The Capital Structure debate
Corporate Finance 35
Capital structure: An introduction to the debate
• Different types of gearing
• The effect of gearing
• Differentiate business and financial risk
• The underlying assumptions, rationale and conclusions
and Miller’s models in a world without tax
of Modigliani
The balance between debt and ordinary share captial
• Bristol Water announced plans to hand out £50m of cash to shareholders in
2003
– ‘Bristol Water was overcapitalised and it was time to do something for the
shareholders’
• In 2001 BT had accumulated debt of over £30bn
– Sir Peter Bonfield recognised that he had allowed the debt to rise too high. ‘We
identified the need to introduce new equity capital into the business to support
the reduction in the unsustainable level of group debt’
– Raised £5.9bn through a rights issue
• Next implemented a share buy-back plan for up to 19 per cent of its shares
in 2002, following the return of £435m to shareholders through buy-backs in
the 2000–2 period
– David Jones, chairman, said the share buy-backs represented the best way to
enhance earnings per share
At low gearing levels the risk of financial distress is low, but the cost of capital is
high; this reverses at high gearing levels
Note: *This assumption is considered in the text.
What do we mean by ‘gearing’?
• Operating gearing refers to the extent to which the firm’s total
costs are fixed
• Financial gearing concerns the proportion of debt in the capital
structure
• Gearing and leverage are used interchangeably
• Balance sheet (book) figures
• Market values of debt and equity
• Capital gearing focuses on the extent to which a firm’s total
capital is in the form of debt
• Income gearing is concerned with the proportion of the annual
income stream (that is, the pre-interest profits) which is
devoted to the prior claims of debtholders
Capital gearing
Capital gearing (1) =
Capital gearing (2) =
Capital gearing (3) =
Capital gearing (4) =
Long-term debt
Shareholders’ funds
Long-term debt
Long-term debt + Shareholders’ funds
All borrowing
All borrowing + Shareholders’ funds
Long-term debt
Total market capitalisation
Income gearing
• It may be erroneous to focus exclusively on assets when
company’s ability to repay debts
Profit before interest and tax
Interest cover = ––––––––––––––––––––––––––––
Interest charges
The inverse of interest cover measures the proportion
of profits paid out in interest – this is called income
gearing
trying to judge a
The effect of gearing
• If operating profits are high, the geared firm’s
shareholders will experience a more than proportional
boost in their
returns compared to the ungeared firm’s
shareholders
• Harby plc is shortly to be established
• Capital structures:
– 1 All equity – 10 million shares sold at a nominal value
of £1
– 2 £3m debt (carrying 10 per cent interest) and £7m equity
– 3 £5m debt (carrying 10 per cent interest) and £5m equity
Probabilities of performance levels
* Taxes are to be ignored.
The effect of gearing
Changes in shareholder returns for ungeared and geared capital structures
Expected returns and standard deviations of return to shareholders in Harby plc
Expected returns and standard deviations of return to shareholders in Harby plc
(continued)
Expected returns and standard deviations of return to shareholders in Harby plc
(continued)
Business risk and financial risk
• Business risk is the variability of the firm’s operating
is, the income before interest
income, that
• Financial risk is the additional variability in returns to
shareholders
that arises because the financial structure
contains debt
The value of the firm and the cost of capital
C1
V = –––––––
WACC
Value of the firm, V = VE + VD
WACC = kE WE + kD WD
Assume the cost of equity capital is 20 per cent, the cost of
debt capital is 10 per cent, and the equity and debt weights
are both 50 per cent
WACC = (20% × 0.5) + (10% × 0.5) = 15%
• The firm is expected to generate a perpetual annual cash
flow of £1m
C1
£1m
V = –––––––– = ––––– = £6.667m
0.15
WACC
Does the cost of capital (WACC) decrease with higher debt levels?
• Let us assume that the debt ratio is increased to 70 per cent through
the substitution of debt for equity
• Scenario 1 The cost of equity capital remains at 20 per cent
WACC = kE WE + kD WD
WACC = (20% × 0.3) + (10% × 0.7) = 13%
C1
£1m
V = –––––––– = ––––– = £7.69m
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
WACC = kE WE + kD WD
WACC = (26.67% × 0.3) + (10% × 0.7) = 15%
Change the WACC
• Scenario 3 The cost of equity capital rises, but this does
not completely offset all the benefits of the lower cost of debt capital
WACC = kE WE + kD WD
WACC = (22% × 0.3) + (10% × 0.7) = 13.6%
C1
£1m = £7.35m
V = ––––––– = ––––––
0.136
WACC
• Scenario 4 The cost of equity rises to more than offset the
effect of the lower cost of debt
WACC = (40% × 0.3) + (10% × 0.7) = 19%
C1
£1m
V = ––––––– = –––––– = £5.26m
WACC
0.19
Modigliani and Miller’s argument in a world with no taxes
Proposition 1
• The total market value of any company is independent of its capital
structure
• The total market value of the firm is the net present value of the
income stream. For a firm with a constant perpetual income
stream:
C1
V = –––––––
WACC
The WACC is constant because the cost of equity capital rises to
exactly offset the effect of cheaper debt
MM: The assumptions
1 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
4 Firms can be classified into distinct risk classes
5 Individuals can borrow as cheaply as corporations
Pivot plc
• It needs £1m capital to buy machines, plant and buildings
• Required return is 15 per cent
• Expected annual cash flow is a constant £150,000 in
perpetuity
• 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)
Pivot plc: capital structure and returns to shareholders
Pivot plc: capital structure and returns to shareholders
The cost of debt, equity and WACC under the MM no-tax model
If WACC is constant and cash flows do not change, then the total value of the firm
is constant
V = VE + VD = £1m
C1
£150,000
V = ––––––––
= –––––––––– = £1m
WACC
0.15
MM’s propositions
• Proposition 2
– The expected rate of return on equity increases proportionately
with the gearing ratio
• Proposition 3
– The cut-off rate of return for new projects is equal to the
weighted average cost of capital – which is constant regardless
of gearing
Cost of equity capital for a geared firm that becomes an all-equity financed firm in
a world with no taxes
What would the cost of equity capital be if the firm described
below is transformed into being all equity financed rather than
geared?
Perpetual future cash flow of £2.5m
Market value of debt
–––––––––––––––––––––––––––––––––––––– = 0.40
Market value of debt + Market value of equity
kD = 9% regardless of gearing ratio.
At a gearing level of 40%, kE = 22%.
WACC = kE WE + kD WD
WACC = (22 × 0.6) + (9 × 0.4) = 16.8%
Lecture review
• Financial gearing
• Operating gearing
• Capital gearing
• Income gearing
• The effect of financial gearing
• Business risk
• Financial risk
• Modigliani and Miller’s perfect no-tax world