The Capital Structure Debate 2 Corporate Finance 36

Capital structure: further considerations • Capital structure in a world with tax • Financial distress • Agency costs • Borrowing capacity • Managerial preferences • Pecking order • Financial slack • Signalling • Control • Industry group gearing • Motivation, reinvestment risk, operating and strategic efficiency

The capital structure decision in a world with tax • The introduction of taxation brings an additional advantage to using debt capital: it reduces the tax bill • In a 30 per cent corporate tax environment a profitable firm’s cost of debt falls from a pre-tax 10 per cent to only 7 per cent after the tax benefit: • 10% (1 – T) = 10% (1 – 0. 30) = 7%

Financial distress: where obligations to creditors are not met or are met with difficulty.

Costs of financial distress

The cost of capital and the value of the firm with taxes and financial distress, as gearing increases “Trade-off model”

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

The characteristics of the underlying business influences the risk of liquidation/distress, and therefore WACC, and the optimal gearing level

Agency costs • Agency costs are the direct and indirect costs of attempting to ensure that agents act in the best interest of principals as well as the loss resulting from failure to get them to act this way • Agency costs for lenders • Information asymmetry • Lenders will require a premium on the debt interest to compensate for the additional cost of monitoring • Restrictions (covenants) built into a lending agreement • Psychological element related to agency costs; managers do not like restrictions placed on their freedom of action

A few more factors • Borrowing capacity • Managerial preferences • Financial slack • Signalling • Control • Industry group gearing

Pecking order • Firms prefer to finance with internally generated funds • If still more funds are needed, the debt market is called on first • Only as a last resort will companies raise equity finance • Myers (1984): ‘In this story, there is no well-defined target debt–equity mix, because there are two kinds of equity, internal and external, one at the top of the pecking order and one at the bottom’ • Supposedly stock markets perceive an equity issue as a sign of problems – an act of desperation • Adverse selection problem • Line of least resistance • Shares are more expensive to issue than debt capital, which is more expensive than applying previously generated profits

Some further thoughts on debt finance • Motivation • Reinvestment risk • Operating and strategic efficiency

The WACC is U-shaped and value can be altered by changing the gearing level

Lecture review • The risk of financial distress • Agency costs • Borrowing capacity • Managerial preference • The pecking order of finance • Financial slack, signalling, control, industry group gearing • High gearing motivates managers to perform • Reinvestment risk • Operating and strategic efficiency