Capital Structure

Capital Structure Lecture 8 Dr Francesca Gagliardi 2BUS0197 – Financial Management

Learning outcomes By the end of the session students should be able to: Appreciate the traditional approach to the existence of an optimal capital structure Understand Modigliani and Miller’s propositions on capital structure Explain the rational underlying the pecking order theory Critically discuss whether a company can influence its cost of capital by adopting a particular capital structure

Knowledge development • Last week we looked at how a company can determine its average cost of capital (WACC) by calculating the costs of the various sources of finance used and weighting them according to their relative importance • The market value of a company depends on its WACC • The lower the WACC, the higher the NPV of future cash flows, hence a company’s market value • We now need to consider whether the way in which a company’s financing decisions affect its WACC

Key questions Does the mix of debt and equity finance used by a company affect its weighted average cost of capital? Is there a mix of debt and equity that will minimise the average cost of capital? A minimum cost of capital will maximise the market value of the firm and hence maximise shareholder wealth The academic debate on the above questions has been controversial

The traditional approach Simplifying assumptions No taxes exist Financing choice is between ordinary shares and perpetual debt Capital structure changes incur no cost and entail replacing debt with equity or vice versa All earnings are paid out as dividends Business risk is constant over time Earnings and hence dividends are constant

Key proposition An optimal capital structure exists A company can increase its total value by sensibly using debt finance within its capital structure The combination of debt and equity finance that minimises a company’s overall cost of capital should be selected as this enables shareholder wealth maximisation

The traditional approach to capital structure Cost (%) Ke • Ke increases as gearing increases due to rising financial risk and, later, bankruptcy risk • Kd rises at high levels of gearing due to bankruptcy risk • As the company starts to replace expensive equity with cheaper debt, WACC falls • As gearing continues to increase, Ke and Kd increase, offsetting the benefit of cheap debt • Point A: the firm is entirely financed by equity • Point B: minimum WACC WACC A Kd B 0 Optimal capital structure Debt/Equity

Modigliani and Miller (I): the net income approach (1958) Capital markets are assumed to be perfect No risk of bankruptcy so Kd curve is flat Linear increase in Ke due to increasing financial risk As the company gears up and replaces equity with debt, the benefit of cheaper debt is exactly balanced by the increasing cost of equity No optimal capital structure is found

Modigliani and Miller (I): the net income approach • In their model, beside the assumptions previously discussed, capital markets are assumed to be perfect • Bankruptcy risk can be ignored as firms in financial distress can always raise additional finance • The key proposition is that a company’s WACC remains unchanged at all levels of gearing, implying that NO optimal capital structure exists for a particular firm • The market value of a company depends on its expected performance and commercial risk • A firm’s market value and its cost of capital are independent of its capital structure

Net income approach Cost (%) • The Ke line shows a linear relationship between the cost of equity and financial risk (level of gearing) • Since debt holders do not face bankruptcy risk, Kd is horizontal to illustrate that the cost of debt is independent of the level of gearing • WACC is constant as the benefit of using an increased level of cheaper debt finance is exactly offset by the increasing cost of equity finance • Since WACC is constant, net income is constant too and so is the firm’s market value Ke A WACC Kd 0 Debt/Equity

Implications of M&M proposition I • The WACC of a geared company is identical to the cost of equity the company would have if it were financed entirely by equity • The cost of equity is determined by the risk-free rate of return and the business risk of the company • Cost of equity independent of financial risk (i.e. level of gearing)

M&M (I) and arbitrage theory • Miller and Modigliani supported their argument of capital structure irrelevance in determining a firm’s market value and WACC by using arbitrage theory • Arbitrage proof using companies A and B: A B Net income 1000 1000 Interest at 5% Nil 150 Earnings 1000 850 Divide by cost of equity 10% 11% MV of equity 10 000 7 727 MV of debt Nil 3 000 Total market value 10 000 10 727 WACC 10% 9.3%

M&M (I) and arbitrage theory Assume you own 1% of B’s shares (i.e. £77.27): (1) Sell your shares for £77.27 (2) Borrow £30 to copy B’s gearing (x : £77.27 = £3000 : £7727) (3) Buy 1% of A’s shares for £100 [(£30 + £ 77.27) – 100 = surplus of £7.27] Original situation • Return on B’s shares: 11% × £77.27 = £8.50 New situation • Return on A’s shares: 10% × £100 = £10 • Less interest: £30 × 5% = £1.50 leaves £8.50 • Same return but you now have £7.27 surplus, i.e. an arbitrage profit • The process would repeat until the opportunity to earn a profit disappears and the companies’ WACC are equal

Modigliani and Miller (II): corporate tax (1963) Miller and Modigliani adjusted their first model to reflect the existence of corporate tax and the tax deductibility of interest payments Gearing up by replacing equity with debt gives the benefit of a tax shield, increasing the value of company This implies that an optimal capital structure does exist: this is 100% debt finance Kd curve falls from before-tax to after-tax level, so WACC curve slopes downwards

Modigliani and Miller (II) Ke Cost (%) WACC Kd Kd(1 –CT) 0 Debt/Equity

Modigliani and Miller (II) Cost (%) Ke • The tax advantage enjoyed by debt finance over equity finance means that WACC decreases as gearing increases • Hence, the optimal capital structure is one that uses as much debt finance as possible (ideally 100%) WACC Kd(1 –CT) 0 Debt/Equity

Market imperfections • Since in practice firms do not adopt an all-debt capital structure, this means that there are market imperfections which undermine the tax advantages of debt finance • These factors are: • Bankruptcy costs • Agency costs • Tax exhaustion

Bankruptcy costs By assuming perfect capital markets, Modigliani and Miller’s second proposition ignores bankruptcy costs In reality at high levels of gearing there is a default risk on interest payments, hence a bankruptcy risk Hence, at high levels of gearing shareholders require a higher rate of return to compensate them from facing bankruptcy risk Combining the tax shield advantage of increasing gearing with the bankruptcy costs associated to high gearing, an optimal capital structure emerges

Modigliani and Miller incorporating bankruptcy risk Firm’s market value Market value with tax benefit Market value with tax and bankruptcy costs C B A D Market value of all-equity firm Optimal capital structure Debt/Equity 0 X Y

Agency costs With high gearing levels shareholders have a lower stake in the company and have fewer funds at risk if the company fails Shareholders will prefer the company to invest in high-risk high-returns projects since they will enjoy the benefit of the higher returns If those projects were undertaken, providers of debt finance would not share the higher returns (their returns are not related to firm’s performance). They would only be exposed to a higher risk Debt financiers will take steps to prevent the company from starting high-risk projects (e.g. restrictive covenants, increased management monitoring) The above agency costs will reduce the tax shields benefits associated with increasing gearing levels

Tax exhaustion Many companies have insufficient profits from which to derive all available tax benefits as they increase their gearing level This will prevent them from enjoying the tax shield benefits associated with high gearing, but still leave them liable to incur bankruptcy costs and agency costs

Pecking order theory • Donaldson (1961): companies have a well-defined order of preference with respect to the sources of finance available to them • First preference is internal finance or retained earnings • Next, bank borrowings and corporate bonds • Finally, issue of new equity • The order of preferences is based on issue costs and the ease with which financing sources are accessed • Myers (1984) suggested that the pecking order is explained by asymmetric information between firms and capital markets

Recap on existence of optimal capital structure (OCS) Traditional approach: OCS exists Modigliani and Miller I: no OCS is found Modigliani and Miller II: OCS is 100% debt Market imperfections: OCS exists In practice, rather than one optimal capital structure existing for each firm, a range of optimal capital structures may exist

A practical view Cost (%) Theoretical WACC WACC in practice 0 OCS Debt/Equity A range of optimal capital structures

Summary Today we discussed the main theoretical approaches to the existence of an optimal capital structure and We evaluated the extent to which they seem to be relevant in practice

Readings Textbook Watson, D. and Head, A. (2009). Corporate Finance. Principles & Practice, 5th Ed, FT Prentice Hall, Chapter 9 Research papers Bradley, M., Jarrell, G. A., Kim, E. H. (1984). On the Existence of an Optimal Capital Structure: Theory and Evidence, Journal of Finance, vol. 39, 3, pp. 857-878 Modigliani, F., Miller, M. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review, vol. 48, pp. 261-96 Modigliani, F., Miller, M. (1963). Taxes and the Cost of Capital: A Correction, American Economic Review, vol. 53, pp. 433-43

Your coursework is due by 9pm on Friday 2nd April

Capital Structure