CHAPTER SIX GEARING AND THE COST OF CAPITAL

Preamble In problems that we have considered so far, a discount rate has been specified. In practice, we shall have to choose an appropriate discount rate. It seems plausible that there will be a connection between a companys cost of capital and the discount rate for project appraisal. Consequently, we explore the concept of the weighted average cost of capital in this section. We also examine some views of the relationship between cost of capital and capital structure. However, we begin with a review of interest rates. Learning Outcomes On successful completion of this Chapter, students should normally be able to: Identify the principal interest rates in the UK financial markets Explain the term structure of interest rates Define and calculate weighted average cost of capital for companies with simple capital structures Explain the traditional view of the relationship between cost of capital and capital structure Explain the view expounded by Modigliani and Miller of the relationship between cost of capital and capital structure Perform arbitrage calculations that support the view of Modigliani and Miller Identify and discuss critically the assumptions underpinning the pre-tax version of the Modigliani and Miller model Discuss the possible impact of incorporating taxation in the Modigliani and Miller model

Interest Rates Introduction Interest rates are an important factor in the financial environment of companies and, consequently, they have a significant impact on financial strategists decision-making. Interest rates are of significance for a number of reasons, including the following: 1. Interest rates measure the cost of borrowing. When interest rates rise, companies will pay more interest on those borrowings with a variable rate of interest (including on bank overdrafts), 2. Interest rates in a country influence the foreign exchange value of that countrys currency, 3. Interest rates can be used as a guide to the return that a companys shareholders will require,

4. Changes in market interest rates will affect share prices. In addition, as we have seen, there is a strong connection between interest rates and the discount rate to be used in investment appraisal. Principal interest rates in the financial markets of the UK The interest rates in the UK financial markets that are most commonly quoted are as follows. 1. Base rates of the clearing banks1. Banks lend money to small companies and individual customers at certain margins above their base rate. Theoretically, each clearing bank sets its own base rate independently of the others; however, in practice, a change in the base rate of one clearing bank is followed by similar changes to the base rates of all the other banks, 2. LIBOR is the most widely used reference rate for short-term interest rates. LIBOR stands for the London Interbank Offered Rate, and is the rate of interest at which banks borrow funds from other banks in the London interbank market. It is compiled by the British Bankers Association and released to the market at about 11.00 a.m. each day. For large loans to large companies, banks set interest rates at a margin above LIBOR, rather than at a margin above base rate, 3. The Treasury bill rate is the rate payable by the Bank of England on Treasury bills it has sold to the discount market, 4. The yield on long-dated2 gilt-edged securities. Gilt-edged securities are interest-bearing securities issued by the government, 5. The yield on bank deposit accounts or building society accounts, 6. The bank overdraft rate for personal customers. There are a number of reasons why interest rates are different in different markets: Risk lenders will require compensation for lending to borrowers at higher risk of default. The need to make a profit on re-lending financial intermediaries make profit from lending at a higher rate of interest than the cost of their borrowing. The length of the loan normally, long-term loans will earn a higher yield than short-term loans, this is known as the term structure of interest rates, and is discussed below. The size of the loan deposits greater than a certain amount lodged with a bank or building society may attract higher rates of interest than smaller deposits.
1

A clearing bank is a member bank of a national cheque clearing system. In the UK, the clearing banks include the main English high-street banks, their Scottish and Northern Irish equivalents, and several regional banks. 2 Say, 20 years to maturity.

International interest rates interest rates varies from country to country due to differing rates of inflation from country to country and different government policies on interest rates and foreign currency exchange rates. Different types of financial asset different types of financial asset attract different rates of interest. This is mainly a result of the competition for deposits between different types of financial institution. For example, building societies have to offer a high enough yield to depositors to attract enough deposits to meet the demand for mortgages. Since bank deposit accounts are seen as a competitor for individuals savings, building societies may offer a slightly higher rate of interest than bank deposits. Similarly, discount houses, banks, local authorities, and finance houses3 all compete to borrow money in the money markets. To attract funds away from the discount houses, local authority deposits will offer a slightly higher yield, and the interbank rate could be slightly higher than that. Finance houses, to attract one-month deposits, could be obliged to offer a higher yield than the one-month interbank rate. The term structure of interest rates Suppose an investor decides to invest in some government securities. Since the securities represent borrowing by the government, and the investment is therefore risk-free, it might seem reasonable to expect that the nominal rate of interest paid would be the same, no matter what the type of security. However, this is not the case. One reason for this is that the government borrows by issuing new securities from time to time, and the rate of interest offered on a new issue of securities will depend on conditions in the market at the time. This explains why the nominal interest rate on new gilt-edged securities might be 12% on one occasion, 9% on another, and 11% on another. Another important reason why interest rates on the same type of financial asset might vary is that interest rates depend on the term to maturity of the asset and, for example, Treasury Stock can be short-dated, medium-dated, or long-dated. The term structure of interest rates refers to the way in which the yield on a security varies according to the term of the borrowing, i.e. the length of time until the debt will be repaid. Normally, the longer the term of an asset to maturity, the higher the rate of interest paid on the asset. There are two reasons for this, firstly, there is a greater risk in lending long-term than in lending short-term, simply because the borrower has more time in which to get into financial difficulties. To compensate investors for this risk, they will require a higher yield on longer dated investments. Secondly, an investor will require compensation for tying up his or her money in the asset for a longer period of time. To illustrate, if the government were to make two issues of 12% Treasury Stock on the same date, one with a term of five years and one with a term of 20 years (and if there were no expectations of changes in interest rates in the future) then the liquidity preference of investors would make them prefer the five year stock. The only way to overcome the liquidity
3

Finance houses, also known as finance companies, provide the financing for various transactions, particularly hire purchase.

preference of investors is to compensate them for the loss of liquidity; that is to say, to offer a higher rate of interest on longer dated stock. This leads us to expect that the yield curve will normally be upward sloping, so that long-term financial assets offer a higher yield than short-term assets. However, a yield curve can slope downwards, with short-term rates higher than longer-term rates. The most likely causes are: 1. Expectations about the way that interest rates will move in the future. When interest rates are expected to fall, short-term rates might be higher than long-term rates, and the yield curve would be downward sloping. Thus, the shape of the yield curve gives an indication to the financial strategist about how interest rates are expected to move in the future. 2. Government policy on interest rates. If government influence over interest rates is directed mainly towards short-term interest rates, a policy of keeping interest rates relatively high could have the effect of forcing shortterm interest rates higher than long-term rates. The Weighted Average Cost of Capital Ideally, perhaps, to carry out investment appraisal using a discounted cash flow approach, a particular project should be associated with its specific funding: however, it is often the case that this is not possible and, in these circumstances, it is arguable that the companys funding should be seen as a pool of resources. Indeed, a number of commentators argue that the pool approach ought to be adopted even where it is possible easily to identify a specific source of funding for a given project. If the pool approach is taken, the appropriate discount rate for appraising a project would be the weighted average cost of capital (WACC). Once the cost of individual sources of finance for a company have been established, it is possible to calculate the weighted average cost of capital for the company as a whole. The weighting is usually based on the market values of the different types of capital, rather than on book amounts4. Example: The following information relates to the long term funding of Thompson plc: Component of Capital Ordinary Shares Preference Shares Debentures Cost 15% 12% 8% Market Value 000 980 550 350 1,880

The book amounts can get out of line with market values so quickly they will often have no economic significance.

Using the market value as the weighting, we can generate a fourth column by multiplying the cost of capital by the market value as follows: Component of Capital Ordinary Shares Preference Shares Debentures Cost 15% 12% 8% Market Value 000 980 550 350 1,880 Cost x MV 000 147 66 28 241

The weighted average cost of capital is the sum of the products (241,000 in this case) divided by the sum of the weightings (1,880,000 in this case), i.e. 241,000/1,880,000 = 0.12819..., say 13%. In general, if there are n sources of long-term funding with individual costs of capital K1, K2, K3, ... Kn and market values V1, V2, V3, ... Vn, then the weighted average cost of capital (WACC) is given by: WACC = K1V1 + K 2V2 + K3V3 + K + K nVn V1 + V2 + V3 + K + Vn

Obviously, the value of the company as a whole is simply the sum of the values of the individual sources of funding. Thus, V1 + V2 + V3 + K + Vn is the total market value of the company, MV, and we may write: WACC = K1V1 + K 2V2 + K3V3 + K + K nVn MV

Question 6.1 The following information relates to the long term funding of Snowy plc: Component of Capital Ordinary Shares Preference Shares Debentures Cost 14% 11% 5% Market Value 000 980 45 360

Estimate the weighted average cost of capital of Snowy plc.

The Traditional View of the WACC-Gearing Relationship Historically, fixed interest investors have not demanded as high a return as equity investors. This is because they experience a lower level of risk. Hence, it is argued, the introduction of debt into a previously all-equity company will lower the WACC at low levels of gearing. As gearing increases, equity holders will require higher returns in order to compensate them for the increase in risk. At very high levels of gearing the fixed-interest investors will themselves demand a higher return for higher risk. Thus, WACC will decrease at low levels of gearing and increase at higher levels. The WACC profile against gearing will be saucer-shaped at low and medium levels of gearing, indicating that for a particular company there is an optimum mix of debt and equity. This is shown in Exhibit 1 below, where f(x) is the WACC, expressed as a percentage, and x is the level of gearing, expressed as the ratio of debt to total funding:
40

30

f( x ) 20

10

0.2

0.4 x

0.6

0.8

Exhibit 1: WACC as a Function of Gearing If the traditional view is an accurate representation of how WACC varies with changes in gearing, then it should be possible to create wealth by optimising the firms capital structure. The next section shows how this would happen. Creating Wealth in a Firm by Changing its Capital Structure The following two assumptions are made: 1. 2. Investors prefer more wealth to less The wealth associated with a project may be measured by calculating its net present value, as in the example below:

Leverage Ltd. has the opportunity to engage in a three-year project (known as Project X) that is expected to have the following cash flows associated with it:

Year 0 1 2 3

Cash Flow (000) (1,000) 400 500 600

Leverage Ltd. is an all-equity financed company that has a cost of capital of 12%. The net present value of Project X is calculated as follows: Year 0 1 2 3 Cash Flow (000) (1,000) 400 500 600 12% Discount Factor 1 0.893 0.797 0.712 Present Value (000) (1,000) 357 399 427 183

= Net Present Value

Clearly, the amount of wealth (the NPV) is critically dependent on the discount factors and hence on the choice of discount rate. Now, suppose that the traditional view is reliable, and that the following additional information is available. Leverage Ltd. is a company in which the cost of equity capital is 12% at low levels of gearing. The cost of debentures at low levels of gearing is 7%. The company moves from being all equity financed to being funded partly by debentures, and the ratio of the market values of debt to equity is 2:3. Despite this change in the companys gearing, the cost of both equity and debt is unaltered. The weighted average cost of capital (WACC) of Leverage Ltd. is calculated as follows: WACC= 2 x 7% + 3 x 12% = 10% 5

Our earlier calculation of the NPV of Project X now needs to be amended because of the change in the discount rate, the earlier calculation of NPV at 12% is also shown to aid comparison:

Year 0 1 2 3

Cash Flow 12% Discount (000) Factor (1,000) 1 400 0.893 500 0.797 600 0.712

Present Value (000) (1,000) 357 399 427 183 NPV at 12% DF Present Value (000) (1,000) 364 413 451 228 NPV at 10% DF

Year 0 1 2 3

Cash Flow 10% Discount (000) Factor (1,000) 1 400 0.909 500 0.826 600 0.751

It appears that the introduction of debt into the company has resulted in an increase in wealth from 183,000 to 228,000. This conclusion relies on the assumption that the cost of equity will remain unchanged despite the introduction of debt. It is as if the holders of equity have not noticed that their risk position has worsened. The question arises as to whether this is likely will the holders of equity really fall asleep and not notice that debt has been issued and their risk increased? If the cost of equity remains more or less unchanged (because enough of the ordinary shareholders fail to notice the introduction of debt) then there is an opportunity to make abnormally high returns for anyone who does notice. To put it another way, the ordinary shareholder who remains alert when the cost of equity remains unchanged despite the introduction of debt has access to a money making machine...

A Money Making Machine (or Profiting through Arbitraging) Ordinary Limited is a company that is identical to Leverage Ltd. except for funding. Both make an operating profit of 96,000 p.a. and both companies have a policy of paying out all residual profit as dividend. Further details are as follows: Market Value 000 625 300 925 Market Value 000 800

Leverage Ltd. 400,000 ordinary shares of 1 each 300,000 7% debentures

Ordinary Limited 400,000 ordinary shares of 50p each

The pre-interest profit of 96,000 is apportioned as follows: Leverage Ltd. 000 96 21 75 Ordinary Limited 000 96 nil 96

Profit before Interest Interest (7% x 300,000) Dividend

We note that the return on equity in Leverage Ltd. is 100% x 75,000/625,000 = 12%, and that the cost of equity for Ordinary Limited is also 12% (100% x 96,000/800,000 = 12%). So, the market values of the two companies are in line with the traditional view that at low levels of gearing equity investors do not require increased return for low levels of financial risk. Note that the total market values of the two firms are different, even though the companies are identical in all respects except for their sources of funding. This is a result of the return on equity in both companies being the same, although one company also has debt. That the total market values of the two firms are different, even though the companies are operationally identical, is arguably anomalous. For example, if an investor wanted to gain an annual income of 96,000 they could buy all the shares in Ordinary Limited and receive dividends totalling 96,000 each year, or the investor could buy all the shares and all the debentures in Leverage Ltd. and receive interest on their debentures of 21,000 and dividends of 75,000: both alternatives would yield an annual income of 96,000, as required. However, to buy all the shares in Ordinary Limited would only cost 800,000 compared with the cost of acquiring the shares and debentures in Leverage Ltd. of 925,000. Given the choice of acquiring something for either 0.8m or 0.925m the rational person would opt for the former. (Remember that the two companies are identical, except for their capital structure, so they are subject to the same level of business risk.)

Now, it may be said, quite rightly, that people with 0.925m (or even 0.8m) to spare are fairly rare creatures: however, the differential pricing of the two companies provides an opportunity for even small investors to increase their wealth, as we shall (eventually) see: Roxy holds 4,000 ordinary shares in Leverage Ltd. This is an investment with a modest market value of 6,250. The level of risk associated with this investment is exactly the level she wants, or to put it another way, the shareholding reflects her attitude towards risk. As a 1% investor in Leverage Ltd., any sales of shares that Roxy chooses to make will have no material affect on the market price of the shares. In addition, she will not materially alter her current level of investment in Leverage Ltd. It follows that any share dealings in Leverage Ltd. that Roxy has will not materially alter the market price. To put it another way, Roxy is a price-taker. Her current annual return is: 1% x (96,000 - 7%.300,000) = 750. A check on this calculation would be to argue that since Roxy is a 1% investor, she will receive a 1% share of the total shareholders dividend. This total dividend was calculated above as 75,000, so Roxys share would be 1% x 75,000 = 750. A simple-minded approach would be for Roxy to sell her shares in Leverage Ltd. and invest the proceeds in Ordinary Limited equity, as follows: 1 2 Sell the shares for 1% x 625,000 = 6,250 Invest 6,250 in shares in Ordinary Limited. These shares have a market value of 800,000/400,000 = 2 each, so she can buy 6,250/2 = 3,125 shares, ignoring trading costs such as commission.

As an investor in Ordinary Limited, Roxys annual return is calculated as follows: annual return from Ordinary Limited is 96,000/0.4m = 24p per share and 24p x 3,125 shares = 750. This is the same return as she received from Leverage Ltd. However, her risk position has improved, in that her returns from Ordinary Limited are less volatile than they were from Leverage Ltd. Suppose, for example, that the operating profit in both companies fell by 5% to 91,200. Then a 1% investor in Leverage Ltd. would see their return decrease to 1% x (91,200 - 7%.300,000) = 702. However, Roxys investment in Ordinary Limited would yield: 91,200 x 3,125/400,000 = 712.50. Thus, this simple-minded strategy would allow Roxy to maintain her expected return but decrease her risk. Since Roxy was happy with her risk in Leverage Ltd., this suggests that she could improve her expected return whilst leaving her risk position as it was when she held shares in Leverage Ltd.

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A strategy to increase her wealth without altering her risk position is as follows: 1 2 3 Sell the shares for 1% x 625,000 = 6,250 Substitute personal borrowing for the corporate debt by borrowing 1% x 300,000 = 3,000 at 7% p.a. Roxy has funds of (6,250 + 3,000) = 9,250. She uses this to acquire 1% of the equity in Ordinary Limited, buying 4,000 shares at 2 each for 8,000. This realises a capital gain of (9,250 8,000) = 1,250.

As an investor in Ordinary Limited, Roxys annual return is now calculated as follows: Gross annual return from Ordinary Limited of: 96,000/0.4m = 24p per share: 24p x 4,000 shares = 960 in total Less: interest on borrowings of 7% x 3,000 = 210 Receive a net return of 750 We see that Roxy has the same return as before but has realised a gain of 1,250. The second stage of Roxys strategy (borrowing money) is intended to maintain her risk position. We were told that The level of risk associated with [her original] holding [in Leverage Ltd.] is exactly the level she wants..., and hence her strategy must maintain that level of risk. However, if she simply sold shares in the geared company and bought shares in the ungeared company then she would change the riskiness of her investment, as we saw above: there was financial risk associated with the debt in Leverage Ltd. whereas there is no financial risk associated with shares in Ordinary Limited. Hence, to maintain her risk position, she needs to reintroduce the financial risk associated with the debt in Leverage Ltd. To effect this reintroduction, Roxy borrows money personally. The ratio of her debt to her equity investment in Ordinary Limited is the same as the ratio of debt to equity in Leverage Ltd. This ensures that the level of risk associated with her new investment is identical with that of the original investment. We show that her risk position has been maintained, in that her returns from Ordinary Limited are just as volatile as they were from Leverage Ltd. Suppose, for example, that the operating profit in both companies fell by 5% to 91,200. Then a 1% investor in Leverage Ltd. (as Roxy used to be) would see their return decrease to 1% x (91,200 - 7%.300,000) = 702. Roxys investment in Ordinary Limited would yield 91,200 x 4,000/400,000 = 912, gross and the interest payments would reduce this to 702 net, the same as yielded by the equivalent investment in Leverage Ltd. It follows that the degree of volatility in return and hence risk has been maintained.

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You may be wondering what the position would be if, instead of taking the capital gain, Roxy invested all her available funds in Ordinary Limited. Her strategy would then be as follows: 1 2 3 Sell the shares for 1% x 625,000 = 6,250 Substitute personal borrowing for the corporate debt by borrowing 1% x 300,000 = 3,000 at 7% p.a. Invest (6,250 + 3,000) = 9,250 in shares in Ordinary Limited. These shares have a market value of 800,000/400,000 = 2 each, so she can buy 9,250/2 = 4,625 shares, ignoring trading costs such as commission.

As an investor in Ordinary Limited, Roxys annual return is calculated as follows: Gross annual return from Ordinary Limited: 96,000/0.4m = 24p per share and 24p x 4,625 shares = 1,110 in total Less: interest on borrowings of 7% x 3,000 = 210 Net annual return of 900 Roxy is now receiving an annual income of 900 instead of 750, so she is better off by 150 each year. Note that Roxy had been a 1% equity investor in Leverage Ltd., but now holds more than 1% of the ordinary shares in Ordinary Limited (4,625/0.4m = 1.15625%, to be exact). Hence, as a shareholder, she is entitled to a larger share of the same cake. The reduction in her return due to interest payments is the same in both cases. When Roxy was a 1% equity investor in Leverage Ltd. she was entitled to 1% of the profit after interest, this was 750 [1% of (96,000 less the interest of 21,000)]5. However, now she is entitled to 1.15625% of 96,000, and is still only paying 210 to service debt (which she has now taken on personally). Hence, she is better off by the difference between 1.15625% of 96,000 and 1% of 96,000 = 0.15625% x 96,000 = 150, as shown earlier. A further effect of the change in her holding from 1% to slightly more than 1% is that she has slightly decreased her risk. Suppose, for example, that the operating profit in both companies fell by 5% to 91,200. Then a 1% investor in Leverage Ltd. would see their return decrease to 1% x (91,200 - 7%. 300,000) = 702, a decrease of 6.4%. Roxys investment in Ordinary Limited would yield 91,200 x 4,625/400,000 = 1,054.5 gross, and the interest payments would reduce this to 844.5 net, a decrease from 900 of just under 6.2%. So, Roxy has both increased her income and reduced her
5

Another way of looking at this is to consider that she was entitled to 1% of 96,000 (i.e. 960), and that the company was paying directly to the lenders her share of the associated debt financing (i.e. 1% of 21,000 = 210). So her net entitlement was 960 less 210, i.e. the 750 we calculated earlier in a different way.

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risk. This has arisen because Roxy borrowed only 1% of the debt in Leverage Ltd, although she bought 1.15625% of the equity in Ordinary Limited. Suppose that she borrows 1.15625% of the debt in Leverage Ltd.: 1 2 Sell the original shares for 1% x 625,000 = 6,250 Substitute personal borrowing for the corporate debt by borrowing 1.15625% x 300,000 = 3,468.75 at 7% p.a. Total funds = (6,250 + 3,468.75) = 9,718.75. Buy 1.15625% of the shares in Ordinary Limited at a cost of 9,250, i.e. 4,625 shares, ignoring trading costs such as commission. This realises a capital gain of 468.75.

As an investor in Ordinary Limited, Roxys annual return is calculated as follows: Gross annual return from Ordinary Limited: 96,000/0.4m = 24p per share and 24p x 4,625 shares = 1,110.00 Less: interest on borrowings of 7% x 3,468.75= 242.81 Net annual return of 867.19 Roxy is now receiving an annual income of 867.19 instead of the 750 she received from Leverage Ltd., so she has increased both her annual income and realised a capital gain. We now consider her risk position. Suppose, for example, that the operating profit in both companies fell by 5% to 91,200. Then a 1% investor in Leverage Ltd. would see their return decrease to 1% x (91,200 - 7%.300,000) = 702, a decrease of 6.4%. Roxys investment in Ordinary Limited would yield 91,200 x 4,625/400,000 = 1,054.5, gross and the interest payments of 242.81 would reduce this to 811.69 net, a decrease from 867.19 of 6.4%. Thus, she has the same risk as she had originally. We have seen strategies that have resulted in: maintenance of income with a reduction in risk maintenance of both risk and income with a capital gain an increase in income and a capital gain with a reduction in risk

The remaining outcome that a rational investor might wish to see is maintenance of risk with an increase in income but no capital gain. Consider the following: 1 2 3 Sell the original shares for 1% x 625,000 = 6,250 Borrow 3,750. Total funds available for investment = (6,250 + 3,750) = 10,000. Buy 5,000 shares in Ordinary Limited at a cost of 10,000, ignoring trading costs such as commission. 13

As an investor in Ordinary Limited, Roxys annual return is calculated as follows: Gross annual return from Ordinary Limited: 96,000/0.4m = 24p per share and 24p x 5,000 shares = 1,200.00 Less: interest on borrowings of 7% x 3,750= 262.50 Net annual return of 937.50 Roxy is now receiving an annual income of 937.50 instead of the 750 she received from Leverage Ltd., so she has increased her annual income. We now consider her risk position. Suppose, for example, that the operating profit in both companies fell by 5% to 91,200. Then a 1% investor in Leverage Ltd. would see their return decrease to 1% x (91,200 - 7%.300,000) = 702, a decrease of 6.4%. Roxys investment in Ordinary Limited would yield 91,200 x 5,000/400,000 = 1,140, gross and the interest payments of 262.50 would reduce this to 877.50 net, a decrease from 937.50 of 6.4%. Thus, she has the same risk as she had originally. Question 6.2 Calculate the WACC in both Leverage Ltd. and Ordinary Limited before and after the various strategies outlined above. Question 6.3 Mixed Ltd and Pure Ltd are companies that are identical except for funding. Both make an operating profit of 2.5m p.a. and both companies have a policy of paying out all residual profit as dividend. Further details are as follows: Mixed Ltd 4m ordinary shares of 1 each 4m 5% debentures Pure Ltd 50m ordinary shares of 50p each Market Value 000 12,500 This Market Value 000 8,000 5,000 13,000

Your client, Valentina, holds 40,000 ordinary shares in Mixed Ltd. reflects her attitude towards risk. Required:

1. Devise a strategy to increase Valentinas wealth whilst maintaining her risk position. 14

2. Calculate the WACC for Mixed Ltd. and Pure Ltd. Where Nominal and Market Values of Debt are Different In the Question of Mixed Ltd. and Pure Ltd., the 5% debentures in Mixed Ltd. had a market value that was 25% higher than their nominal value. Someone with 125 to invest would be able to acquire debentures with a nominal value of only 100. Interest receivable on those debentures would be 5% x 100 = 5 p.a. So the investor would receive 5 interest from an investment that cost 125: this implies a market rate of interest of (5/125) x 100% = 4%. The reason for the difference between the market rate and nominal rate of these debentures could be that 5% was the market rate of interest for those debentures when they were issued, but that the current market rate is 4%. It is possible to approach the question by assuming that an investor could borrow in the same way as Mixed Ltd., that is, by assuming that the investor could borrow 50,000 and pay interest at 5% on 40,000 (= 2,000). However, it is more realistic to assume that she would be able to borrow 50,000 at the prevailing rate of interest, 4%, leading to interest payable of 4% x 50,000 = 2,000. The strategy is given below: As a 1% investor in Mixed Ltd., Valentinas current annual return is: 1% x (2.5m - 5%.4m) = 23,000. 1 2 Sell the shares for 1% x 8m = 80,000 Pay the same amount of interest as her earlier share of the corporate interest, 2,000 p.a.. The prevailing rate of interest is 4% p.a. so she can borrow 50,000 (the quickest way of calculating this amount is simply to take 1% of the market value of the corporate debt). Invest 125,000 in 500,000 shares to become a 1% investor in Pure Ltd., realising a gain of (80,000 + 50,000) - 125,000 = 5,000. Receive an annual return from Pure Ltd of: 2.5m/50m = 5p per share; 5p x 500,000 shares = Less: interest on borrowings of 4% x 50,000 = Receive a net return of 25,000 2,000 23,000

We conclude that our investor is maintaining both her income and risk exposure, but has realised a capital gain of 5,000. Note that the interest calculation can be checked as follows: interest paid by the company at 4% on 5m debentures = 4% x 5m = 200,000, Valentinas 1% share of this = 2,000: Checks.

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We now identify the anomaly implicit in the traditional view, in relation to the previous illustration: WACC of Pure Ltd.: An ordinary shareholder in Pure Ltd receives 2.5m/50m = 5p per share. The market value of a share in Pure Ltd is 12.5m/50m = 25p. So, the cost of capital is 5/25 = 20%. WACC of Mixed Ltd.: The 4m shares in Mixed Ltd. have a market value of 8m so each share is worth 2. The total return to the shareholders is 2,300,000 or 57.5p per share, hence the return on equity is 57.5/200 = 28.75%. The return on 100 nominal value debentures is 5%x100 = 5 and the market value of such a holding is 100x5/4 = 125. Thus, the return on the debentures is 5/125 = 4%. So, the WACC in Mixed Ltd. is: (8m.28.75% + 5m.4%)/(8m + 5m) 19.23%. These calculations demonstrate the anomaly of ostensibly identical (except for funding) companies having different WACCs. The view of Franco Modigliani and Merton Miller is that the state of affairs outlined above would result in investors selling shares in Mixed Ltd. and buying shares in Pure Ltd. This would result in the price of shares in Mixed Ltd. falling and the price of shares in Pure Ltd. increasing until an equilibrium position was reached at which there would be no benefit in adopting the arbitrage strategy. That view is discussed further in the next section. The Modigliani and Miller View The essence of this view is that firms of identical size experiencing identical operating risks are identical in all material economic aspects and will therefore have the same value and hence the same WACC 6 irrespective of their gearing. Hence, the WACC profile is a straight line parallel to the x-axis. Thus, the MM view is that the capital structure of a firm is irrelevant to its value. The value of the firm stems from expectations about the future cash flows that the firm will generate. Investors are effectively buying future cash inflows, if a particular set of cash flows is available from a choice of two investments (of identical risk) then the cash flows should cost the same. If they have different prices, rational investors will switch from the more expensive to the cheaper company (as we saw with the earlier examples of Leverage Ltd. and Ordinary Limited, and Mixed Ltd. and Pure Ltd.), and supply and demand will mean that the cheaper company will become more expensive and the more expensive company will become cheaper until such time as their prices will no longer lead to a gain on switching. At that stage, the prices are said to be in equilibrium and those prices will be such that the total market value of the companies are the same.

If the firms have the same total income and the same market value, then they have the same WACC.

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There are two arguments that are fundamental to the Modigliani and Miller view:1. 2. The issue of debt increases the risk for holders of equity. These holders therefore demand an increase in return which will exactly offset the effect on WACC of the use of the cheaper debt financing At high levels of gearing, risk-seeking investors will buy equity for the first time.

The second argument is an assumption to which we shall return later, for the time being we note that there is little experience in Western economies of very high levels of gearing. The first argument contradicts the traditional view that the ordinary shareholders do not require compensation for being exposed to low levels of financial risk, i.e. the Modigliani and Miller view is that ordinary shareholders will always require compensation for increased financial risk even at comparatively low levels of gearing. Furthermore, it is argued that if such compensation is not supplied the shareholders can themselves create the compensation by switching their investment to an ungeared company of identical business risk and using personal borrowing to replace the corporate financial risk that was present in their original investment. This was illustrated above by means of an arbitrage effect calculation. The following question gives a further example of an arbitrage strategy. Question 6.4 Geared Ltd. and All-Equity Ltd. are identical in every respect, except funding. The annual pre-interest profit for both firms is 1m, and, as a matter of company policy, all profit is distributed as dividend. Geared Ltd. 6m ordinary shares of 1 each 4m 4% debentures All-Equity Ltd. 10m ordinary shares of 1 each Required: Demonstrate an arbitrage opportunity open to a holder of 1% of the equity in Geared Ltd. We now calculate the return available to an equity investor in Geared Ltd. and then calculate the return available to an equity investor in All-Equity Ltd. Cost of equity capital in Geared Ltd. The annual pre-interest profit for both firms was 1m. The cost of servicing the debt in Geared Ltd. is 4% x 4m, i.e. 160,000 leaving 1m - 160,000 = Market Value m 8.4 4.0 12.4 m 10.0

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840,000 net profit for the holders of the 6m equity shares. Each shareholders annual return is 14p per share. The market value of a share in Geared Ltd. is 8.4m/6m = 140p. The cost of equity capital in Geared Ltd. is therefore (14p/140p) x 100% = 10%. Cost of equity capital in All-Equity Ltd: The return for an equity investor in All-Equity Ltd. = (1m/10m) = 10p per share, and the cost of equity capital in All-Equity Ltd. is therefore (10p/100p) x 100% = 10%. Supporters of the MM view claim that this state of affairs would be unacceptable to an investor in Geared Ltd. Such an investor is receiving only the same return as an investor in the equity of All-Equity Ltd., but is running a higher risk due to the presence of gearing. Inter alia, the investor could: sell shares in Geared Ltd. and buy shares in All-Equity Ltd. to earn the same return at less risk, or sell shares in Geared Ltd., substitute personal borrowing for corporate debt, and buy shares in All-Equity Ltd. to yield a higher rate of return, or sell shares in Geared Ltd., maintain the same level of risk by borrowing money, and buy enough shares in All-Equity Ltd. to yield the same return as before this will leave some money left over, being a capital gain. The course of action would depend on the amount of risk the investor wanted to run. The first option is covered by the following Question, a solution is set out below for the second, and the third is left as an exercise for the reader7. Question 6.5 Required: (a) (b) Calculate the annual return to a holder of 30 shares in Geared Ltd. Calculate the annual return available to a holder of 30 shares in Geared Ltd. who sold the shareholding and invested the proceeds in All-Equity Ltd.

Hint: To maximise income while maintaining risk, the investor has to use the money borrowed together with that realised by selling the shares in the geared company to buy shares in the ungeared company such that the ratio of equity acquired in the ungeared company to the total equity in that company is the same as the ratio of the amount borrowed to the corporate debt in the geared company. Let the percentage of both equity and debenture be f: Sale proceeds + Borrowings = Investment in ungeared company and we have: 1% x MV Geared Company + f x Debt = f MV Ungeared Company. Now solve for f.

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Option 2: Consider a 1% investor in the equity of Geared Ltd. The investor owns 60,000 shares worth 1.40 each, i.e. 84,000 worth of shares in total. The annual return is 14p per share, i.e. 8,400 in total. Our investor would: 1 2 3 Sell the shares for 84,000 Maintain the same effective gearing as before (4:8.4) by borrowing 40,000 With the (84,000 + 40,000) = 124,000 available for investment buy 124,000/1 = 124,000 shares in All-Equity Ltd. 12,400 1,600 10,800

Receive an annual return from All-Equity Ltd. of 10p per share = Pay interest on borrowings of 4% x 40,000 = Receive a net return of

The arbitrageur is now receiving an annual income of 10,800 instead of 8,400. Clearly, under these circumstances arbitrageurs will sell shares in Geared Ltd. and buy shares in All-Equity Ltd.: as they do so, the price of shares in Geared Ltd. will fall and the price of shares in All-Equity Ltd. will rise. Arbitrageurs will stop switching from Geared to All-Equity when the return from All-Equity is the same as that from Geared. This will occur when the total market values of the two firms are the same. The characteristics of this equilibrium position are explored in the following section. The Equilibrium Position For ease of calculation let us assume that the market value of the debt in Geared Ltd. is correctly priced, and that the price of shares in All-Equity Ltd. remains constant whilst the price of shares in Geared Ltd. falls: Market value of All-Equity Ltd. = 10m. Put the market value of Geared Ltd. = 10m. The market value of the debt is 4m so that the equity component must be worth 6m. There are 6m ordinary shares in issue so they are worth 1 each at equilibrium. If shares in AllEquity remain at their original value, arbitrageurs will stop switching from Geared to All-Equity when shares in Geared fall to 1 each.

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Demonstration: Reconsider our investor in Geared Ltd. holding 60,000 shares. The annual return is 14p per share, so our investor receives 60,000x14p = 8,400 p.a. Consider the arbitrage steps: 1 2 3 The shares are worth 1 each, so 60,000 will be sold for (only) 60,000 Maintain the same effective gearing as before by borrowing 40,000 With the (60,000 + 40,000) = 100,000 available for investment, buy 100,000/1 = 100,000 shares in All-Equity Ltd. 10,000 1,600 8,400

Receive an annual return from All-Equity Ltd. of 10p per share = Pay interest on borrowings of 4% x 40,000 = Receive a net return of

Thus the net return is exactly the same as was available from holding the 60,000 shares in Geared Ltd., so there is no point in switching the investment from the geared to the ungeared company. We now calculate the WACC of the two companies at equilibrium. WACC of Geared Ltd.: When shares in Geared Ltd. are worth 1 each, the cost of equity in Geared Ltd. is (14p/100p).100% = 14%. The cost of debt in Geared Ltd. is 4% and the WACC of Geared Ltd. is thus: (6,000.14% + 4,000.4%)/(6,000 + 4,000) = 10% WACC of All-Equity Ltd.: Since the company is funded exclusively by equity, the WACC for the company is simply the cost of equity which we have already calculated above as 10%. The WACC is the same for the two companies, lending weight to the view that the WACC is independent of gearing. The next section proves that arbitraging will stop when the market capitalisations of the firms are equal. Proof That Arbitraging Stops When the Market Capitalisations of the Firms are Equal Let: Su = market value of the ungeared firm Sg = market value of the equity of the geared firm Lg = both the nominal and the market value of the geared firms loan capital i = interest rate X = (pre-interest) operating income of each firm

Both companies distribute all residual profit by way of dividend. Consider an individual holding a proportion, a, of the equity in the geared firm. That

20

individuals annual dividends would be a(X - iLg). The first arbitrage stage would be to sell this holding for aSg. The second stage would be to substitute personal borrowing for corporate debt by borrowing money in the same ratio as in the geared firm, this amount will be aLg. With the funds now available the investor can invest aSg + aLg = a(Sg + Lg) in the equity of the ungeared firm. This investment is a(Sg + Lg)/Su of the market value of the ungeared firm. The annual dividends from the new investment would be Xa(Sg + Lg)/Su. However, the investor would have to pay interest on the debt of iaLg. Hence, the net income from the new investment would be [Xa(Sg + Lg)/Su] - iaLg. Switching to the new investment is only worthwhile when the income from the new investment, [Xa(Sg + Lg)/Su] - iaLg, exceeds the income from the original investment, a(X - iLg). Switching ceases to be worthwhile and equilibrium is attained when [Xa(Sg + Lg)/Su] - iaLg is equal to a(X - iLg). If [Xa(Sg + Lg)/Su] - iaLg = a(X - iLg) Then [X(Sg + Lg)/Su] - iLg = (X - iLg) and (Sg + Lg)/Su = 1 so (Sg + Lg) = Su But (Sg + Lg) is the market value of the geared firm and Su is the market value of the ungeared firm, so arbitraging will stop and equilibrium will be reached when the market capitalisations of the two firms are equal. Question 6.6 We saw in an earlier example that, given the arbitraging opportunities open to them, holders of equity in Mixed Ltd. would sell their shares and buy ordinary shares in Pure Ltd. Assuming that this would result in the market capitalisation of Pure Ltd. at equilibrium being 12.75m and, assuming that the debt in Mixed Ltd. is already correctly priced, calculate the following: the equilibrium market value of a share in Pure Ltd. the equilibrium market value of a share in Mixed Ltd. the WACC (to 2 decimal places) of Pure Ltd. at equilibrium the WACC (to 2 decimal places) of Mixed Ltd. at equilibrium

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Question 6.7 It has been suggested that, if the equity and long-term capital of a company are valued at market price, and if the rate of return on that capital is calculated from earnings before loan interest, then that rate of return (ignoring taxation) will be identical for all companies having the same total risk. The relevant data for two such companies are given below: Lever Number of ordinary shares Market price per share 6% loan stock at par Earnings before interest 90,000 1.20 60,000 18,000 Hume 150,000 1.00 nil 18,000

All income after loan interest is distributed as dividend. Required: (i) explain and illustrate the process by which the market values of the companies might be brought into equilibrium; (ii) list the assumptions implicit in your calculations; (iii) comment on the likely effect of taxation on the market values of the two companies no calculations are required. [15 marks]

So far, we have been very brave heroic, in fact by assuming that there is no taxation. It is now necessary to investigate the impact of taxation by abandoning the assumption of no corporate taxes.

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Abandoning the Heroic Assumption (by Incorporating Taxation) Interest on corporate debt is tax allowable (deductible) in the UK and USA, whereas dividend payments (being an appropriation of profit, rather than an expense) are not. There is therefore an advantage associated with debt financing. Reconsider the data in an earlier example in a world in which corporate taxes are charged at 25%: Geared Ltd. All-Equity Ltd. 1,000 1,000 160 nil 840 1,000 210 250 630 750 630 160 790 750 nil 750

Profit before interest and tax Interest Profit before tax Taxation Profit after tax Income to Financiers: Equity Debt Total

The total income available to the people who finance Geared Ltd. is greater than the income available to the people who finance All-Equity Ltd. Some of the income has been shielded because the interest paid to service debt is tax allowable. This benefit is known as the interest tax shield: Interest Tax Shield Value Geared Ltd. All-Equity Ltd. 40 Nil

Note that the value of the tax shield is 25% x Interest = 25% x 160 = 40. The interest tax shield is an asset. It can be valued as a perpetuity using a discounted cash flow approach. Of course there is a need to choose a discount rate. The appropriate discount for the tax shield depends on the relative riskiness of the tax shield itself. One assumption that is commonly made is that the risk attached to the tax shield is identical with the risk of the interest payments that give rise to the shield. This seems plausible. The interest payment of 160 in the above example arose from interest of 4% on 4,000 debentures: the discount rate used would therefore be 4%. The Present Value (PV) of the tax shield is computed as 40/0.04 = 1,000. Effectively, the government is taking on the servicing of 25% of the loan of 4,000. Adopting the assumptions above there is a clear shortcut to calculating the PV of the tax shield. It is the product of the corporation tax rate and the amount of the debt, DT, where D is the amount borrowed and T is the rate of corporation tax. This is because the tax saving is TrD where r is the interest rate, and the PV of the tax shield is the tax saving divided by the interest rate, r; thus, the PV of the tax shield is TrD/r = DT.

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Let Vg be the market value of a geared company, and Su be the market value of an ungeared company identical to the geared firm except for its financial structure. Now, the value of a geared firm is the value it would have if allequity financed plus the PV of the tax shield, so: Vg = Su + DT To return to the example introduced above: A 1% investor in the geared firm will receive income of 6.30. S/he can sell the holding for 84. S/he borrows: 1%.(1 - 25%).4,000 = 30. To this is added only 70 from the 84 in order to buy 100 shares in the ungeared company. The return from these shares is 7.50 from which interest of 4%.30 = 1.20 is payable, giving net income of 6.30, as before. However, a capital gain of (84-70) = 14 has been made. Using the same symbols as before: The sale of shares in the geared firm yields aSg. The equity in the ungeared firm costs aSu , of which a(1 - T)Lg is met by borrowing. The capital gain is then: aSg - [aSu - a(1 - T)Lg ], rearranging gives a[Sg - Su + (1 - T)Lg ]. Gains are available until Su = Sg + (1 - T)Lg. Example: Consider two firms identical in all respects save funding:Caro plc 8m ordinary shares of 1 each 2.8m 8% debentures Orca plc 5m ordinary shares of 1 each Market Value 000 10,500 Market Value 000 9,600 2,800 12,400

Pre-interest operating income is 5,000,000. Corporation tax is charged at 25%. Calculate the capital gain available without loss of income to a 1% equity investor by switching from Caro plc to Orca plc. Calculate the equilibrium share prices when the market value of Orca plc is 11,450,000.

24

The gain is a[Sg - Su + (1 - T)Lg] a = 1% Sg = 9.6m Su = 10.5m T = 25% Lg = 2.8m Substituting gives 12,000. If the 5 million shares in Orca plc are worth 11,450,000 in total, then the price per share is 2.29. In Caro plc the loan capital has a market value of 2.8m; 75% of this is 2.1m leaving equity at (11.45m - 2.1m) = 9.35m. With 8m ordinary shares in issue this indicates a share price of about 1.17. Even after abandoning the assumption of no corporate taxation, there are still a number of assumptions inherent in the Modigliani and Miller hypothesis. These are briefly examined in the next section. The Modigliani & Miller (Post-Tax) Assumptions 1. Investors are rational. Task 1: Read the following three articles regarding share prices, and then consider whether the cases of Yahoo Japan (in 2000), John Laws Compagnie (in 1720), and Bre-X (in 1996) have anything in common with each other: In August 1717 [convicted murderer] John Law acquired a controlling interest in the derelict Mississippi Company and renamed it the Compagnie dOccident. This company had a monopoly on trade with French Louisiana in North America (at the time thought to abound in precious metals) By mid-1719 the Compagnie dOccident was re-organized as the Compagnie des Indes and had expanded to monopolize all French trade outside Europe. In July 1719 the Compagnie purchased the right to mint new coinage. In August 1719 the Compagnie bought the right to collect all French indirect taxes and in October 1719 the Compagnie took over the collection of direct taxes. Finally, a plan was launched to restructure most of the national debt, whereby the remainder of existing government debt would be exchanged for Compagnie shares. The activities of John Law were financed with share issues. The Compagnie share price was around 500 livres in May 1719, rose to nearly 10,000 livres in February 1720, and declined to 500 livres in September 1721. Erasmus Universiteit Rotterdam website: http://www.few.eur.nl/few/people/smant/m-economics/johnlaw.htm (Accessed 3 September 2004.)

25

Yahoo Japan shares nudge $1m each Yahoo Japan is seen as a future money-spinner Internet fever has helped create Japans first ever 100m yen share. Following a 50-fold rise in its stock price in little more than two years, Yahoo Japans shares are worth more than 100m yen, or just under $1m each. The huge price tag is a result of scarcity of shares there are only 4,200 shares on offer and continued internet fever. Share split In an effort to make the shares a little more affordable, there is to be a twofor-one share split but that will still leave each one costing hundreds of thousands of dollars. Yahoo Japans current share price puts its price-toearnings (PE) ratio the number of times the earnings per share must be multiplied to reach the share price at 3,355. That compares with an average PE ratio of 80 for the Tokyo Stock Exchanges 1,900 companies, and a historical average across the world of about 10. Potential remains Shares in Yahoo Japan, the countrys most popular internet portal, briefly rose by the daily limit to hit 101.4m yen ($959,600), on Wednesday [19 January 2000]. The landmark followed a five-day rally partly inspired by the planned two-for-one share split unveiled last week. The move the firms third share split in the past year was aimed at feeding the demand for shares in Japans core internet stock, which has risen 30-fold in value in the past year. Kota Nakako, an analyst at Warburg Dillon Read, said: Probably, Yahoo Japans (PE) valuation is the highest in Japan, and, of course, much higher than that of its US parent Yahoo Inc. Despite the huge gap between its market valuation and actual performance, most analysts agree that Yahoo Japan has more upward potential because there is still a lot of money chasing relatively few shares in Japans youthful internet industry. Softbank investor Another reason for the high price is the fact that there are just 4,200 Yahoo Japan shares offered for trading. Yahoo Japan is owned by Softbank Corp., with 51% of the company, and Yahoo Inc. of the US which has 34%. Ben Wedmore of HSBC in Tokyo said that the small number of shares available had added scarcity value to them. He said: Average volume over the last couple of months was 23 shares a day. There are shares where you can only buy a hundred or a thousand at a time. Yahoo is unusual in that the lot size is one, but thats because the price is so high.

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Yahoo Japan shares were priced at two million yen when they went public in November 1997. http://news.bbc.co.uk/1/hi/business/610317.stm Wednesday, 19 January, 2000. (Accessed 3 September 2004.) From end-1995 until early-1996 a Canadian mining company called Bre-X Minerals experienced a spectacular rise in its share price. The share price went from little more than a few C$ cents to more than C$ 25 per share. The reason was that the company had announced a large find of gold reserves in Indonesia (promising to be the largest new find of gold in the 20th century). Estimates of the gold reserves increased over time and subsequent reports of mining consultants and the Indonesian Mines Ministry indeed confirmed the existence of the gold reserves. Financial firms such as Lehman Brothers and J.P. Morgan strongly recommended to buy the shares of Bre-X. The share price increased accordingly. Trouble started when the chief geologist of Bre-X went missing and was presumed dead. It turned out that the mining reports were based on salted samples and the gold reserves non-existent. The share price of Bre-X Minerals collapsed in the early months of 1997. Using the benefit of hindsight, some experts may label the Bre-X Minerals case a typical example of irrational investor behavior in the stockmarket. However, the fact remains that ex ante, based on what appeared to be qualified and independent reports, rational stockmarket investors had valid reasons to expect large future profits from this proposed mining operation. They therefore increased the share price of Bre-X, which, according to fundamental finance theory, should currently reflect the expected discounted value of future cash flows. Erasmus Universiteit Rotterdam website: http://www.few.eur.nl/few/people/smant/m-economics/southsea.htm (Accessed 3 September 2004.) Task 2: Consider the following facts and consider whether investors could be said to be behaving rationally in the light of the information available to them at the time (rather than considering the matter with the benefit of hindsight). In 1929, Radio Corporation of Americas (RCA) price rose from $94 to $505, gaining 435 percent in just 18 months. By 1932, its price had fallen to just $2. RCA was not an exceptional case The Dow Jones Industrial Average peaked in 1929 at 381, and, three years later, reached a low of 41. Shares in the Australian nickel mining company, Poseidon, were trading for just two or three A$ cents in 1966. In 1969/70, Poseidon shares rose from A$1 to a peak of A$280, in less than four months, after news was reported of a nickel discovery. In the mid-1970s, Poseidon went into receivership: its final price zero.

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Do you think it is possible to learn how to avoid investing in shares that will later collapse from these historical examples? Or do you think the unavoidable uncertainty about the future combined with human fallibility makes investment in shares a lottery? 2. There are no transaction costs. This is unrealistic because of the existence of brokers commissions and other dealing costs. This could prevent exploitation of minor mispricing of equity in geared firms but would not invalidate the hypothesis where there was significant mispricing of equity in a geared firm relative to equity in an ungeared one. 3. Capital markets are efficient. It seems reasonable that investors are able to understand that an income stream is an income stream irrespective of its packaging - an income stream does not change value when it is packaged differently. To this extent at least it seems plausible that capital markets are efficient. 4. There are equivalent firms. This is an assumption which is unlikely but also unnecessary, as demonstrated by Stiglitz (1974). 5. Individuals can achieve corporate gearing. There seems no reason why a few very wealthy individuals should not be able to achieve corporate gearing. In addition, there is no reason why a company should not be an arbitrageur. 6. Interest rates are independent of the level of gearing. At low levels of gearing lenders enjoy high asset to loan ratios. It seems plausible that a lender would be indifferent between a ratio of 5:1 and 10:1. However, at high levels of gearing when the ratio approaches 1:1 then it seems likely that a price would be exacted for the erosion of the security. 7. There are no costs associated with financial distress. In the event of bankruptcy, it is unlikely that assets could be sold for an amount that would return to the ordinary shareholders the market value of their shares immediately prior to liquidation. This is because of dealing costs and inefficiency in the market for real assets. Liquidation is most likely to occur when gearing has been very high. In the UK, USA and continental Europe gearing levels are modest so the assumption is arguably unnecessary: indeed, it has been argued that the very existence of bankruptcy costs is the cause of these modest levels of gearing (although it is hard to reconcile this with the situation in Japan where gearing is

28

tremendously high, except by seeing the providers of loan capital in that country as de facto equity partners which is not unrealistic). Conclusion The only serious weaknesses stem from assumptions 6. and 7. above. Furthermore, it appears that the weaknesses are only significant at high levels of gearing. We might hypothesise that the tax advantages of loan capital cause the cost of capital to fall steadily from low to moderate levels of gearing. Above these moderate levels the increase in return to providers of debt capital caused by the erosion of their security, and the increase in return to holders of equity occasioned by the increased risk of bankruptcy costs cause the cost of capital to increase. The problem then becomes the identification of a moderate level of gearing. Of course, there will not be a single point representing moderate gearing there will be a range, or, rather, there will be a set of ranges, since the range will vary from industrial sector to industrial sector. Appendix A Note on the Relationship between Weighted Average Cost of Capital and Market Capitalisation in the Case of Identical Companies Consider a company with two sources of funding, namely equity and a single source of debt. Let the market value of the equity be Me , let the market value of the debt be Md , and let the market value of the company be Mc = Md + Me . Let the cost of equity be K e and let the cost of debt be K d . Let k be the coupon rate of the debt and P be the nominal value of the debt, then the kP return to holders of debt will be kP . The cost of debt will be K d = . Md Suppose the company has a policy of distributing all residual profit as dividend. Let the annual pre-interest profit be , then the return to equity kP investors will be kP and the cost of equity will be K e = . The Me weighted average cost of capital, C, will be given by: C= Md K d + Me K e Md + Me

Md =

( kP ) kP + Me Md Me Mc

kP + kP = . Mc Mc

29

Suppose there is a second company with identical characteristics (including annual profit), except for its capital structure (being funded exclusively by equity). The weighted average cost of capital in this company will be simply the cost of equity, namely , where ME is the market value of the second ME company, and it follows that the weighted average costs of capital for the firms will be identical unless there is a difference in their market capitalisations.

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Tutorial Sheet Question 6.8 The following information relates to two companies that are identical except for their capital structure: Dixon Ltd Equity: 175,000 ordinary shares of 1 each Debt: 125,000 5% Debentures Morse Ltd Equity: 250 000 ordinary shares of 1 each Market Value (000) 250 100 350 Market Value (000) 300

The usual pre-interest profit for both companies is 100,000 per annum. Required: (a) Calculate the capital gain that can be realised by a holder of 1,750 shares in Dixon Ltd., without altering their exposure to risk; (35%) Identify and discuss the assumptions that you have made in answering part (a) above; (30%) Comment on the likely effects of introducing corporation tax into the model you have employed in answering parts (a) and (b); (15%) If the market value of each of the companies at equilibrium is 325,000, calculate for both companies, firstly, the equilibrium price of an ordinary share, and, secondly, the WACC; (30%) Demonstrate that the approach that you used in part (a) fails to yield any benefit at the equilibrium position defined in part (d) (30%) [Total 140%]

(b)

(c)

(d)

(e)

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Question 6.9 The following information relates to two companies that are identical except for their capital structure: Allen Ltd Equity: 15m ordinary shares of 1 each Debt: 20m 5% Debentures Campion Ltd Equity: 80m ordinary shares of 1 each Market Value (m) 60 20 80 Market Value (000) 60

The usual pre-interest profit for both companies is 10m per annum. Required: (a) Demonstrate an opportunity open to a 1% investor in the equity of Allen Ltd. (35%) Identify and discuss the assumptions that you have made in answering part (a) above. (30%) Calculate the equilibrium price of an ordinary share in each of the companies if their market value at equilibrium is 70m. (20%) Comment on the likely effects on the post-tax model of Modigliani & Miller of a company operating at very high levels of gearing. (15%) [Total 100%]

(b)

(c)

(d)

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Question 6.10 The following information relates to two companies that are identical except for their capital structure: Curran plc Equity: 40m ordinary shares of 1 each Debt: 25m 5% Debentures Market Value (m) 40 25 65

Dowe plc

Market Value (m)

Equity: 120m ordinary shares of 50p each

60

The usual pre-interest profit for both companies is 5m per annum. Required: (i) Demonstrate an opportunity open to a holder of 400,000 shares in Curran plc. (60%) Explain how your scheme in a) maintained the same level of risk for the investor as s/he originally enjoyed. (30%) Calculate the equilibrium price of an ordinary share in each of the companies if their market value at equilibrium is 62.5m. (10%)

(ii)

(iii)

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Question 6.11 The following information relates to two companies that are identical except for their capital structure: Uccello Ltd Equity: 100,000 ordinary shares of 1 each Debt: 95,000 5% Debentures Bellini Ltd Equity: 185 000 ordinary shares of 1 each Market Value (000) 300 100 400 Market Value (000) 370

The usual pre-interest profit for both companies is 150,000 per annum. Required: (a) (b) (c) (d) Explain the ideas behind the traditional view of the relationship between the weighted average cost of capital and gearing, (25%) Calculate the weighted average cost of capital for Uccello Ltd and Bellini Ltd, (20%) Demonstrate an opportunity open to a holder of 1,000 shares in Uccello Ltd. (35%) Calculate the equilibrium price of an ordinary share in each of the companies if their market value at equilibrium is 385,000. (20%) [Total 100%]

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Question 6.12 Bergen plc and Oslo plc are two companies operating in the aerospace engineering industry. The companies enjoy the same business risk and are identical in all material respects except for their capital structures. Both companies anticipate earnings before interest and tax of 10m, and both companies have a policy of paying out residual income by way of dividend. The companies capital structures are as follows: Bergen plc Ordinary shares of 1 each Profit & Loss account 10% Debentures Oslo plc Ordinary shares of 50p each Profit & Loss account 000 40,000 60,000 100,000 000 40,000 35,000 75,000 25,000 100,000

Shares in Bergen plc and Oslo plc are currently trading at 200p and 150p each, respectively, whilst the debentures in Bergen plc are trading at 200%. Fredrik, an arbitrageur who holds 1% of the equity in Bergen plc, is intending to realise a capital gain of 100,000 without changing his exposure to risk. Required: (i) (ii) (iii) Calculate Fredriks dividend income from Oslo plc if he proceeds with his plan, (30%) Calculate the weighted average cost of capital for each of Bergen plc and Oslo plc, (40%) Calculate the weighted average cost of capital for Bergen plc at equilibrium, if, at equilibrium, the market capitalisation of Oslo plc is 125 million. (30%) [Total 100%]

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Question 6.13 Hare plc and Blake plc operate in the electronic engineering industry. The companies enjoy the same business risk and are identical in all material respects except for their capital structures. Both companies anticipate annual earnings before interest and tax of 30m, and both companies have a policy of paying out residual income by way of dividend. The companies capital structures are as follows: Hare plc Ordinary shares of 50p each Profit & Loss account 10% Debentures Blake plc Ordinary shares of 1 each Profit & Loss account 000 20,000 80,000 100,000 000 25,000 50,000 75,000 25,000 100,000

Shares in Blake plc and Hare plc are currently trading at 560p and 200p each, respectively, whilst the debentures are trading at par. Maclean plc owns 1% of the equity in Hare plc. Required: (i) Demonstrate the arbitrage opportunity open to Maclean plc if the Board of that company wish to maximise their companys income (without changing the exposure to risk), (30%) Calculate the maximum capital gain that could be anticipated by an arbitrageur holding 1% of the equity in Hare plc who wished to maintain both their income and exposure to risk, (30%) Discuss critically the assumptions upon which the arbitrageur in (ii) relies. (40%) [Total 100%]

(ii)

(iii)

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Question 6.14 [Question 2 June 2004] Ghiberti plc and Brunelleschi plc are two companies operating in the construction industry. The companies enjoy the same business risk and are identical in all material respects except for their capital structures. Both companies anticipate earnings before interest and tax of 25m, and both companies have a policy of paying out residual income by way of dividend. The companies capital structures are as follows: Ghiberti plc Ordinary shares of 1 each Profit & Loss account 10% Debentures Brunelleschi plc Ordinary shares of 25p each Profit & Loss account 000 20,000 80,000 100,000 000 25,000 50,000 75,000 25,000 100,000

Shares in Brunelleschi plc and Ghiberti plc are currently trading at 140p and 400p each, respectively, whilst the debentures are trading at par. Required: (i) Identify, explain, and justify the actions that an adherent to the views of Modigliani and Miller would take to improve their financial position if they held 1% of the equity in Ghiberti plc, (20%) (ii) Calculate the maximum capital gain that could be anticipated by the arbitrageur in (i) without reducing their income, (20%) (iii) Discuss critically the assumptions upon which the arbitrageur in (i) relies. (60%) [Total 100%]

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Question 6.15 [Question 3 June 2006] Tey plc and Crispin plc are two companies operating in the electronic engineering industry. The companies enjoy the same business risk and are identical in all material respects except for their capital structures. Both companies anticipate annual earnings before interest and tax of 30m, and both companies have a policy of paying out residual income by way of dividend. The companies capital structures are as follows: Tey plc Ordinary shares of 50p each Profit & Loss account 10% Debentures Crispin plc Ordinary shares of 1 each Profit & Loss account 000 20,000 80,000 100,000 000 25,000 50,000 75,000 25,000 100,000

Shares in Crispin plc and Tey plc are currently trading at 560p and 200p each, respectively, whilst the debentures are trading at par. Marsh plc owns 1% of the equity in Tey plc. Required: (i) Demonstrate the arbitrage opportunity open to Marsh plc if the Board of that company wish to maximise their companys income (without changing the exposure to risk) from Tey plc, (20%) (ii) Calculate the maximum capital gain that could be anticipated by an arbitrageur holding 1% of the equity in Tey plc who wished to maintain both their income and exposure to risk, (20%) (iii) Discuss critically the assumptions upon which the arbitrageur in (ii) relies. (60%) [Total 100%]

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Question 6.16 [Question 2 March 2007] Cocteau plc and Renoir plc are two companies operating in the electronic engineering industry. The companies enjoy the same business risk and are identical in all material respects except for their capital structures. Both companies anticipate earnings before interest and tax of 25m, and both companies have a policy of paying out residual income by way of dividend. The companies capital structures are as follows: Cocteau plc Ordinary shares of 1 each Profit & Loss account 10% Debentures Renoir plc Ordinary shares of 25p each Profit & Loss account 000 20,000 80,000 100,000 000 25,000 50,000 75,000 25,000 100,000

Shares in Renoir plc and Cocteau plc are currently trading at 140p and 400p each, respectively, whilst the debentures are trading at par. Required: (i) Calculate the maximum capital gain that could be anticipated (without any reduction in income) by an adherent to the views of Modigliani and Miller who holds 1% of the equity in Cocteau plc, (20%) (ii) Identify, explain, and justify the actions taken by the arbitrageur in (i), (20%) (iii) Discuss critically the assumptions upon which the arbitrageur in (i) relies. (60%) [Total 100%]

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Question 6.17 [Question 2 March 2008] Bill plc and Suzanne plc operate in the electronic engineering industry. The companies enjoy the same business risk and are identical in all material respects except for their capital structures. Both companies anticipate annual earnings before interest and tax of 40m, and both companies have a policy of paying out residual income by way of dividend. The companies capital structures are as follows: Bill plc Ordinary shares of 50p each Profit & Loss account 10% Debentures Suzanne plc Ordinary shares of 1 each Profit & Loss account 000 20,000 80,000 100,000 000 25,000 50,000 75,000 25,000 100,000

Shares in Suzanne plc and Bill plc are currently trading at 560p and 200p each, respectively, whilst the debentures are trading at par. Maclean plc owns 1% of the equity in Bill plc. Required: (i) Calculate the maximum capital gain that could be gained by Archie plc, an arbitrageur holding 1% of the equity in Bill plc, whilst maintaining that arbitrageurs income and exposure to risk, (30%) Explain how your scheme in (i) ensured that Archie plcs exposure to risk remained unchanged, (30%) Discuss critically the assumptions upon which Archie plc would have to rely for your scheme to be effective. (40%) [Total 100%]

(ii) (iii)

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Question 6.18 [Question 2 September 2008] Haddad plc and Habash plc operate in the same engineering industry. The companies enjoy the same business risk and are identical in all material respects except for their capital structures. Both companies anticipate annual earnings before interest and tax of 23m, and both companies have a policy of paying out all residual income by way of dividend. The companies capital structures are as follows: Haddad plc Ordinary shares of 1 each Profit & Loss account 6% Debentures Habash plc Ordinary shares of 1 each Profit & Loss account 000 50,000 150,000 200,000 000 100,000 50,000 150,000 50,000 200,000

Shares in Habash plc and Haddad plc are currently trading at 700p and 250p each, respectively, whilst the debentures are trading at par. Nayef owns 1% of the equity in Haddad plc. Required: (i) Demonstrate the arbitrage opportunity open to Nayef if he wishes to maximise his income (whilst maintaining approximately the same level of risk), (30%) (ii) Calculate the maximum capital gain that could be anticipated by Nayef if he wished to maintain both his income and his level of exposure to risk, (40%) (iii)Calculate the weighted average cost of capital for each of the companies at equilibrium if their market value at that point is 325m. (30%) [Total 100%]

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Question 6.19 [Question 2, March 2009] Rossini plc is identical in all operating and risk characteristics to Wagner plc, except in terms of capital structure: Rossini plc is financed by equity, whereas Wagner plc is financed by a mixture of debt and equity. The market values of Wagner plcs debt and equity are 2.1m and 0.9m, respectively. To service its debt, Wagner pays 72,000 p.a., and the company pays an annual dividend of 378,000. Rossini plc pays a dividend of 450,000 p.a. Required: (a) (b) (c) (d) (e) (f) Calculate the market value of Rossini plc, (5%) Calculate the cost of capital for Rossini plc, (5%) Calculate the cost of equity for Wagner plc, (10%) Calculate the cost of debt for Wagner plc, (10%) Calculate the weighted average cost of capital for Wagner plc (10%) In a world where debt tax relief is available at 30%, calculate the weighted average cost of capital for Wagner plc. (60%) [Total 100%]

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