß, the greater the systematic risk and the expected return from the share.
* When ß is at 45 degrees, it indicates that the systematic risk of the share is equal to the systematic risk of the
market. The ß of the share is 1 in this case and the movement on the vertical and horizontal axis is similar. The
higher (or lower) return of the share is in line with the return on the stock market.
<br></br>
* When the gradient of the regression line is greater than 45 degrees, it indicates that the systematic risk of the share
exceeds the systematic risk of the stock market; hence, the excess return on the share is greater than the excess
return on the stock market. The ß is greater than 1 in this case.
* When the gradient of the regression line is less than 45 degrees, it indicates that the systematic risk of the share
is lower than the systematic risk of the stock market; hence, the excess return on the share is less than the excess
return on the stock market. The ß is less than 1 in this case.
* The vertical intercept point of the regression line is termed alpha (a). In a perfect world, the alpha coefficient should
be zero, that is, the regression line should go through the graph’s origin. If the alpha coefficient is greater than zero,
this implies that the return on the share is generating an abnormal return due to an element of unsystematic risk.
However, over time, such abnormal returns should cancel out and the alpha coefficient will become zero.

Question 10

Calculating cost of equity

Answer 10

RADR = RFR + ß (RM – RFR)

Where:
* RFR = Risk-free rate
* RM = return on stock market portfolio
* ß = risk premium statistically derived
* RM – RFR = market risk premium (the expected return on the market minus the risk-free rate).

Question 11

Main assumptions of CAPM

Answer 11

• Investors are rational and possess full knowledge about the market.
• Investors expect greater returns for taking greater risks.
• It is possible for an investor to diversify the unsystematic risk by actively managing the portfolio.
• Borrowing and lending rates are equal.
• There are no transaction costs.
• Markets are perfect and market imperfections tend to correct themselves in the long run.
• The RFR is the same as the returns on the government bonds.
• There is no taxation and no inflation.

Question 12

Main criticisms of CAPM

Answer 12

• Research has shown that the linearity of the SML has been lost with changes of gradient at different levels of ß
• during some periods.
• Apart from changes in ß, there are also other reasons (such as company size or market value) for the shares to give
• excess returns. These are not considered by CAPM.
• There are practical difficulties in deriving the systematic risk and the ß of any company as trading on the stock
• market is subject to numerous factors.
• Companies with more than one division and company channel might have different systematic risks for each
• division – yet ß is derived on the basis of a single share price.

Question 13

Dividend valuation (dividend growth) method

Answer 13

The dividend valuation model (or dividend growth model) states that the value of the company/share is the present value
of the expected future dividends discounted at the shareholders’ required rate of return.
Assuming a constant growth rate in dividends:

P = Do (1 + G) / (Ke-G)
Where:
P = current share price
Do = current level of dividend
g = expected growth rate in dividends
<br></br>
Ke = (Do (1 + g) / P ) + g
<br></br>
Do (1 + g) is the dividend at the end of the year (D1)

.

Question 14

What is cost of debt and basically how calculated?

Answer 14

Raising debt to finance a company’s operations comes at a cost. Conceptually, the cost of debt refers to the effective
interest rate a company pays on its debt (such as bonds, mortgages or debentures). The cost of debt is usually
expressed as an after-tax rate, = (1 – t), because interest is a tax-deductible expense.

Question 15

What is/calculating irredeemable debt

Answer 15

Irredeemable debt is a perpetual debt which is never repaid.Calculated using the following equation

Kd = I (1 - t) / Sd

Kd = Cost of debt capital
I = Annual interest
t = Corporate tax rate
Sd = Market price of the debt
<br></br>
The higher the rate of corporate tax payable by the company, the lower the after-tax cost of debt capital<br></br>

While calculating the cost of debt, we assume that the interest payable on debt instruments attracts the tax deduction.
The cost of preference shares with the same coupon rate and market value will be higher than the cost of debt capital
as there is no tax relief on a preference share dividend.
<br></br>
The cost of any debt with no tax relief and the cost of preference shares is calculated as:
Kd = I / Sd

Question 16

Redeemable debt

Answer 16

Redeemable debt is usually repaid at its nominal value (at par) but may be issued as repayable at a premium on
nominal value. It is repayable at a fixed date (or during a fixed period) in the future.
A company raises redeemable debt to pay back at a fixed future date. The cost of debt on redeemable debt can be
calculated by the internal rate of return (IRR). The internal rate of return is a method used for investment appraisal
that calculates the rate of return at which the net present value of all the cash flows (both positive and negative) from
a project or investment is equal to zero. It evaluates the profitability and the attractiveness of potential investments.
Calculation of IRR is covered in Chapter 13.
The cost of debt helps to understand the company’s risk level compared to others. Companies carrying higher risk will
have a higher cost of debt.

Question 17

Redeemable debt - IRR method

Answer 17

Yr 0 = £100m
Yr1 = £121m (121/100 = 1.21 = 1 / 0.21)
Return = 21p for every £1 investment / for every £100 investment = £21
21% per annum

Where cost of capital is 10% -

		return is higher than cost of capital, leaves 	
		^11% to keep – where higher than cost of capital, KEEP

Question 18

Weighted average cost of capital

Answer 18

The weighted average cost of capital (WACC), commonly referred to as the company’s cost of capital, represents
the minimum return that a company must earn on its existing assets. It reflects the weighted average rate of return a
company is expected to pay to all the providers of long-term finance. The weights are the fraction of each financing
source in the company’s total capital. WACC is influenced by the external market.
The WACC is derived by averaging a company’s cost of equity and cost of debt according to the market value of each
source of finance. The appropriate weights are the target capital structure weights expressed in market value terms.

<br></br> WACC = Ke x ( E / E + D) +Kg (1-t) x (D / E + D)
<br></br>

Where:
WACC = Weighted average cost of capital
E = Total market value of equity
D = Total market value of debt
t = Corporate tax rate
<br></br>
GRID
Market Value - 2nd column
Equity (shares x pps)
Debt (debentures x coupon rate)
Equity + debt bottom line
Weight - 3rd Column
E or D / E+D and put total
KW - 4th column
Multiply Ke and Kd % by weighting colum figures
<br></br>
Wacc = ADD THE 2 FIGURES PER COLUMN 4

Question 19

Capital structure

Answer 19

After determining the finance required for an investment or project, a company must consider the use of various sources
of finance . Capital structure refers to the mix of equity and debt financing that shows how the company, or its overall
operation, is financed. It is concerned with the balance between equity (shares and retained earnings) and non-current
liabilities (loans, debentures or fixed-return capital). The sources and the mix of capital are decided on the basis of need
of the company and the cost of capital.

Question 20

Main decisions re capital structuring

Answer 20

• the sources (form of capital)
• their quantity (amount to be funded)
• the use of their relative proportions in total capitalisation

Question 21

How can one measure the value of a company (for uses in financing/decisions re capital struture)

Answer 21

EBIT ÷ WACC
Market value (MV) = future cash flows ÷ WACC
<br></br>
Ex. if a project generates future cash flows of £100,000 at 10% WACC:
MV = £100 ÷ 10% = £1,000

Question 22

Main factors which effect capital structure (8)

Answer 22

• Financial leverage/gearing: EPS increase with use of long-term debt/preference share capital if company’s returns are higher than cost of debt
• Growth: equity financing popular with start ups and high growth industries like tech. High cost of servicing the debt restricts growth
• Cost principle: debt capital is cheaper than equity capital. Debt is less risk. Interest on debt is tax deductible for CT, but isn’t on dividends. Debt capital should minimise cost of capital and increase EPS
• Risk principle
  * Company - variability of earnings resulting in inadequate profit or ,loss due to company uncertainties (ex. lack of strateguic management, inadequate resources). Internal and external (ex. competition/overall economic climate)
  * Operating risk - risk of disruption of core operations of the company due to breakdown of systems, people and procedures. Operating gearing = proportion of fixed costs company has relative to variable costs..
  * Financial risk - risk from financing - risk of default if company cannot cover its fixed financial costs. Extent depends on leverage of capital structure. A company with debt financing has higher financial risk.
• Control principle : funds raised via equity - dilution / adverse affect on control. This would not happen if raise through debt capital.
• Market Conditions - ex. interest ratests higher in a struggling market due to economic uncertainties compared to the market in a ‘normal ‘ state
• Tax Exposure - tax deductibility of debt interest payments can increase attractiveness of debt finacing.
• Other Factors -ex. gov regs, trends in markets, capital structure of other companies, floation costs

Question 23

What is financial gearing?

Answer 23

Financial gearing measures the proportion of debt a company has relative to its equity. It is a measure of a company’s
financial leverage (also called ‘trading on equity’) and shows the extent to which its operations are funded by interest
bearing lenders versus shareholders.
Debt is normally cheaper than equity. Lenders are likely to require a lower return than shareholders because debt is
considered to be a less risky investment compared to investing in shares. Interest payable to debt lenders is normally
tax deductible, which makes the net cost of debt even lower. Debt financing should minimise the cost of capital and
maximise the EPS. A company with significantly more debt than equity is regarded as highly geared (or leveraged).
However, increasing the amount of debt or gearing in a company also increases risks for the shareholder because fixed
interest must be paid each year before the company is able to pay dividends.

Question 24

What are the two ways of calculating financial gearinfg?

Answer 24

Equity gearing = (Debt borrowing + preference share capital) / (Ordinary share capital + Equity)
Total or capital gearing = (Debt borrowing + preference share capital) / Total Long-Term Capital
<br></br>
Debt is the book or market value of interest-bearing financial liabilities. It could be in the form of a secured or
unsecured loan such as debentures, loans, redeemable preference shares, bank overdrafts or lease obligations. If
available, market values should be used for debt and for equity to get the best measure of gearing. An investor looks
for the market required rate of return on the market value of the capital, not the book value of the capital. When not
available, values from financial statements can be used.
With both methods, gearing will increase with higher proportions of debt.

Question 25

What is interest gearing and how can it be calculated

Answer 25

Interest gearing shows the percentage of profit absorbed by interest payments on borrowings. It measures the impact of
gearing on profits. It is calculated as:

Interest gearing = (Debt interest + preference dividends) / Operating Profit

Question 26

Ratio for determining effect of changes in operating profit on EPS

Answer 26

% change in EPS / % changes in EBIT

Question 27

Main problems around high levels of gearing

Answer 27

A high level of gearing implies a higher obligation for a company to pay interest when using debt financing. It has a
higher risk of insolvency than equity financing. While dividends on equity shares need only be paid when there are
sufficient distributable profits, the interest on debt is payable regardless of the operating profit of a company. Other
problems associated with high gearing include:
<br></br>
* bankruptcy risk increases with increased gearing;
* agency cost and restrictive conditions imposed in the loan agreements constrain management’s freedom of action,
* such as restrictions on dividend levels or on the company’s ability to borrow;
* after a certain level of gearing, companies will have no tax liability left against which to offset interest charges (tax
* exhaustion);
* companies may run out of suitable assets to offer as security against loans with high gearing;
* gearing increases the cost of borrowing; and
* directors have a natural tendency to be cautious about borrowing and the related solvency issues.

Question 28

What is meant by a highly geared company?

Answer 28

A highly geared company has a high ratio of long-term debt to shareholders’ funds. A high level of gearing implies a
higher obligation for the business in paying interest when using debt financing. It has a higher risk of insolvency than
equity financing. While dividends on ordinary share capital need only be paid when there are sufficient distributable
profits, the interest on debt is payable regardless of the operating profit of a company.
A review of the gearing ratio is key in the funding decisions made by financial managers and investors. It affects risk,
returns and controls associated with equity capital. Investors may require a higher return to compensate for the higher
risk associated with the higher gearing. According to the control principle, debt may also be preferred over equity to
minimise possible risk of loss of control.

Question 29

When might investors and other stakeholders prefer gearing and why?

Answer 29

Other stakeholders who have an interest in the profitability and stability of the company, including employees, customers
and particularly creditors, will also be interested in the level of gearing. Since debt capital is cheaper than equity
capital, debt financing should minimise the cost of capital and maximise the earnings per share. The interest on debt is
deductible for income tax purposes, making debt capital cheaper, whereas no such deductions are allowed for dividends.
Debt should be used to the extent that it does not threaten the solvency of the firm.

Question 31

What is operation gearing?

Answer 31

Operating gearing measures the proportion of fixed costs a company has relative to its variable costs. As with financial
gearing, fixed operating costs increase the risk for the shareholders in the same way as fixed interest payments. For
example, the costs of staff employed on annual contracts are fixed, whereas those employed on a day-to-day basis are
variable.

In times of growth, a high proportion of fixed costs and a low proportion of variable costs can be advantageous. There is
a cost advantage for producing a higher level of output, also referred to as economies of scale. Higher fixed costs mean
greater operational gearing that makes a company’s profits sensitive to a change in sales revenue – a small percentage
change in sales will lead to a large percentage in operating profit. With each pound in sales revenue earned beyond the
break-even point, the company makes a profit. The opposite is true in times of recession.

Question 32

How is operation gearing measured?

Answer 32

The common method of measuring operating gearing is to consider the level of contribution earned in relation to sales –
known as the contribution-to-sales ratio (C/S ratio). The contribution margin is the excess of total sales over total variable
costs. The margin will be positive if sales exceed variable costs and vice versa. Operating gearing can be calculated
using any one of the three ratios below:

Contribution-to-sales ratio = (sales revenue – cost of sales) / sales revenue x 100
The higher the operational gearing, the higher the sensitivity of profit to a change in sales.

% change in earnings before interest and tax / % change in sales
The higher the operational gearing, the higher the sensitivity of EBIT to a change in sales.

fixed costs / variable costs
The higher the fixed costs, the higher the operating gearing.

Question 33

What do capital structure theories seek to discover? (3)

Answer 33

• whether an optimal capital structure exists;
• the optimal mix between debt and equity finance; and
• the relationship between WACC, the market value of the company and the level of gearing in the capital structure.

Question 34

Traditional approach to capital structure

Answer 34

The traditional approach suggests an optimal capital structure is obtained by a blend of equity and debt financing that
minimises WACC while maximising its market value.
The WACC changes with the level of gearing because equity is more expensive than debt. Higher levels of gearing,
however, increase the risk to shareholders and therefore result in higher equity costs.
A company’s value initially increases alongside debt financing, as debt is cheaper than equity. After a certain point, it
begins to plateau and eventually decreases as levels of gearing increase. This decrease in value is caused by excessive
borrowings, also referred to as over-leveraging. Lenders will require higher rates of interest in order to compensate for
increased risk.
Under the traditional view, the only way of finding the optimal mix is by trial and error, as WACC will change with the level
of gearing. The optimal level of gearing is achieved when the WACC is at a minimum. This is illustrated in Figure 12.6.

Question 35

Gearing and the cost of equity (Ke)

Answer 35

An investor return (Ke) equals the risk-free rate (RFR) plus an additional return for financial risk (related to the gearing
of the company). At higher levels of gearing, the risk of investors increases with increased gearing due to the added
financial risk of borrowing.

Question 36

Gearing and the cost of debt (Kd)

Answer 36

The cost of debt remains constant until a point at which the increasing gearing increases the risk of lenders. The lender
will also require higher rates of interest in order to compensate for increased risk to interest payments and principal.

Question 37

Gearing and cost of debt and WACC

Answer 37

The overall cost of capital initially falls due to the introduction of debt, which is cheaper than equity. The low cost of debt
immediately reduces WACC until a point at which the increase in gearing causes both the cost of equity (Ke) and the
cost of debt (Kd) to increase. This causes WACC to increase. Point X is the optimal level of gearing, after which the cost
of capital carries on increasing as debt and gearing increase.
In the traditional approach, the financial manager should raise debt finance until it achieves the optimal level of gearing –
that which gives the cheapest overall cost of capital. Once achieved, the optimum level of gearing must be maintained by
keeping the same ratio of gearing (part equity/part debt) in future financing.

Question 38

Limitations of traditional approach to capital structure

Answer 38

• The traditional theory illustrates the importance of gearing and the optimal balance between equity and debt, but
  does not quantify the effect of changes in gearing. It locates the optimal point by trial and error.
• The traditional theory of capital structure ignores other real-world factors such as corporate tax rates and the
  investment habits of investors.
• It is based on the following assumptions:
  – the company distributes all of its earnings as a dividend
  – the company’s total assets and revenue are fixed
  – only debt and equity financing is available
  – investment habits remain rational
  – there are no taxes

Question 39

The Modigliani and Miller theory of capital structure

Answer 39

Modigliani and Miller (1958) argued that the relationship between the cost of capital, capital structure and the valuation
of the company should be explained by the net operating income approach. Under this approach, the levels of operating
income influence market value. This is known as the capital structure irrelevancy theory. It suggests that the valuation of
a company and the weighted average cost of capital are irrelevant to the capital structure of a company.
The basic concept of Modigliani and Miller’s (MM) approach is that the value of a company is independent of its capital
structure. Market value is determined solely by investment decisions. When the gearing increases, the increase in the
cost of equity (associated with the higher financial risk) exactly offsets the benefit of the cheaper debt finance. As WACC
remains unchanged, the value of a leveraged company is the same as the value of an unleveraged company if they
operate in the same type of company and have similar operating risks. The value of a company depends upon the future
operating income generated by its assets.
The MM hypothesis can be explained through two propositions.
MM proposition I
With the assumption of no taxes, capital structure or leveraging does not influence the market value of the company. It
assumes that debt holders and equity shareholders have the same priority in the earnings of a company and that the
earnings are split equally,
Value of the geared company = Value of the ungeared company (net operating income (NOI) ÷ WACC).
MM proposition II
The cost of equity is a linear function of the company’s debt equity ratio. With an increase in gearing, the equity
investors perceive a higher risk and expect a higher return, increasing the cost of equity. The rate of return required by
shareholders (Ke) increases in direct proportion to the debt/equity ratio.
The cost of equity in geared company Kg = the cost of ungeared company Ku + a premium for financial risk
<br></br>
As the gearing increases, the cost of equity rises just enough to offset any benefits conferred by the use of apparently
cheap debt (Kd). This means that WACC remains constant at all levels of gearing.
<br></br>
Under the MM theory, the company value depends upon future operating profits. The essential point made by M&M
is that the company’s cost of capital is independent of the way in which investment is financed. Arbitrage (market
pressures) will ensure that two identical companies, with same company risk and identical provisions before interest and
tax (PBIT), will have the same overall market value and cost of capital irrespective of their gearing level.

Question 40

Assumptions of MM theory without taxes

Answer 40

• No corporate taxation.
• No transaction costs relating to buying and selling securities or bankruptcy costs.
• Perfect capital markets with a symmetry of information. An investor will have access to same information that a
  company would and they react rationally.
• The cost of borrowing is the same for investors and companies.
• Debt is risk free.

Question 41

MM with taxes - trade-off theory

Answer 41

The impact of tax cannot be ignored in the real world, since debt interest is tax deductible. Modigliani and Miller revised
their theory in 1963 to recognise tax relief on interest payments.
The actual cost of debt is less than the nominal cost of debt because of tax benefits. However, the same is not the case
with dividends paid on equity. The trade-off theory advocates that a company can use debt as long as the cost of distress
or bankruptcy does not exceed the value of tax benefits. This is illustrated in Figure 12.8.
Cost of capital
K
e
WACC (K
o
)
Gearing Gearing
Value of
company
K
d
(1 – t)
Figure 12.8 The Modigliani and Miller theory with taxes
As gearing increases, the cost of equity (Ke) increases in direct proportion with gearing. However, as the overall cost of
debt after tax relief (Kd(1-t)) is lower than the nominal cost of debt (Kd), investor returns are less volatile. This leads to
lower increases in Ke, causing the WACC to fall as gearing increases.
Therefore, gearing up reduces the WACC and increases the market value of the company. The optimal capital structure
is 99.9% gearing. This means the higher the debt, the lower the WACC and the higher the market value. The company
should use as much debt as possible.

Question 42

Criticisms of MM trade-off theory

Answer 42

• It ignores bankruptcy risk. In practice, companies never gear up to 99.9%. As gearing increases, so does the
  possibility of bankruptcy. If the company is considered to be risky, the share price will go down, increasing the
  company’s WACC.
• Restrictive conditions in the loan agreements associated with debt finance can constrain a company’s flexibility to
  make decisions (such as paying dividends, raising additional debt or disposing of any major fixed assets).
• After a certain level of gearing, companies may no longer have any tax liability left against which to offset interest
  charges. Kd(1–t) simply becomes Kd due to tax exhaustion.
• High levels of gearing may not be possible with companies exhausting assets to offer as security against loans.
• Different risk tolerance levels between shareholders and directors may impact the gearing level.
• It can be argued that directors have a tendency to be cautious about borrowing.

Question 43

MM outline

Answer 43

The Modigliani–Miller theory states that capital structure is irrelevant and efforts to reduce the cost of capital using
gearing will not succeed.
<br></br>
* 1st proposition - the value of the geared firm equals the value of the ungeared firm (earnings before
interest ÷ WACC). The value of WACC is constant at all levels of gearing.
* 2nd proposition - that savings from debt being cheaper than equity are equal to the increase in the cost of
equity due to increased risk arising from gearing. The cost of equity in geared company Kg equals the cost of ungeared company Ku plus a premium for financial risk.
<br></br>
Later developments in the theory with the introduction of tax state that debt interest is tax-deductible, whereas ordinary
share dividends are not. The conclusions are that debt is, in fact, cheaper than equity. Tax relief on debt interest reduces
the WACC. Therefore, gearing up reduces the WACC and increases the market value of the company. The optimal
capital structure is 99.9% gearing. This means the higher the debt, the lower the WACC and the higher the market value.
The company should use as much debt as possible.

Question 44

Pecking order theory

Answer 44

The ‘pecking order’ theory popularised by Myers and Majluf (1984) was developed as an alternative theory on capital
structure. It states that companies have the following order of preference for financing decisions:
* retained earnings
* straight debt
* convertible debt
* preference shares
* equity shares
The reasoning is that as companies are risk averse and will prefer retained earnings to any other source of finance,
they will choose debt and equity last of all. They invariably prefer internal finance over external finance. The costs of
borrowing also follow the same order, equity shares being the most expensive.
The value of a project depends on how it is financed. If a company follows the pecking order approach, only projects
funded with internal funds or with relatively safe debt will be accepted. Risky projects funded by risky debts or equity will
be rejected.

Question 45

Real world factors and capital structuring

Answer 45

Companies take a balanced approach in the real world, whereby the different theories can be reconciled to make the
correct financing decisions. Capital structures can also be affected by other factors such as growth, market conditions
and tax exposure.
Companies consider the signalling effect of raising new finance by assessing the impact of the new finance on a
company’s statement of profit or loss and OCI and statement of financial position.
Profitable companies will tend to drift away from their optimal gearing position over time – known as ‘gearing drift’,
whereby the level of the debt-equity ratio gradually decreases as accumulated retained earnings help to increase the
value of equity. Companies tend to increase their gearing positions by occasionally issuing debt, paying a large dividend
or buying back shares.