1. CHAPTER 12
CAPITAL STRUCTURE 1

2. Chapter outline Introduction The different types of equity finance
The different types of non-current debt finance
Debt versus equity
Medium-term finance
Gearing
Capital structure
Optimal capital structure
Conclusion

3. Learning outcomes By the end of this chapter, you should be able to:
explain and discuss the different types of equity finance
calculate and interpret the valuing of rights
explain and discuss the different types of debt finance
distinguish between equity and debt finance
distinguish between long- and medium-term sources of finance
evaluate and advise on whether to use borrow-and-buy or lease financing
explain, calculate and interpret the different types of gearing
analyse and evaluate capital structure
provide recommendations for achieving an optimal capital structure.

4. Introduction Every business requires finance or capital
Two broad categories of capital/finance exist:
Equity instruments
Debt instruments
The above instruments can also be divided into external and internal sources
Debt finance is cheaper, but increases financial risk – known as gearing
The combination of equity and debt finance in an entity is known as the capital structure

5. Different types of equity finance
External sources of equity finance include:
Ordinary shares
Preference shares
Internal sources of equity finance include:
Reserves
Retained earnings
Revaluation shares
Share premiums

6. Ordinary shares Ultimate owners of the entity
Highest risk for providers of capital
Return in form of capital growth and dividends
Dividends are not tax-deductible
Can be listed on a stock exchange
Stock exchange can act as a:
Primary market
Helps entities raise capital
Secondary market
Matching investors that want to buy and sell shares

7. Ordinary shares Methods of listing on a stock exchange include:
Offer for sale
Existing shareholders sell shares to public at a fixed price
Offer for subscription (IPO)
Entity offers unissued shares to public
Offer for sale by tender (auction)
Shares are not issued at fixed price but auctioned
Private placement
Shares are offered to institutional clients
Rights issue
Entity offers its existing shareholders additional shares
TERP

8. Preference shares Entitle shareholders to a fixed rate of dividend
Carry part ownership in an entity
Dividends are not tax-deductible
Rank ahead of ordinary shares in the event of liquidation but behind debt finance
Preference shares are a hybrid instrument

9. Preference shares Types of preference shares include:
Convertible preference shares
May convert into ordinary shares or other security
Cumulative preference shares
Cumulative – dividend accumulates when not paid
Non-cumulative – does not accrue and dividend forfeited
Participating preference shares
Fixed dividend and shareholders share profits with ordinary shareholders
Redeemable preference shares
Preference shares that will be repaid
Characteristics of debt instruments

10. Internal sources of equity finance
Reserves
Includes retained earnings, revaluation reserves and share premiums
Accumulated profits entity has retained
Important source of finance – generally cheapest source of finance
Cash is available and no transaction costs
Retained earnings are not a “free” source of finance – opportunity cost involved
Amount of retained earnings depends on growth strategy and dividend policy

11. Different types of non-current debt finance
Debt may be classified as:
Fixed rate
Variable (floating) rate
Debt may also be classified as:
Secured
Unsecured
Types of non-current debt include:
Bonds and debentures
Mortgage bonds
Other non-current loans (such as term loans)

12. Debt versus equity Characteristic Ordinary shares (equity)
Preference shares
(hybrid)
Debt
Ranking in event of liquidation
Last
Second
First
Return provided
Capital growth and dividend
Dividend (possible additional profits)
Interest
Statement of comprehensive income and tax effect
Appropriation of after-tax profits; not tax-deductible
Interest expense- tax deductible
Risk to entity
Low risk
Medium risk
High risk
Capital repayment
No: some shares may be repurchased
Depends on whether they are redeemable
Yes: all debt will be repaid eventually
Risk to investor
Low risk, if secured
Control effect
May affect control unless use a rights issue
Yes, if shares are cumulative and dividend in arrears
No, unless convertible in the future

13. Medium-term finance
Medium-term finance generally has a maturity of between one and five years.
Sources of medium-term finance include:
Term loans
Finance leases
Operating leases
Sales and leasebacks
Factoring
Invoice discounting
Venture capital and private equity
Business angels

14. Medium-term finance The borrow and buy versus lease decision
This is a financing decision that follows on from the investing decision
An entity will only investigate whether to borrow and buy or lease if the investment decision is positive (i.e. positive NPV)
Separate discounted cash flow calculations should be performed to identify the lowest cost option (buy or lease)
The after-tax cost of debt is the most suitable discount rate to use for the financing decision

15. Gearing
Gearing (or leverage) refers to the amount of debt included in an entity’s capital structure
Gearing can be calculated in a number of ways
Market values rather than book values should be used to calculate gearing (where possible)

16. Capital structure
Combination of debt and equity included in the long-term finance of an entity
Debt generally has a lower cost than equity
If entity increases the amount of debt in capital structure, it lowers its WACC and generates a higher return for the shareholders
Increasing return for the shareholders means additional financial risk
As financial risk increases, shareholders require a higher rate of return

17. Optimal capital structure
Optimal capital structure is the capital structure that results in the lowest possible WACC
Results in highest share price
In line with maximising wealth of the shareholder
Two theories explain the effect of changes in capital structure on market value of entity:
Modigliani and Miller’s theory of gearing
Traditional theory of gearing

18. Modigliani and Miller’s theory of gearing
Proposed that optimal capital structure does not exist
Value of a company is determined by value of assets and not method in which entity is financed
Based on assumptions:
Individual investors borrow at same rate and terms as entity
Taxation is ignored
Transaction costs are ignored
Financial distress costs are ignored

19. Modigliani and Miller’s theory of gearing
Based on premise that a business’s WACC will not change irrespective of level of gearing
As more debt is added to capital structure, financial risk increases
As a result, ordinary shareholders require higher return for additional risk
Benefit of cheaper debt will be offset by more expensive equity
Optimal capital structure does not exist

20. Modigliani and Miller’s theory of gearing
Limitations
Individuals not generally able to borrow at same rate and same terms as entities
Taxation cannot be ignored in the real world – dividends are subject to additional withholding taxes and capital gains
Transaction costs are incurred in the real world
High levels of gearing do carry dangers and costs of financial distress

21. Traditional theory of gearing
As the gearing ratio increases, the WACC decreases
Value of the entity increases
Increasing risk associated with entity leads to higher required return by shareholders
Cancels out the benefits of lower debt
WACC starts to increase and the value of the entity starts to decrease

22. Traditional theory of gearing
Assumptions:
Profits will remain constant in perpetuity
Taxation is ignored
Risk will remain constant
All profits are paid out as dividends
Assumes WACC is lowest at level of gearing that represents lowest point of the WACC line (optimal capital structure OPS)
WACC will decrease until a certain point and then start to increase as the rising cost of equity becomes significant

23. Traditional theory of gearing

24. Traditional theory of gearing
Cost of equity (Ke) increases as level of gearing increases. Financial risk causes profits to become more volatile and shareholders will require higher returns
Cost of debt (Kd) increases after certain level of gearing as interest cover reduces – few assets to offer security
WACC falls initially as the level of debt increases and then increases as the cost of equity becomes more expensive
The optimum level of gearing is where WACC is at a minimum (OCS)
Capital structure that minimises WACC will also maximise the value of the entity

25. Conclusion
The mix of debt and equity that an entity adopts is known as the capital structure. The capital structure is a very important component of an entity’s financing.
An entity’s capital structure consists of various sources of finance.
Equity and debt are the two main categories of finance available to entities to finance their operations.
Equity sources of finance include external sources, such as ordinary shares and preference shares.

26. Conclusion (cont.)
Equity sources of finance include internal sources, such as retained earning. Retained earnings are not a free source of finance.
Rights issues occur when an entity wishes to raise additional ordinary share capital from existing shareholders. In a rights issue, existing shareholders are given the first right to purchase shares, usually at a discount to the current market price.
Non-current debt finance includes bonds and debentures, mortgages and term loans.

27. Conclusion (cont.)
There are various implications that an entity must consider when deciding between equity and debt sources of finance. These include the tax effect, risk and return effect and effect on control.
Various types of medium-term sources of finance are available to businesses, including leasing, factoring and invoice discounting.
Small entities may find it more difficult to raise finance than larger entities, therefore sources such as venture capital, private equity and ‘business angels’ may be appropriate.

28. Conclusion (cont.)
Gearing (or leverage) refers to the amount of debt included in an entity’s capital structure.
The optimal capital structure refers to the point at which an entity’s WACC is at its lower point so that returns for shareholders can be maximised.