QUESTION 1:

INTRODUCTION

Capital is regarded as the backbone of any business. Black (2005) noted that for any
business to grow and develop, selection of the ways in which finance is raised plays a
vital and a significant part. The most important financial decision an organization has
makes is choosing varying levels of debt or equity (Glen and Pinto, 1994). Myers(1984)
pointed out that although advice from financial economists has been a part and parcel
of designing an optimal capital structure but the basis of which a capital structure is
designed still remains a puzzle. They argued that the theories developed to predict
financial behavior lacked evidence.

CRITICAL EVALUATION OF ALTERNATIVES AVAILABLE:

EQUITY FINANCING:

Brain et al pointed out that equity share holding does not form any kind of economic
burden on the resources of a company. Further long term capital can be mobilized
through equity capital without any financial burden on the assets of the company.
(Myers,1977 ). Rao(2001) placed his argument in favor of equity share holding pointing
out that credit worthiness of a company is enhanced by equity shares. Many
researchers like Kuhn (2006), have pointed out that equity share capital eliminates the
liability of repayment at the time of liquidation. Also Kuhn (2006) pointed out that it does
not involve obligatory dividend payment. Pride et al. (2000b) note that retained earning
can also be used as a source of equity financing, thereby increasing the range of
sources of capital generation (Institutional Investors, Partnership, Joint venture, Public
and Retained earnings). Siedman (2002) argued that investing through equity leaves a
organizations assets available for other financial needs.

However Ramos et al (2000) pointed out that as a compensation to higher risk, the rate
of return paid to shareholders increases many fold. Again noted that because equity
dividends are non-tax deductible, they are paid as post-tax profits. Also issuing equity is

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far more expensive as compared to issuing of debentures. Glen (2002), Also rights issue
of equity can result in centralized control of an organization. Hanief (2001b) pointed out
that in the period of boom appreciation in the value of shares is consequent of higher
dividend payments which lead to ample speculation. Black, (2005) argued that because
of the uncertainty of returns investors are speculative over investing in equity shares.
Whaite (2005) argued that a higher amount of risk is associated with investment of
equity as they tend to be volatile to market fluctuations. Again Khan and Jain(2002)
noted that because of public issue of shares, scattered and unorganized shareholders
do not exercise proper control over a PLC. Stock dilution is another potential
disadvantage of issuing shares. Also in absolute money terms and percentage basis , if
the investment turns out to be successful, may turn out to be a lot more than actually
invested thereby increasing stake in a business organization. (Vance ,2005)

RIGHTS ISSUE:

The advantages of public issue are mainly directed towards achieving liquidity and
diversification of the current shareholders base, creation of a negotiable instrument by
creating visible market value. Further stated that equity financing flexibility is increased
by public issue and public issue enhances public image of the firm. This can be justified
as standards of investment bankers are high before agreeing for public issue ( Lasher
2007).However Brayshaw, (2000b) pointed out that the main disadvantages include
extended time of share selling process completion. Also rights issues eliminate the
possible cost saving as blocks of shares are not sold in bulk to selling institutions.

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DEBT FINANCING:

Weaver and Wetson, (2000) refer debentures as a long term bond that is guaranteed by
a pledge of any specific property. In other words debenture holders are general
creditors whose claim is protected by unpledged property of a business Organization.
Debt finance is usually raised by means of bonds, loan, deep discounted bonds( issued
at less than nominal value, redeemed at nominal value). Further debt is paid following
and defined interest rate and agreed repayment schedule.

Banerjee (2000) points out that in the calculation of taxable income debentures tend to
be an admissible charge as against revenue thereby enforcing that cost of this source of
finance tends to be lower than that of the ownership capital. Also Horne (2002) points
out that by offering convertible debentures, an organization creates an opportunity to
sell shares at a premium owing to the current market value. Hanif (2001) argues that
dilution of control is void as a direct consequence of non-transfer of ownership in case
of debentures. Sofat and Hiro (2000) noted that during inflation issuing debentures is
advantageous to a company as only a fixed amount of interest obligations need to be
met. Blackwell and Kidwell (1988) argued that PLC's are more likely to benefit from
public issue of debt. They based their argument on the "Floatation Cost Hypothesis"
which states economies of scale can be achieved through substantiated amount of
public debt. Fabozzi and Nevitt (2000) pointed out that debt can be raised through
varied means as against equity which has numerous shortcomings

However Banerjee and Jain (2000) also noted that interest payments to the
shareholders account for a large chunk of pre-tax earnings, and a consequence rate of
dividends paid to the shareholders will be less. Again Fried et al. (2007) note that bonds
can have an adverse effect on the credit rating of an organization and can make future
borrowing's difficult. In case of unstable earnings presence or issue of new debt capital
increase the financial leverage of the Organization is seen, as payment of interest on
low earnings becomes burdensome. Pinto (1994) points out that cash outflow at the

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time of maturity of debentures can hinder the working capital requirements of an
organization to a large extent. Chemmanur and Fulghieri, (1994) argue based on
"liquidation and renegotiation hypothesis" that firms generally tend to avoid public debt
because renegotiation can be costly and difficult.

CONCLUSION:

As seen financing from both the sources have its pros and cons. DeGarmo et al. (1984)
argued that selecting a source of financing is dependent on a host of factors for a PLC.
They may be shareholder expectations, growth, current market trends, market position
of the organization and expansion. They further argued that these dynamics along with
the best suited option at that point of time (Debt or Equity) influence the decision of
choosing and formulating a capital structure.

QUESTION 2:

COMPARISON OF TRADITIONAL THEORY OF GEARING AND M-M THEORM: The

traditional view encompasses that careful use of gearing can amplify the overall value of
the firm. Further the view assumes an optimal capital structure. The approach
underlines that initially a downturn in the cost of capital is noted when firm raises its
value through gearing. As a consequence rate of return on equity (ke) increases. The
approach assumes that cost of equity rises with the increasing rate of gearing and yield
on debt increases after a significant level of gearing takes place. Erlhardt and Brigham
(2002) argued that initially WACC declines because rise in cost of equity is cancelled by
cheap debt funds. But after a certain point increase in cost of equity offsets the use of
cheap debt funds and consequently overall cost of capital begins to rise. This is the
point of optimal capital structure. Thus the traditional view confirms the inter-
dependence of cost of capital and capital structure.

However Modigliani and Miller postulate that in a non-tax circumstances, for a firm of an
agreed risk set, capital costs are steady despite the varying financial risk. The model

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argues that substitution of financial risk and cost of capital is unitary. Modigliani and
Miller (1958) argue that the weighted cost of capital remains constant as the cost of
debt and return on equity increases proportionately. The argument which Arnold (2002)
brought forward is that the benefits of raising capital cheaply through debt will exactly
offset the increasing returns demanded by the shareholders. Mcleney, (2006) pointed
out that the theory is based on the assumption that the value of a business is
determined by the future income and risk of investments rather than the way in which
finance is raised. This approach suggests that financial structuring decisions are not
important and optimal capital structure does not exist.

TRADITIONAL VIEW

Cost of Ordinary Share capital

Cost Overall cost of capital

Of

capital Cost of Debt Capital

Level of Borrowing

Optimal capital Structure.

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Assumptions: Unvarying Earnings and matching investor expectations of future
earnings, Taxation is Ignored, Constant Risk, And Full Earnings paid out in dividends.

MODERNIST VIEW

Cost of Cost of Equity

Capital

Overall cost of Capital

Cost of Loan Capital

Level of Borrowing

Assumptions: Taxation is Ignored, existence of a perfect capital market, Information

readily available, Similar expectations of Investors.

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CONTRASTING FEATURES OF THE MODELS:

Samuels et al. (1995) pointed out that the irrationality of the traditional model of gearing
is that equity shareholders tend to ignore an imperative element of risk involved. Further
they questioned as to whether or not investors would accept identical rate of return in
similar industries at different levels of gearing. However this is the base of MM theorem.
Pike and Neal noted that a severe drawback of this model is its failure to pin point a
specific optimal gearing ratio regardless of the circumstances. Key points over looked
by this model are marketability of a company's assets, market expectations and interest
rates. Samuels et al. chances of finding identical companies and of the same risk set
are austere. Further the assumption that personal borrowing can be regarded as an
alternative for corporate borrowing is weak. The principal factor here is corporation's
ability to buy at cheaper rates with limited liability. In the MM model distinction between
long term and short term debt are imprecise and are deemed to be eternal. Further
Grant and Miller (2000) argued that proper mixture of carefully selected source of
finance with a positive investment opportunity lead to the creation of wealth. Further
they argue that integration of corporate debt policy with investment decisions impact
discounted economic returns and consequently shareholder value. However Grant and
Miller (2000) further in their argument they state that MM propositions can give critical
insight on the available financing opportunities. They argued comparing the effect of
NPV theory in investment decisions (positive NPV generally means higher shareholder
utility). Hoffman (2000) pointed out that the traditional view provides clarity in impact of
gearing over capital. However the counter argument is that impact of gearing on cost of
capital is not quantifiable because specification of its presupposition is ambiguous.
Lumby (2000) pointed out that several attempts to show the traditional theory in an
algebraic form as to why the cost of capital should have a non- linear relationship with
the gearing ratio but no satisfactory results were achieved as compared to the M&M
model did use the existence arbitrage transactions. Further with the periodic increase in
debt levels and consequent tax payment by corporations (modified M&M model with
taxes), governments would provide increasing subsidies and consequently enhance the

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firm's value. This is in steep contrast with the traditional theory which considers
increasing levels of debt as risky.

SIMILARTIES OF THE MODELS:

A major similarity between both the models arises in a situation of extreme debt
financing. Hypothetically if the debt holders keep on increasing in a firm then M&M
theory and the traditional model of debt stand a common ground. This is because with
the increase in the number of debt holders and commitment to pay interest, financial
risk shoots up. Further Ogilvie (2006) pointed out that with the inclusion of corporate tax
in a perfect market both the models implied an optimal capital structure. Also the
assumptions taken in both the models match to an extent. For example assumptions
like absence of taxation and rational behavior of investors.

QUESTION 3:

EXPLINATION OF GEARING:

Elliot and Elliot (2007) stated that gearing is essentially a measure of a firm's financial
leverage. This essentially refers to the proportion to which firms activities are funded by
owner's funds as against creditors' funds. Arnold (2005) points out that gearing is said
to have taken place if a firm chooses borrowings as a source of finance. In capital
structure gearing is synonymous with terms like growth and risk. Stowe et al.(2004)
argues that the there are two situations in which a firm tends to borrow and gear highly.
These are arisen either when a company is looking to yield higher returns or has
insufficient funds. The latter is a forced upon choice while the former is when a
company is seeking growth.

An organization is referred to being highly geared when the proportion of is high in

context with equity in a capital structure. Ostring (2004) argues that a organization is

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deemed to be highly geared when the proportion of debt overlaps or is more than the
proportion of debt in an organization.

APPROACHES TO FINANCIAL GEARING:

McAulay and Dixon (1995) described two approaches of financial gearing. The first
approach used is capital gearing. The first approach involves using ratio of prior charge
capital against shareholders' funds. This ratio tries to ascertain the level of debt
financing to equity financing as already discussed. The second approach is known as
Income gearing. This ratio involves profits before interest and tax against interest
payable. The lesser the ratio, the lesser is the firms capability to pay off its interests and
hence increased chances of liquidation.

CRITICAL EVALUATION OF HIGH GEARING:

Nobes (1992) argued that high gearing increases the value of a firm through tax
advantage as interest payment is a tax deductible expense. Also EPS should be
increased if the fixed interest capital is used to earn returns that are in excess of the
interest charge thereby a benefit to the real owners (equity share) of the firm. Moreover
Bedward and Stredwick (2004) argue in favor of gearing. His based his argument on the
rationale that creation of new equity increases the risk of potential/dilution loosing of
control. Further Elearn (2008) argued that creation of income generating assets can be
financed without any immediate reference to equity shareholders and moreover the cost
of gearing is comparatively lower than that of the equity capital. Whittington(1997)
argues that in periods of inflation high level of gearing is preferable. This is because
profits might increase owing to the fact that interest payment's value can relatively
diminish. The rationale behind his argument is that earnings during these periods can
be retained and used as a major source of funding later on.

However Berry (2005) in a high gearing scenario if the earnings are not sufficient to
cover up the expenses then effectively the firm can face bankruptcy. Also many

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researchers have pointed out that profits must always be thrice than that of the interest
payments due. Adding market fluctuations into picture the expense of debt during
turbulent times can have adverse effects on the firm's financial structure. Also
Whittington (1997) noted that in a scenario of liquidation companies will try to borrow
still more and consequently aggravating the already precarious of a company. He
further pointed out that a firm may consequently find it increasingly harder to get loans
as there is a chance that investors might be put off owing to the already high gearing
levels. Armstrong (2010) pointed out that further venturing through equity as owing to
high gearing precarious equity investors might well not invest or the existing
shareholders would tend to sell off their shares. He argued that in this scenario further
problems are aggregated for the firm. Pizzery (2001) states that the fall of profits can
largely upset the shareholders during turbulent times, as a major chunk of the earnings
will go towards the payment of interests. Also Tracy (2002) lenders only lend a
particular amount of money to a business. This is measured by valuation of assets,
sales revenue and history. It is just like a collateral security and upon reaching this level
no more debts is available to the organization and lending terms remain prohibitive.
Further if an organization reaches this level and profit margins diminish the level of risk
increases celestially. In this scenario the organization may well become bankrupt.

EXAMPLE:

Scenario A (p=0.25) Scenario B(p=0.50) Scenario C(p=0.25)

Net operating Income £5m £20m £35m

Zero Gearing(£100m
equity)

Shareholder earning £5m £20m £35m

ROE 5% 20% 35%

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25% Gearing (£75 m
equity and £25m debt)

Debt Interest @10% £2.5m £2.5m £2.5m

Shareholders Earnings £2.5m £17.5m £35m

ROE 3.3% 23.3% 43.3%

50% Gearing (£50 m

equity and £50m debt)

Debt Interest @10% £5m £5m £5m

Shareholders Earnings 0 £15m £30m

ROE 0 30% 60%

(Adapted from Capital structure and required return, Pike and Neal, 1995, p564)

From the above example certain valid conclusions can be made. The example reflects
an earnings of £5 million, £20 million and 35£ for scenarios A, B and C respectively. It
can be noted from the example that with 25% gearing, if NOI increases by 300% (£5m
to £30m), then an increase of 600% is noted in the earnings of the shareholders.(£2.5 to
£17.5m). This shows that the shareholders earnings increase with considerable gearing.
However when 50% of the capital is geared under scenario A then all the earning are
wiped owing to prior Interest charges. Also it can be assumed that at any further level of
gearing the return on equity would be negative.

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GENERAL IMPLICATIONS TAKEN FROM THE EXAMPLE

The spectrum of probable return on equity is wider and this may concern the risk
averting shareholders. This effectively means that shareholders enjoy a profitable return
when the market is good but serve huge losses in case of turbulence and hence risk is
always associated with gearing.

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