Capital Structure Lecture 8 Dr Francesca Gagliardi 2BUS0197 – Financial Management
Dec 16, 2015
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
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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
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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
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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
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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
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The traditional approach to capital structure
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
Debt/Equity0
Cost (%) Ke
WACC
Kd
Optimal capitalOptimal capitalstructurestructure
A
B
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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
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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
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Net income approach 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
WACC
Kd
Cost (%)
Debt/Equity0
Ke
A
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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)
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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% 12
M&M (I) and arbitrage theoryAssume 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 13
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
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Modigliani and Miller (II)
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%)
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Debt/Equity0
Ke
WACC
Kd(1 –CT)
Cost (%)
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
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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
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Modigliani and Miller incorporating bankruptcy risk
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Market value with tax benefit
Market value of all-equity firm
Market value with tax and bankruptcy costs
0
Firm’s market value
Optimal capitalOptimal capitalstructurestructure
Debt/Equity
X Y
A
B
C
D
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
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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
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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
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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
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A practical view
Theoretical WACC
WACC in practice
OCS0
A range of optimal capital structures
Debt/Equity
Cost (%)
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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
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ReadingsTextbook 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
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