Chapter 18 - Capital structure

Question 1

Financial gearing

Answer 1

A measure of the extent to which debt is used in the capital structure.

Equity gearing = Preference share capital plus long-term debts/ Ordinary share capital and reserves

Total or capital gearing = Preference share capital plus long-term debt/ Total long-term capital

Interest gearing = Debt interest/ Operating profits before interest and tax

Question 2

Modigliani & Miller (M&M) - 1958 theory with no taxation

Answer 2

M&M argued that:

1. As investors are rational, the required return of equity is directly proportional to the increase in gearing. Therefore a linear relationship between K(e) and gearing exists.
2. The increase in K(e) exactly offsets the benefit of the cheaper debt finance and therefore WACC remains unchanged.

Conclusion:

1. The WACC and the value of the firm are unaffected by changes in gearing levels and gearing is irrelevant.
2. Choice of finance is irrelevant to shareholder wealth, company can use any mix of funds.

Question 3

Assumptions underpinning M&Ms theory

Answer 3

1. No taxation.
2. Perfect capital markets where investors have the same information.
3. No transaction costs.
4. Debt is risk free.

Question 4

M&M - 1963 theory with tax

Answer 4

1. As investors are rational, the required return of equity is directly linked to the increase in gearing. As gearing increases, K(e) increases in direct proportion.

However, this is adjusted to reflect the fact that:

• Debt interest is tax deductible so the overall cost of debt to the company is lower than in M&M - no tax.
• Lower debt costs results in less volatility in returns for the same level of gearing which leads to lower increases in K(e).
• The increase in K(e) does not offset the benefit of the cheaper debt finance and therefore. The WACC falls as gearing increases.

Conclusion:

1. Gearing up reduces the WACC and increases the MV of the company. The optimal capital structure is 99.9% gearing.
2. The company should use as much as possible.

Question 5

The problems of high gearing

Answer 5

1. Bankruptcy risk.
   As gearing increases so does the possibility of bankruptcy. If shareholders become concerned, this will increase the WACC of the company and reduce the share price.
2. Agency costs: restrictive conditions.
   To safeguard their investments
   - On the level of dividends
   - On the level of additional debt that can be raised
   - On management form disposing of any ,ajar fixed assets without the debenture holders agreement
3. Tax exhaustion.
   After a certain level of gearing, companies will discover that they have no tax liability left against which to offset interest charges.

K(d)(1-t) becomes K(d)

4. Borrowing/ debt capacity.
   High levels of gearing are unusual because companies run out of suitable assets to offer as security against loans.
   Companies with assets which have an active second hand market and with low levels of depreciation have a high borrowing capacity.
5. Difference risk tolerance levels between shareholders and directors.
   Business failure can have a far greater impact on directors than a well diversified investor.
6. Restrictions in the AOA may specify limits on the company’s ability to borrow.
7. The cost of borrowing increases as gearing increases.

Question 6

Pecking order theory

Answer 6

1. There is no search for an optimal capital structure through a theorised process. Instead, firms will raise new funds as follows:

• Internally generated funds
• Debt
• New issue of equity

Internally generated funds:

• Already have the funds.
• Do not have to spend any time persuading outside investors of the merits of the project.
• No issue costs.

Debt:

• The degree of questioning and publicity associated with debt is usually less than the associated with a share issue.
• Moderate issue costs.

New issue of equity:

• Perception of stock markets it is a sign of problems.
• Expensive issue costs.

Question 7

Summary of gearing theories

Answer 7

1. Traditional theory:
   Net effect as gearing increases: The WACC is U-shaped.
   Impact on WACC: At optimal point, WACC is minimised.
   Optimal finance method: Find and maintain optimum gearing ratio.
2. M&M (No tax):
   Net effect as gearing increases: Cheaper debt = Increase in K(e).
   Impact on WACC: WACC is constant.
   Optimal finance method: Choice of finance is irrelevant - use any.
3. M&M (with tax):
   Net effect as gearing increases: cheaper debt > Increase in K(e).
   Impact on WACC: WACC falls.
   Optimal finance method: As much debt as possible.
4. The pecking order:
   Net effect as gearing increases: No theorised process.
   Impact on WACC: No theorised process.
   Optimal finance method: Simply line of least resistance. First internally generated funds, then debt and finally new issue of equity.

Question 8

Understanding betas

Answer 8

1. Beta(Asset) reflects purely the systematic risk of the business area.
2. Beta(Equity) reflects the systematic risk of the business area and the company specific financial structure.

Question 9

Using betas in project appraisal

Answer 9

1. Find an appropriate asset beta.

De-gear a given equity beta.

Beta(Asset) = Beta(Equity) x [V(e)/ (V(e) + V(d)(1-t)]

V(e) = market value of equity
V(d) = market value of debt
T = Corporation tax rate

2. Re-gear the asset beta to convert it to an equity beta based on the gearing levels of the company undertaking the project. The same formula above can be used except this time V(e) and V(d) will relate to the company making the investment.
3. Use the re-geared beta to find K(e) using CAPM.

Required return = Rf + Beta(Rm - Rf)

Rf = risk-free rate
Rm = average return on the market
(Rm - Rf) = equity risk premium (average market risk premium)
Beta = The beta factor calculated in Step 2.

Question 10

Operating gearing

Answer 10

A measure of the extent to which a firms operating costs are fixed rather than variable as this affects the level of business risk in the firm.

Operating gearing= Fixed costs/ Variable costs

Or Fixed costs/ Total costs

Or % change in EBIT/ % change in turnover