CAPITAL STRUCTURE (GEARING)

1.0 INTRODUCTION

The cost of capital of a firm is fundamental in the decision as to whether a proposed

project is acceptable. If the return from a project (r) exceeds the cost of capital (ko)
then the project should be accepted. If the cash flows from the project were to be
discounted at ko then the project would have a positive net present value (N.P.V.).

This would be profitable for the firm and will mean an increase in the present net
worth.

Illustration 1.1

A firm has $200,000 of cash available for investment, ko = 10%. If the company were
to invest the $200,000 in a project with a return greater than k o, then the present value
of the firm would increase.

Consider a project that will require all the $200,000 now and will return $30,000 per
annum indefinitely.

$30 ,000
Using i = ko = .10 the present value of the income stream = = $300,000
.10
(the IRR equals 15%)

The present value of the projects inflows exceeds the present value of costs by
$100,000 and this is an increase in the present value of the firm and the market price
of its shares would reflect this increase (provided that shareholders perceive the
situation).

The increase would be even greater if ko could be reduced. In present value terms the
value of the firm is at a maximum when the cost of capital is at a minimum.

Attention can, therefore, be focussed on two questions”

(1) Can a firm reduce ko?

(2) If so, is there a minimum ko that can be achieved?

Since ko is a function of the costs of the different components of capital (k s, kd etc.), it

must be considered whether or not changing the relative proportions of component
capital (gearing) will affect ko. That is to say, is there an optimal capital structure and
can a firm affect ko and its total valuation by changing the financing risk?

Note

ko could always be reduced if the business risk of the firm were reduced e.g. if the
firm were to diversify into less risky activities or if the technology that a firm is
working in ceased to be risky and became established.

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There are a number of different views on capital structures and financing risk.

Initial assumptions of all models

(1) No taxation

(2) Immediate change in gearing

(3) All earnings distributed

(4) All shareholders expect same future earnings

(5) No growth in earnings

Basic equations

annual interest charges

kd =
Market val ue of debt

earnings available to shareholde rs

ks =
Market val ue of equity

Net operating earnings

ko =
Total market val ue of firm

ko is the WACC weighted by market values.

2.0 THE NET INCOME APPROACH

According to this approach the average cost of capital (ko) declines as gearing
increases. The cost of shareholders funds (ks) and the cost of debt (kd) are
independent. Since kd is usually less than ks as debt is less risky than equity from the
investor’s point of view, an increase in gearing should lead to a decrease in ko.

The strict net income approach assumes that ks and kd remain constant.

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Illustration 2.1

A company has $9,000, 5% debt with EBIT of $3,000 ks = 10%

Current required yields on debt = 5%.

∴ The value of the firm is $

EBIT 3,000
Interest 450
---------
Equity earnings 2,550
Capitalization rate (ks) .10
---------
Equity value 25,500
Market value of debt 9,000
---------
Value of firm 34,500
=====

$3,000
= 8.7%
$34 ,500

Say the company has 2,500 $10 shares, then each one is valued at par.

Another company with the same capital requirement has only 1,650 $10 shares and
$18,000 of 5% debt.

The business risk and EBIT of this company is the same as the first one. So,

$
EBIT 3,000
Interest 900
---------
Equity earnings 2,100
Capitalization rate (ks) .10
---------
21,000
Market value of debt 18,000
---------
Value of firm 39,000
=====

$3,000
ko = $39 ,000 = 7.7%

Note: 7.7% can also be found by calculating the WACC.

This firm has a share price of 21,000 ÷ 1,650 = $12.73 per share and a lower k o
because of increased gearing.

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The net income approach can be demonstrated graphically as:

ks
ko
kd

gearing

This approach suggests that gearing should be maximized.

2.1 The traditional View

The traditional view is that there is an optimal capital structure. As gearing increases
so financial risk increases because the fixed charges increase.

Illustration 2.2

Two companies have the same EBIT but different capital structures

Company A: E (EBIT) = $80,000 – all equity capital

Company B: E (EBIT) = $80,000 – DEBT = $500,000 @ 6%, remainder equity.

The debt service cost (interest) = $30,000 p.a.

For both companies future earnings are randomly distributed with

σ A = σ B = $40,000

The expected earnings of shareholders are

Company A = $80,000
Company B = $50,000 ($80,000 – 30,000)

Shareholders earnings have greater relative dispersion for Company B than for
Company A (coefficient of variation).

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The dispersion of income = business risk

The dispersion of shareholders earnings = financial risk

$40 ,000
Coefficient of variation for Company A = $80 ,000 = 0.5

$40 ,000
Coefficient of variation for Company B = $50 ,000 = 0.8

The financial risk of Company B is greater.

The traditional view follows the net income approach in that it suggests there is a
benefit to be gained from increased gearing. However, increased gearing increases
financial risk and ks will, therefore, increase with gearing, but this increase is not
sufficient to offset the gearing effect on ko until a certain point is reached when the
increase in ks is such as to increase ko. The traditional model usually incorporates an
increase in kd at a certain level of gearing due to increased risk to debt holders.

This implies there is an optimal capital structure.

It can be show graphically as:

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The graph demonstrations that there is a range of gearing where k o is fairly constant
and is not sensitive to small changes in the financing mix.

3.0 THE NET OPERATING INCOME APPROACH

According to this approach, there is no optimal capital structure. The financing mix
does not effect the average cost of capital of the company; and the total value of the
firm remains unchanged with changes in the gearing.

i.e. ko remains constant.

This can be shown graphically as:

k
ks

ko

kd

gearing

All capital structures are optimal.

The increase in ks is exactly sufficient to offset the effect of the increased importance
of kd so ko is constant.

Illustration 3.1

Firm R.C. has an EBIT of $900,000. There is debt of $4 million in the capital
structure. kd = 7.5% and WACC (ko) = 10%.

The total value of the firm V is given by:

EBIT
V= = $9,000,000
ko

The value of debentures = $4,000,000

Thus equity is worth $5,000,000

9,000,000 − ( 4 m x .075 )
ks = = .12 or 12%
5,000,000

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 $4 m x .075 + $5 m x .12
WACC = = 10%
$9 m

If debt is increased to $5 million, ko remains constant.

Value of the firm is still $9 m.

EBIT $900,00
as V = = = $9m.
ko .10

The value of equity goes up:

9 m - (5 m x .075)
ks = = 13.12%
4m

5 m x .075 + .1312 x 4 m
ko = = 10% (as before)
9m

3.1 The Modigliani – Miller Model

One of the leading arguments in favor of the net operating income approach is the
behavioural model developed by Modigliani and Miller.

Modigliani and Miller favor the net operating income approach that ko is constant.

Their model has some crucial assumptions:

(1) Capital Markets are perfect – All investors have perfect cost-free information
(2) Expected future earnings constant
(3) Initial assumption of no taxes
(4) Firms can be classified into ‘equivalent risk’ classes.

Their propositions are

(1) Total market value of firm is independent of capital structure

(2) ks increases to exactly offset use of cheaper debt
(3) Required rate of return for investment is independent of the financing decision.

Illustration 3.2(a)

Two companies (A & B) have identical capital requirements of $500,000. Company

B is 30% geared with 5% debt; Company a is ungeared.

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 Company A Company B

Net operating income 50,000 50,000

Debt interest - 7,500
----------- -----------
Equity earnings = 50,000 42,500
assumed equity capitalization rate = .10 .11
---------- -----------
Market value of equity 500,000 386,364
Market value of debt - 150,000
----------- -----------
Market value of firm $500,000 $536,364

50 ,000 50 ,000
ko = = 10 % = 9.3%
500 ,000 536 ,364

Midgliani – Miller argue that the above situation is not stable. A shareholder in
company B will take advantage of the better share price the lower ko for company B
gives him, by selling shares in B and buying them in A. This process is called
arbitrage and will have the effect of decreasing the market value of shares in B and
increasing the market value of shares in A (supply and demand function). This
process will continue until the share prices stabilize at a value that gives an equal k o in
both companies.

Illustration 3.2 (b)

Assume that a shareholder owns 10% of company B. This has a market value of
$38,636, and gives him a return of $4,250 (10% of $42,500).

Note that he owns 10% of a company that is 30% geared and is presumably satisfied
with the risk of a 30% gearing.

He will now substitute a personal gearing of 30% for the corporate gearing and invest
in company A in the following way:

Step I - He will sell his shares in company B and realize $38,636.

Step II - He will borrow $15,000 at 5% giving him total funds of $53,636.

N.B. He is now geared in the same proportion as company B.

$150 ,000 $15 ,000

i.e. $536 ,364
= $53 ,636

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Step III - He will buy 10% of company A, which will cost $50,000.

This will give him a return of $5,000 from which he must pay his debt
interest of $750 leaving a net return of $4,250.

This is the same as he was receiving in company B but he now has

$3,636 available for consumption.

The behavioral model suggests that the arbitrage process will continue until no
shareholder can make a gain from the process and at that point ko will be identical in
both companies.

3.2 Assumptions and criticism of the Modigliani – Miller Model

Assumptions

(1) Shareholders can obtain the same personal gearing as companies at the same
cost. This is very unlikely.

(2) Firms can be classified into equivalent risk classes.

Note: it is possible to demonstrate that the arbitrage proof of the M-M thesis
is not dependent on equivalent risk classes. All propositions can be illustrated
by general equilibrium analysis where arbitrage occurs across firms with
different risk.

(3) Capital markets are perfect. All investors have access to perfect, cost-free
information.

(4) There are no transaction costs in the arbitrage process.

The crucial factor is the assumption of rational investors who will substitute personal
gearing for corporate gearing.

Arguments against the Modigliani – Miller position

These are based on reasons why the arbitrage process may not work perfectly

(1) If there is a possibility of bankruptcy and if these costs are significant a geared
firm may be less attractive.

In perfect markets if the firm is liquidated all assets are realized with zero
costs.

(2) The perceived risks of personal and corporate gearing may be different
because of limited liability on corporate debt.

(3) Personal borrowing costs are generally higher than corporate costs.

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(4) Transaction costs restrict arbitrage.

(5) Some institutional investors may be precluded from ‘personal’ borrowing by

the articles or by law.

(6) Investors do not have access to perfect, cost-free information.

M-M deny the importance of these criticisms by arguing that they are too general.
They suggest that as long as there are enough market participants at the margin to
behave in a manner consistent with ‘homemade’ gearing the total value of the firm
cannot be altered through gearing. The M-M approach is most vulnerable at extreme
levels of gearing.

Extreme Gearing

When gearing reaches a certain level kd will rise as debt investors expect the firm to
pay a higher interest rate on debt. The greater the gearing the lower the coverage of
fixed charges and the riskier the loan.

Even if kd rises, M-M maintain the ko will be constant because ks will increase at a
decreasing rate to offset the increase in kd.

Many authorities object strongly to the contention that shareholders became relatively
less risk-averse with extreme gearing. Modigliani – Miller are on much weaker
ground in defending their thesis for the extreme gearing case.

3.3 The Introduction of Taxation

When corporate taxation is introduced into the models kd must be decreased as debt
interest is allowed against corporation tax. Therefore gearing must lower ko and
increase the value of the firm.

Modigliani – Miller recognize that by introducing corporation tax into the model ko
can be lowered by gearing. Effectively the government is subsidizing debt so the
greater the debt the greater the subsidy and the greater the value of the firm. The
implication of this is that a firm should maximize its debt.

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Proponents of the traditional model argue that extreme gearing must increase financial
risk and eventually ko will rise. The Modigliani – Miller thesis is again on weakest
ground for extreme gearing.

Modigliani – Miller recognize that by introducing tax-allowances as a subsidy, ko can

be reduced by increasing gearing and they argue that a firm should aim for a ‘target
debt ratio’ that does not violate any limits on gearing imposed by creditors. The
implication is that debt funds are simply refused beyond a certain point. This implies
that ko would rise beyond this point and that there is an optimal capital structure.

‘Certainly this is a position with which Modigliani – Miller should feel

uncomfortable’ (Van Horne).

4.0 CONCLUSIONS ON CAPITAL STRUCTURE

In the absence of perfect capital markets and with the existence of corporate taxes, an
optimal structure is implied by both the M-M and the traditional view. Over a fairly
extensive range of gearing ko is relatively less sensitive to changes in the financing
mix.

Decisions on the optimum level of debt will differ from firm to firm and should
involve considerations of the firm’s future strategies and external factors like the rate
of inflation.

One other factor which influences the capital mix is the attitude of company
management. As employees, management will tend to put constraints on the level of
gearing as they will perceive a decrease in their job security with an increase in
financial risk.

5.0 EBIT – E.P.S. ANALYSIS

One way of examining the question of issuing debt or equity is by examining the
effect on earnings per share (EPS) of possible capital structures. At different levels of
earnings, different combinations of debt and equity in the capital structure would give
different earnings per share. Since EPS is usually an important factor in determining
the actual market value of a company’s shares, the financial manager should carefully
consider the implications of issuing one type of capital as opposed to another. An
E.B.I.T. – E.P.S. chart shows graphically the relation between E.P.S. and the Earnings
before tax and interest for various capital structures.

Illustration 5.1

Firm H.V. Ltd. are considering raising $200,000 for a new project. At present the
entire capital comprises equity of $800,000 in shares of $1 each. It is estimated that
either debt at 8% or shares at per can be issued to raise the finance required. A likely
level of earnings before tax is estimated to be $300,000 p.a. and the rate of
corporation tax to be used is 50%.

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Earnings per share under the two alternatives (at an EBIT level of $300,000) would
be:

Debt Equity
$ $
EBIT 300,000 300,000
Interest @ 8% 16,000 -
--------- ---------
284,000 300,000
Tax @ 50% 142,000 150,000
====== ======
Number of shares in issue 800,000 1,000,000

Earnings per share .1775 .15

An EBIT/EPS chart can now be drawn. The ‘starting point’ for debt and equity can
be arrived at by calculating the required EBIT under both alternatives to give a zero
EPS.

1. For equity EBIT = 0, when EPS is zero.

2. For debt EBIT = 16,000 (the amount of the debt interest) when EPS is zero.

The point where the two lines cross each other is the breakeven or indifference point.
It can be seen that the breakeven point in the above chart is at an EBIT figure of
$80,000. At this point, both debt and equity give the same EPS. At EBITs of over
this figure, using debt gives a higher EPS, while below this figure, use of equity
results in a higher EPS. this can be confirmed as follows:

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 Debt Equity

EBIT 60,000 60,000

Interest @ 8% 16,000 -
--------- ---------
44,000 60,000
Tax @ 50% 22,000 30,000
--------- ---------
22,000 30,000
===== =====
Number of shares in issue 800,000 1,000,000

EPS .275 .03

The breakeven point can also be calculated algebraically (figures in $’000).

Equity Debt

50% (x - 0) = 50% (x - 16)

1,000 800

800 (x – 0) = 1,000 (x – 16)

800 (x – 0) = 1,000 x – 16,000
800 x = 16,000
x = 80

It should be noted that EBIT – EPS analysis takes only the explicit costs of debt into
account. The increase in the financial risk of the business by taking on debt should
also be considered. The probability of future profits being above a breakeven point
would also effect the financial manager’s decision to introduce debt in the capital
structure.

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