The Capital Structure debate Corporate Finance 35 Capital

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 £ 50 m 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 £ 30 bn – 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. 9 bn 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 £ 435 m 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 (1) = Capital gearing (2) = Capital gearing (3) = Long-term debt Shareholders’ funds Long-term debt + Shareholders’ funds All borrowing + Shareholders’ funds Long-term debt Capital gearing (4) = 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 £ 3 m debt (carrying 10 per cent interest) and £ 7 m equity – 3 £ 5 m debt (carrying 10 per cent interest) and £ 5 m 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)

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 C 1 V = ––––––– WACC Value of the firm, V = VE + VD WACC = k. E WE + k. D 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 £ 1 m C 1 £ 1 m V = ––––– = £ 6. 667 m 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 = k. E WE + k. D WD WACC = (20% × 0. 3) + (10% × 0. 7) = 13% C 1 £ 1 m V = ––––– = £ 7. 69 m 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 = k. E WE + k. D 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 = k. E WE + k. D WD WACC = (22% × 0. 3) + (10% × 0. 7) = 13. 6% C 1 £ 1 m = £ 7. 35 m 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% C 1 £ 1 m V = ––––––– = £ 5. 26 m 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: C 1 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 £ 1 m 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 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

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 = £ 1 m C 1 £ 150, 000 V = –––––––––– = £ 1 m 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. 5 m Market value of debt ––––––––––––––––––– = 0. 40 Market value of debt + Market value of equity k. D = 9% regardless of gearing ratio. At a gearing level of 40%, k. E = 22%. WACC = k. E WE + k. D 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