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
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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.
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
OHT 18.5
INCOME GEARING
Interest cover = Profit before interest and tax Interest charges
The inverse of interest cover is called income gearing.
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
OHT 18.6
INCOME GEARING
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
(%)
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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%
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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 =
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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.
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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).
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
%
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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.
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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 %
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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.
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
OHT 18.29
OTHER FACTORS AFFECTING LEVELS OF DEBT (2)
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
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
OHT 18.30
OTHER FACTORS AFFECTING LEVELS OF DEBT (3)
5 Financial slack
6 Signalling
7 Control
8 Industry group gearing
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
OHT 18.31
IDEAS ON DEBT FINANCE
• Motivation
• Reinvestment risk
• Operating and strategic efficiency
18 CAPITAL STRUCTURE
Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002
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
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