CAPITAL STRUCTURE-theory & practice

Prof. William Coffie

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 Learning outcome

Critically evaluate:
⚫ Capital structure theory
⚫ The effect of gearing on capital structure
⚫ M&M world of tax under props I & II and no
tax theories
⚫ Problems of financial gearing
⚫ The pecking order theory

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 CAPITAL STRUCTURE
⚫ How should a firm choose its debt-equity ratio? Hence capital structure.
⚫ The Pie Theory - 40:60 or 60:40?
⚫ Value of a firm is comprised of its capital or financial structure.

V=B+E
where V = value of firm
B = market of value of debt
E = market value of equity

⚫ Financial risk arises when equity investors take additional burden of debt finance in
their capital structure.
⚫ Introduction of interest bearing debt ‘gears up’ the returns to shareholders.

⚫ Managers should choose the capital structure that they believe will give the highest firm
value and maximise shareholders wealth (i.e. combination of debt-equity ratio
that makes the pie as big as possible).

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 The Balance between Debt and Equity

⚫ Optimal capital structure: given the

ambiguity of financing decision, is there a
better capital structure?
⚫ In 2003 Bristol Water hand out £50m of
cash to shareholders as part of balance
sheet restructuring which they claim would
bring about efficient capital structure.
⚫ Debt was to amount to 65% of asset value in
Bristol Water.
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 Balance between Debt and Equity

⚫ In 2001 BT had over $30bn debt following

‘aggressive’ worldwide acquisition and infrastructure
investment.
⚫ As a call for alarm the company issue $5.9bn via
rights issue and sold off some assets and stop
paying dividend.
⚫ Next in 2002 implemented a share buy-back plan for
up to 19% of its shares in order to increase EPS.
⚫ M&S in 2004,Burberry in 2004 and Capita
resourcing group in 2002 all have implemented
share buy-back to either streamline their capital
5 structure or reduce cost of capital.
 Modigliani and Miller’s (M&M) world with
no-tax theory(1958)

⚫ Theory developed in 1958 on the premise that capital structure is

irrelevant, because as proportion of debt increased, the cost of equity
will rise to offset the benefit of cheaper debt finance and therefore
leave the WACC unchanged. Therefore the value of firm is unaffected
by changes in gearing levels and so gearing is irrelevant.
MM made two propositions:
⚫ MM Proposition I – the value of the firm is always the same under
different capital structure
⚫ MM Proposition II – risk and required return to shareholders rises with
gearing.
⚫ Underlying assumptions:
⚫ There is no taxation
⚫ There are no transaction costs
⚫ There is full information efficiency
⚫ Individual and corporate investors can borrow at the same rate.
⚫ All investors are rational and risk averse.
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 M&M

⚫ The total market value of any company is

independent of its capital structure.
⚫ M&M argued that the total market value of a
firm is the net present value of its income
stream,

i.e. v = c1
WACC,
But not the composition of its capital structure.
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 Gearing and cost of capital (WACC)

⚫ A firm’s cost of capital (WACC) depends on return needed to satisfy

both equity holders opportunity cost of capital kE and that of debt
holders kD.

⚫ WACC = kE WE + kD WD
where

WE and WD are proportions of equity and debt to total finance

respectively.

⚫ Let’s put some figures in the above equation whether we can possibly
deduce some optimal debt level and/or begin the capital structure
argument??????.

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 Illustration
⚫ Assume a firm with 20% cost of equity and 10% cost of borrowing. The equity
and debt weights are both 50%. What is WACC?

WACC = (20%x0.5) +(10% x 0.5) = 15%

⚫ Let’s assume the firm is expected to generate annual cash flow of $1m in
perpetuity,

⚫ V = C1
WACC

= $1m
0.15

= $6.667m

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 Illustration
⚫ If the debt ratio increased to70%,the following are three possible scenarios for this
financing decision;
S1. the cost of equity remains at 20%: shareholders do not respond to financial risk
pose by high gearing

WACC = (20% x 0.3) + (10% x 0.7) = 13%

Value of firm and shareholder wealth will increase as a result of decrease in overall cost
of capital,

V = $1m = $7.69
0.13

S2. cost of equity capital rises to 26.67% due to increased financial risk to exactly offset
the lower cost of debt,

WACC = (26.67%x0.3) + (10%x0.7) = 15% thus V = $6.667m

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 Illustration
S3. cost of equity rises to 40% more than offset the effect of the
lower cost of debt. Equity holders demand higher compensation
for the additional risk of liquidation.

WACC = (40%x0.3) + (10%x0.7) = 19%

V = $1m
0.19
= $5.26m

⚫ The first scenario is unrealistic to a large extent, because as the

amount of debt is increased the riskiness of shares will rise and
shareholders will demand for higher return.
⚫ It is around scenarios 2 and 3 that we have the capital structure
debate.

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 Illustration

For example, MgMiller plc needs $1m to invest in building and

machines and the required return for an all equity firm at that
level of systematic risk is 15%.The expected annual cash flow
is a constant $150,000 in perpetuity. Assume all cash flows are
returned to investors (both shareholders and bondholders).
Let's also assume three different capital structures for MgMiller.
Structure 1 all-equity (1m shares selling at $1 each)
Structure 2 $500,000 of debt capital at 10% rate pa plus
$500,000 of equity capital (500,000 shares at $1 each)
Structure 3 $700,000 of debt capital at 10% rate pa plus
$300,000 of equity capital (300,000 shares at $1 each).
Evaluate MgMiller’s capital structure and total value of the
company. Assume that the company pays no corporate tax.

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 MgMiller capital structure and returns
to shareholder

structure 1 structure 2 structure 3

$ $ $
Annual CF 150,000 150,000 150,000
Less interest 0 50,000 70,000
Dividends 150,000 100,000 80,000
KD 0 50/500 = 10% 70/700 = 10%
KE 150/1m = 15% 100/500 = 20% 80/300 = 26.7%
Price of share(d1/KE) 15c = 100c 20c = 100c 26.7c = 100c
0.15 0.20 0.267
WACC (15%x1)+0=15% (20%x0.5)+(10%x0.5)=15% (26.7%x0.3)+(10%x0.7) = 15%
MV of debt 0 $500,000 $700,000
MV of Equity 150/0.15 = $1m 100/0.2 = $500,000 80/0.267 = $300,000
Total value of firm
V = VD + VE $1,000,000 $1,000,000 $1,000,000

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 Cost of debt, equity and WACC under
MM no-tax theory

⚫ Graph KE

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WACC

10 KD

Debt/equity

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Required return to equityholders of a
geared firm.

⚫ According to MM proposition II the expected return on equity is positively

related to leverage, because the risk to equityholders increases with gearing
⚫ Required return expected by a geared equityholders would be:

RE = RO + B (RO-RB) 15%+500/500(15%-10%)
E

Where:
RE = cost of equity for a geared firm
RO = cost of capital for an all equity firm
B/E = debt-equity ratio
RB = Cost of debt
According to proposition I WACC is unchanged regardless of the capital Structure
therefore value of a geared firm (VG) is equal to the value of an all equity firm (VE).

VG = VE
 Value of firm under M&M no-tax theory

⚫ If cash flow and WACC are both constant,

then the total value of firm is constant.

value $m v

Debt/equity

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 M&M: An Interpretation

⚫ Managers cannot change the value of a firm by repackaging the

firm’s securities.
⚫ The overall firm’s cost of capital (WACC) cannot be reduced as
debt is substituted for equity, even though debt appears to be
cheaper than equity
⚫ This is because as a firm increases its debt level, shareholders
notice the riskiness of their investment and therefore demand
higher return (risk premium for financial risk) .
⚫ And this increases the cost of remaining equity which exactly
offset the higher proportion of the firm financed by low-cost debt
capital.

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 M&M in a new world of tax theory(1963)

⚫ MM adjusted their first model to include taxes.

⚫ Using debt capital reduces tax bill.
⚫ Value of firm increases as debt is substituted for equity in the
capital structure due to tax benefits (or tax shield).
⚫ Gearing up capital structure reduces WACC and increases the
Market Value (VE + VB) of the company.
⚫ The company should use as much debt as possible(100%).
⚫ Glas Cymru in Wales is fully debt finance company. This
reduces the firm’s cost of capital to 4% as compared to 6%
industry average.
⚫ Managers should choose the capital structure that the IRS
hates the most.

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ILLUSTRATION

William Industries has a corporate tax, tc, of 35% and

expected earnings before interest and tax (EBIT) of
$1m. William Industries would fund its project with all
equity under plan I. Under plan II, the company
would have $4m of debt, B. The cost of debt is, RB,
is10%. William Industries has a total asset value of
$8m.
Determine the level of returns to investors, return on
assets (ROA) and return on equity (ROE).
 ILLUSTRATION

Plan I Plan II
Assets $8,000,000 $8,000,000
EBIT $1,000,000 $1,000,000
Interest (RBB) 0 400,000
EBT(EBIT-RBB) 1,000,000 600,000
Taxes (tc = 35%) 350,000 210,000
Earnings After Tax 650,000 390,000
Total CF to both shareholders
& bondholders{EBIT x (1-tc)+tcRBB} $650,000 $790,000
Return on asset(ROA){1m/8}//[1m/8m] 12.5% 12.5%
Return on equity(ROE){0.65/8m}//[0.39m/4m] 8.1% 9.8%
More cash flow reaches owners of the firm both shareholders and bondholders under plan II.
The difference is $140,000(790,000-650,000).
The IRS receives less taxes under plan II ($210,000) than it does under plan I($350,000). The
difference is $140,000 = ($350,000 - $210,000) ≡ 35% x 400,000 = $140,000
20 Return on assets are the same because this ratio is calculated before interest is considered.
The Tax Shield from Debt
Interest = RB x B

⚫ Reduction in corporate taxes is:

TC x RB x B

⚫ That is whatever the taxes that a firm would pay each year without debt, the
firm will pay TCrBB less with the debt of B
⚫ If a firm expects to be in a positive tax bracket in the future, then we can
assume that the cash flow has the same risk as the interest on debt.
⚫ Assume that the cash flows are perpetual, the present value (PV) of tax shield
is:

TC rB B = TCB
rB
 Implication

⚫ Debt capital reduces the tax bill

⚫ Overall corporate value increases as debt is
substituted for equity in capital structure.
⚫ WACC declines for each unit increase in debt
as far as there is taxable profit.
⚫ Cost of equity will increase as debt is
introduced but not sufficient enough to offset
the cheaper debt as found in no-tax theory.

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 MM with corporate tax

Graph ke
Cost of capital%

WACC

kd(1-tc )

Debt/equity
RE = RO + B/E (RO-RB)(1-t)

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 Capital structure and CAPM

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 ⚫ Adjust the asset beta to ascertain the equity
beta using the accounting equation
⚫ Beta of asset = (equity beta*proportion of
equity) + (Debt beta * proportion of debt)

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 Problems with high gearing
Bankruptcy or financial distress Cost ( or Risk)
⚫ At higher level of gearing, where bankruptcy becomes a possibility,
shareholders will require a higher rate of return to compensate them for facing
financial risk.
⚫ This will increase WACC and reduce firm value.
⚫ Legal and administrative costs of liquidation or reorganisation
⚫ Indirect cost of impaired ability to conduct business

Agency Costs
⚫ If gearing levels are high and shareholders have less funds in the company,
they prefer managers to undertake risky projects with higher returns since they
will benefit from this.
⚫ In order to safeguard their investment, debt holders will impose restrictive
conditions in the loan agreement, such as level of dividend payment, level of
additional debt or kind of capital investment undertaken.
⚫ These restrictions also help to reduce cost of debt

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 Problems with high gearing

Signalling Effect
⚫ Managers will increase the gearing level if
they are confident in the future.
⚫ Increase in gearing level should increase
share price as it signals increased optimism.

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 THE PECKING ORDER THEORY
(Donaldson 1961)

⚫ It is argued that firms will raise new funds as follow:

⚫ Internally-generated funds, because retained
earnings is already available, no negotiation or
dealing with third party and no issue costs.
⚫ Debt – issue costs is low and tax efficient
⚫ New issue of equity – expensive issue costs,
expensive questioning and publicity associated with
a share issue, notwithstanding prospectus.

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