UNIT 10 Capital Structure Policy

Copyright 2002 by Thames Management Centre International. All right reserved. No part of these lecture notes may be reproduced in any form or by any means, without permission in writing from Thames.

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10.1 INTRODUCTION
The decision about a firms debt/ equity ratio is called Capital Structure Decisions. A firm can choose any capital structure that it wants. If management so desired, a firm could issue some bonds and use the proceeds to buy back some stock, thereby increasing the debt/ equity ratio. Alternatively, it could issue stock and use the money to pay off some debts, thereby reducing the debt/equity ratio. Activities, such as these, that alter the firms existing capital structure are called capital restructuring. In general, such restructuring take place whenever the firm substitutes one Capital Structure for another while leaving the firms asset unchanged. How should a firm go about choosing its debt/ equity ratio? Here, as always, we assume that the guiding principle is to choose the course of action that maximizes the value of a share of stock. Hence, financial manager should choose a capital structure that maximizes the value of the firm.

10.2 CAPITAL STRUCTURE AND THE COST OF CAPITAL

The primary reason for studying the Weighted Average Cost of Capital (WACC) is that the value of the firm is maximized when the WACC is minimized. WACC is the discount rate that is appropriate for the firms overall cash flows. Since values and discount rates move in opposite direction, minimizing the WACC will maximize the value of the firms cash flows. Thus, financial manager will choose the firms capital structure so that the WACC is minimized. For this reason, we will say that one capital structure is better than another if it results in a lower WACC. Further, we say that a particular debt/ equity ratio represents the optimal capital structure if it results in the lowest possible WACC. This is sometimes called the firms target capital structure.

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10.3 THE EFFECT OF FINANCIAL LEVERAGE (GEARING)

Financial leverage or gearing refers to the extent to which the firm relies on debt. The more debt financing a firm uses in its capital structure, the more financial leverage its employs. 10.3.1 Financial Leverage, EPS and ROE, Financial leverage increases the Return on Equity (ROE) and the Earning per Share (EPS). Earning per share = Net Income / No of shares outstanding

Return on Equity = Net Income / Total equity

Example: Consider the example of ABC Co. The firm has no debt in its capital structure. The assets, debt, equity, the number of shares outstanding, etc. is given in the table below. Assets Debt Equity Shares outstanding Interest rate on debt EBIT Debt / Equity ratio Cost per share = = = = Currently without Gearing $8,000,000 $0 $8,000,000 400,000 10% $1,500,000 0/ $8,000,00 0 $8,000,000 / 400,000 $20

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Calculation of net income, EPS, ROE. EBIT Interest on debt Net income EPS ROE $1,500,000 $ 0 $1,500,000 $1,500,000/400,000 = $3.75 $1,500,000/ $8,000,000 = 18.75%

Now the company propose to change its capital structure by a debt issue of $4 millions, the interest rate is 10 percent and use the debt to buy back the shares. Therefore, the number of shares repurchased = = Therefore, the number of shares outstanding = = $4,000,000 $20 200,000 shares 400,000 200,000 200,000

Assets Debt Equity Shares outstanding Interest rate on debt EBIT Debt/Equity ratio = =

Company after Gearing $8,000,000 $4,000,000 $8,000,000 4,000,000 = $4,000,000 400,000 200,000 = 200,000 10% $1,500,000 $4,000,000/ $4,000,000 1

Calculation of net income, EPS, ROE after gearing EBIT Interest on debt Net income EPS ROE $1,500,000 $ 4,000,000 x 10% = $400,000 $1,500,000 400,000 = $1,100,000 $1,100,000/200,000 = $5.50 $1,100,000/ $4,000,000 = 27.50%

Conclusion: Due to financial leverage, the EPS and ROE has increased.

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10.4 MODIGLIANI AND MILLERS THEORY

Modern capital structure theory began in 1958, when Professor Franco Modigliani and Merton Miller (thereafter MM) published what has been called the most influential finance article ever written. MM proved, under a very restrictive set of assumptions, that a firms value is unaffected by its capital structure. In other words, MMs results suggest that it does not matter how a firm finances its operations, so capital structure is irrelevant. MMs study was based on some simplifying and unrealistic assumptions and they are: 1. There are no taxes. 2. There are no bankruptcy costs. 3. Individuals and company can borrow at the same rate of interest. 4. All investors (individual) have the same information as management about the firms future investment opportunities. 5. The supply of information to the shareholder is cost-less. (There are no brokerage costs.) 6. EBIT (Earning Before Interest and Tax) is not affected by the use of debt. Despite the fact that some of these assumptions are obviously unrealistic, MMs irrelevance (capital structure) result is extremely important. By indicating the conditions under which capital structure is irrelevant, MM also provided us with some clues about what is required for capital structure to be relevant and hence to affect a firms value. MMs work marked the beginning of modern capital structure research.

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10.5 ARBITRAGE
The term arbitrage refers to the process of buying and selling, which takes place within an unstable capital market. This process of buying and selling will affect the prices by supply and demand and return the market to equilibrium. The process of buying and selling yields a profit to those undertaking it MM suggest that if two company have the same level of business risk, they must, all things being equal, have: 1. The same weighted average cost of capital (WACC). 2. The same total market value if the have the same level of earning. If the above situation does not hold, then MM suggest that shareholder will undertake arbitrage transactions and this will result in share prices returning to their equilibrium position. The arbitrage transactions here is that shareholder in a company with the lower cost of weighted cost of capital will sell their shares and purchase shares in company with a higher weighted average cost of capital.

Formula: Market value of Equity = Net income Cost of Equity

Market value of a firm

amount of equity + amount of debts

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Example: Consider two companies, Owen PLC and Twen PLC, in the same risk class, which are identical in all respects except: Owen PLC: Financed entirely by equity (Zero debt) (Therefore the gear ratio: debt/equity = 0) Owen PLC is known as an ungeared company Cost of equity = 13.5% Twen PLC: Financed by $40,000 debt at 8% interest rate. Twen PLC is known as geared company. Cost of equity = 14%

The annual earnings before interest of the two companies are the same, $20,000 Calculate the market value of the two companies. Solution: Interest payment on debt = = 8% x $40,000 $3,200 Owen PLC (ungeared Co) $20,000 $20,000 13.5% $148,148 $148, 148 Twen PLC (geared Co) $20,000 - $3,200 $16,800 14% $120,000 $40,000 $160,000

EBIT (Earning before interest and tax) Interest payment on debt at 8% Net income Cost of equity Market value of equity: Net income / cost of equity Market value of debt Market Value = Equity + Debt

The above two companies, identical is every respect except their gearing, have different market value. MM argue that the above situation could not last for long because investors in Twen PLC would soon see that they could get the same return for a smaller investment by investing in Owen PLC. Therefore, exercising arbitrage, shareholders would sell their shares in Twen PLC and buys shares in Owen PLC. The above arbitrage process would: 1. drive up the share price of Owen, lower the cost of equity 2. force down the share price of Twen, raising the cost of equity. 3. The arbitrage process would stop when the market value of two companies is the same.

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10.6 MODIGILIANI AND MILLERS THEORY IN THE REAL WORLD

MMs theory is criticized for the unrealistic assumptions it makes. These are: 1. Individuals and companies can borrow at the same rate of interest. This is obviously not to be true for individual shareholders. However, some shareholders such as institutions will be able to borrow at rate similar to that paid on corporate. 2. The risks of personal and corporate gearing are the same. Shareholders in a company, which used corporate gearing, enjoy the benefits of limited liability. Whereas, shareholders who invested in an ungeared company and undertake personal gearing have unlimited liability on that personal debt. This is a factor in favor of corporate gearing, however, it is doubtful whether it will have a material effect on a firms value. 3. There is no transaction costs. The arbitrage process will only work perfectly if there are no costs involved in it. The buying and selling of shares, will, of course, mean transaction costs and will cause arbitrage to stop short of completely equalizing costs of capital and market values. Transaction cost are, however, relatively small especially for large investors, and this assumption should not have a significant effect on the theory. 4. There are no bankruptcy costs. If a company undergoes cash flow difficulties then it may be necessary to undergo some sort of capital reorganization where the rights of the various providers of capital will change. The market value of the company will be reduced by the expected bankruptcy costs incurred during reorganization. These costs would include legal fees, management time, lost of sales, accounting expenses and would have a hard time retaining customers, suppliers and employees. Moreover, bankruptcy often forces a firm to liquidate or sell assets for less than they would be worth if the firm were to continue operating. Assets such as company heavy equipment are often illiquid because the are configured to the companys individual needs and also because they are difficult to disassemble and move. The treat of bankruptcy alone could bring a lot of problems! Key employees jump ship, suppliers refuse to grand credit, customers seek more stable suppliers and lenders demand higher interest and impose more restrictive loan covenants.

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Bankruptcy related costs have two components: The probability of their occurrence. The costs they would produce given that financial distress has arisen.

If a company has a high level of gearing, then there will be a very high fixed payment for interest each year. If the company hits bad times then high gearing will cause cash flow difficulties and a possible bankruptcy. If a company has low gearing then difficulties from low profits can be avoided by simply reducing dividends payment. One would expect the market value of the company to fall at high gearing due to the effect of bankruptcy costs.
5.

Information is cost-less. This assumption is necessary since shareholders must be able to identify arbitrage opportunities when they exist in order to take advantage of them and bring about equilibrium. Although information is cost-less and with modern information system fairly good, this assumption will not affect the MM theory significantly.

6. Agency costs. When a company uses debt finance, it is possible for management to act in a way, which increases shareholders wealth at the direct expense of the debt holders. Debt holders can protect themselves against this possibility by writing restrictive covenants into loan agreements. Examples of some of the restriction are: restriction on the use and disposition of assets, restrictions on the issue of new debts and restriction on the payment of dividend.

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10.7 MM PROPOSITIONS, NO TAX CASE

10.7.1 Proposition I MM suggested that the total market value of any company is independent of its capital structure. Vg = Vu where Vg Vu = total market value of a Geared company = total market value of a Ungeared company

Implications of Proposition I: a. A firms capital structure is irrelevant. b. A firms Weighted Average Cost of Capital (WACC) is the same no matter what mixture of debt and equity is used to finance the firm.

10.7.2 Proposition II MM argued that expected return of a share in a Geared company is equal to the expected cost of equity to ungeared company plus a premium related to financial risk. The two companies must be similar. RE = RA + ( RA RD) x Gear ratio where RE = cost of equity of Geared company RA = cost of equity of Un-geared company (WACC) RD = cost of debts in Geared company Gear ratio = Debt Equity Implications of Proposition II: a. The cost of equity rises as the firm increases its use of debt financing. b. The risk of the equity depends on two things: the riskiness of the firms operations (business risk) and the degree of financial gearing (financial risk).

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For a single company: RE = RA + ( RA RD ) x Gear ratio where cost of equity of the company after gearing cost of equity of the company before gearing (WACC before gearing) RD = cost of debt of company after gearing. Gearing ratio = Debt Equity RE RA = =

WACC = E x RE + D x RD V V where E/V = D/V = RE = RD = WACC percentage equity of the company percentage debts of the company. cost of equity of company after gearing cost of debt of the company after gearing = weighted average cost of capital after gearing

Example: Cost of equity of an all equity (zero debt) company is 15%. Thus WACC is 15%. Another company is identical in every respect to the first except that it is geared with the debt: equity ratio = 1:4. The cost of debt capital in this geared company is 5%. What is the cost of equity for the geared company? Solution: RA = WACC = 15% Gear ratio = RD = cost of debt in geared company = 5% RE = cost of equity in geared company = WACC of geared company RE = = = RA + (RA RD) x Gear ratio 15% + (15 5) x 17.5 %

Hence, the WACC in the geared company is the same as in the ungeared company.

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Example: The Jo Corporation, an all equity company has a Weighted Cost of Capital of 12%. It can borrow at 8%. What is the Cost of Equity if it: a. Has a target capital structure of 80% equity and 20% debt. b. Has a target capital structure of 50% equity and 50% debt. Show that the WACC is the same irrespective of the capital structure. Solution:
a.

RE = cost of equity before gearing. = 12% Gearing ratio: debt: equity = = RD = = RE = = = = = =

20: 80 1: 4 cost of debt 8%

RA + (RA RD) x Gear ratio 12 + (12 8) x 13% E x RE + D x RD

V V

WACC

0.80 x 13% + 0.20 x 8% 0.12 (12 %)

.. (1)

b.

RE = cost of equity before gearing. = 12% Gearing ratio: debt: equity = = RD = = RE = = = WACC cost of debt 8% RA + (RA RD) x Gear ratio 12 + (12 8) x 1 16% = = = E x RE + D x RD
V V

50: 50 1: 1

0.50 x 16% + 0.50 x 8% 0.12 (12 %)

.. (2)

From (1) and (2), we have shown that the WACC of the company remain the same irrespective of the capital structure of the company.

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10.8 MM ADJUSTED FOR TAXATION

So far, our analysis of MM theory has ignored the tax relief on debt interest, which makes debt capital cheaper to a company and therefore reduces the Weighted Average Cost of Capital. 10.8.1 Proposition I The value of a firm geared (Vg) is equal to the value of the firm ungeared (Vu) plus the present value of the interest tax shield:

Vg = Vu + Tc x D where Tc D = = the corporate tax rate the amount of debt

Vu = EBIT taxes = EBIT x (1 Tc) RA where RA = the ungeared or unlevered cost of capital

Value of firm = Equity + Debt

The implications of Proposition I: a. Debt financing is highly advantageous, and, in the extreme, a firms optimal capital structure is 100 percent debt. b. A firms Weighted Average Cost of Capital (WACC) decreases as the firm relies more heavily on debt financing.

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9.8.2

Proposition II With tax relief: the Cost of equity of the geared company would: For two identical companies: RE = RA + [(RA RD ) x Gear ratio x ( 1 t )] where RE = cost of equity of Geared company RA = cost of equity of Ungeared company RD = cost of debts in Geared company Gearing ratio = Debt Equity t = percentage tax relief

For a single company: RE = RA + [(RA RD ) x Gear ratio x ( 1 t )] where RE RA cost of equity of the company gearing (after gearing) cost of equity of the company before gearing (WACC before gearing) RD = cost of debt of company after gearing Gearing ratio = Debt Equity t = percentage of corporate tax = =

The WACC with tax relief would be:

WACC

E D RE + R D (1 - t) V V

where

E/V = D/V = RE = RD = WACC t =

percentage equity of the company percentage debts of the company. cost of equity of company after gearing cost of debt of the company after gearing = weighted average cost of capital after gearing percentage tax relief

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Example 1: Cost of equity of an ungeared company is 18%. Cost of debt capital is 8%. After restructuring, the company has decided to have 75% equity and 25% debt. The Corporation tax at a rate of 33%. a. What is the cost of equity after gearing. b. What is the WACC, allowing for taxation.

Solution 1:
a.

RA

= cost of equity before gearing = 18% RD = cost of debt = 8% Gearing ratio: - Debt: equity = 25%: 75% = 1: 3 RE t RE = = = = = = = cost of equity after gearing? percentage taxation 33% RA + [(RA RD) x Gear ratio (1 t)] 18 + [(18 8) x (1/3) (1 0.33)] 18 + 2.23 20.23

W b. ACC =

E D R E + R D (1 - t) V V

= =

0.75 x 20.23% + [0.25 x 8% x (1 0.33)] 16.51%

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Example 2: You are given the following information for Format Co. EBIT Tc Debt RA Cost of debt = RD a. b. c. d. e. $151.52 34% $500 20% 10%

What is the value of the unlevered firm (with no debt)? What is the value of the firm with debt? What is the amount equity? What is the cost of equity after tax? What is the WACC of the gearing?

Solution 2:
a.

Value of the firm with no debt: RA RA

Vu

= EBIT taxes = EBIT (1 Tc) = 151.52 (1 - 0.34) 0.2

= $500 b. Value of the firm with debt: Vg = Vu + Tc x D = 500 + 0.34 (500) = $670

c. Value of firm 670

= =

Equity + Debt Equity + $500 = = 670 500 $170

Amount of equity

d.

RE

= RA + [(RA RD) x Gear ratio x (1 t)] = 0.20 + [(0.20 0.10) x (500/ 170) x (1 0.34)] = 39.4% Therefore, the cost of equity = 39.4%

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e.

WACC

= = =

E x RE + D x RD ( 1 t )
V V

170 x 39.4% + 500 x 10% x (1 34%) 670 670 14.92 %

EXERCISE 9.1
1. What is the guiding principle when financial managers choose the capital structure for their firms? 2. What is the relationship between the WACC and the value of the firm? 3. What is an optimal capital structure? 4. What is the impart of financial leverage on stockholders? 5. What does MM Proposition I state and what are their implications? 6. What does MM Proposition II state and what are their implications?

EXERCISE 9.2
1. EBIT and EPS. Suppose that GNR Corporation has decided in favor of a capital restructuring that involves increasing its existing $5 million debts to $25 million debt. The interest rate on the debt is $12 percent and is not expected to change. The firm currently has 1 million shares outstanding. The Current EBIT $5,400,000. What is the EPS before and after the company restructure? [$4.80] 2. MM Proposition I. The Book Company has a WACC of 20 percent. Its cost of debt is 12 percent. If the company debt/ equity ratio is 2, what is its cost of equity capital? Ignore taxes. [36%]

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3. Calculating the effect of Leverage. Ram Corporation has no debt outstanding and a total market value $10,000. Earnings before interest and taxes (EBIT) are projected at $1,000 if economic conditions are normal. If there is a strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 40 percent lower. The company is considering a $5,000 debt issue at a 9 percent interest rate. The proceeds will be used to buy up stock. There are currently 100 shares outstanding. Ignore taxes. a. Calculate the earning per share (EPS) under each of the three economic scenarios before any debts is issued. b. Redo part (a) assuming that the company goes through with capital restructure. [a. EPS = $12, EPS = $10, EPS = $6; b. EPS = $15, EPS = $11, EPS = $3] 4. Calculating WACC. Butler Corporation has a debt/ equity ratio of 0.50. Its WACC is 20 percent and its cost of debt is 9 percent. a. Ignoring taxes, what is the company cost of equity? b. What would be companys cost of equity be if the debt/ equity ratio were 1.0? c. What would be the company WACC in part b? [25.5%, 31%, 20%] 5. MM. The ABC Corporation uses no debt. The weighted average cost of capital is 10 percent. If the current market value of the equity is $5 million and the corporate tax is 20 percent, what is the EBIT? [$625,000]

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