1. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.1 LEARNING OBJECTIVES Discuss the effect of gearing, and differentiate business and financial risk Describe the underlying assumptions, rationale and conclusions of Modigliani and Miller’s models, in worlds with and without tax Explain the relevance of some important, but often non-quantifiable, influences on the optimal gearing level question

2. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.2 DEBT FINANCE IS CHEAPER AND RISKIER (FOR THE COMPANY) Lenders require a lower rate of return than ordinary shareholders Debt interest can be offset against pre-tax profits before the calculation of the corporation tax bill, thus reducing the tax paid Issuing and transaction costs associated with raising and servicing debt are generally less than for ordinary shares Exhibit 18.1 At low gearing levels the risk of financial distress is low, but the cost of capital is high; this reverses at high gearing levels HighLow Gearing level finance (if the returns to equity are constant or do not rise much with gearing*) Risk of the company becoming financially distressed HighLow HighLow Overall cost of Note: This assumption is considered in the text.

3. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.3 WHAT DO WE MEAN BY ‘GEARING’? Operating gearing Financial gearing Note: Gearing and leverage are used interchangeably. Exhibit 18.2 A firm’s financial gearing can be measured in two ways Overall perspective on debt levels Capital gearingIncome gearing

4. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.4 CAPITAL GEARING Capital gearing (1) = Long-term debt Shareholders’ funds Capital gearing (2) = Long-term debt Long-term debt + Shareholders’ funds Capital gearing (3) = All borrowing All borrowing + Shareholders’ funds Capital gearing (4) = Long-term debt Total market capitalisation

5. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.5 INCOME GEARING Interest cover = Profit before interest and tax Interest charges The inverse of interest cover is called income gearing.

6. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.6 INCOME GEARING

7. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.7 THE EFFECT OF GEARING The introduction of interest-bearing debt ‘gears up’ the returns to the shareholders. Example: Harby plc Three different capital structures £10m of capital being raised 1 All equity – 10 million shares sold at a nominal value of £1 2 £3m debt (carrying 10 per cent interest) and £7m equity 3 £5m debt (carrying 10 per cent interest) and £5m equity Exhibit 18.6 Probabilities of performance levels Customer response to firm’s products Income before interest* Probability (%) Modest success£0.5m20 Good response£3.0m60 Run-away success£4.0m20

8. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.8 Exhibit 18.7 The effect of gearing Customer responseModestGoodRun-away Earnings before interest£0.5m£3.0m£4.0m All-equity structure Debt interest at 10%0.0 Earnings available for shareholders£0.5m£3.0m£4.0m Return on shares£0.5m£3.0m£4.0m = 5% = 30% = 40% £10m 30% Gearing (£3m debt, £7m equity) Debt interest at 10%£0.3m Earnings available for shareholders£0.2m£2.7m£3.7m Return on shares£0.2m£2.7m£3.7m = 3% = 39% = 53% £7m 50% Gearing (£5m debt, £5m equity) Debt interest at 10%£0.5m Earnings available for shareholders0.0£2.5m£3.5m Returns on shares£0.0m£2.5m£3.5m = 0% = 50% = 70% £5m

9. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.9 Exhibit 18.8 Changes in shareholder returns for ungeared and geared capital structures All-equity structure 50% debt, 50% equity structure 0.501.02.03.0 10 30 50 Earnings before interest, £m Returns to shareholders (%)

10. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.10 EXPECTED RETURNS AND STANDARD DEVIATIONS FOR HARBY PLC All equity Return, R (%)Probability, p i Return  Probability 50.2 1 300.618 400.2 8 27 Expected return, R = 27% Return, R(%)Expected return, RProbability (R – R) 2 p i 527 0.2 96.8 3027 0.6 5.4 4027 0.2 33.8 Variance  2 = 136.0 30% Gearing Standard deviation  = 11.7% Return, R(%)Probability, p i Return  Probability 30.2 0.6 290.623.4 530.210.6 34.6 Expected return, R = 34.6% Return, R(%)Expected return, RProbability (R – R) 2 p i 334.60.2 199.71 3934.60.6 11.62 5334.60.2 67.71 Variance  2 = 279.04 Standard deviation  = 16.7% Exhibit 18.9 Expected returns and standard deviations of return to shareholders in Harby plc

11. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.11 EXPECTED RETURNS AND STANDARD DEVIATIONS FOR HARBY PLC 50% Gearing Return, R (%)Probability, p i Return  Probability 00.2 0 500.630 700.214 44 Expected return, R = 44% Return, R(%)Expected return, RProbability (R – R) 2 p i 0440.2387.2 50440.6 21.6 70440.2135.2 Variance  2 = 544.0 Exhibit 18.9 Expected returns and standard deviations of return to shareholders in Harby Plc Standard deviation  = 23.3%

12. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.12 BUSINESS RISK AND FINANCIAL RISK Business risk is the variability of the firm’s operating income, that is, the income before interest Financial risk is the additional variability in returns to shareholders that arises because the financial structure contains debt Exhibit 18.10 A company has responsibilities to a number of interested parties GearingExpected returnStandard deviationBusiness riskRemaining total (%)to shareholders(total risk)(%)risk due to (%) financial risk* (%) 0 (all equity)2711.7 0 3034.616.711.75 504423.311.711.6

13. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.13 THE VALUE OF THE FIRM AND THE COST OF CAPITAL C 1 WACC where: V = value of the firm; C 1 = cash flows to be received one year hence; WACC = the weighted average cost of capital. The value of the firm, V, is the combination of the market value of equity capital, V E (total capitalisation of ordinary shares), plus the market value of debt capital, V D. V = V E + V D V =

14. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.14 DOES THE COST OF CAPITAL (WACC) DECREASE WITH HIGHER DEBT LEVELS? The firm’s cost of capital depends on both the return needed to satisfy the ordinary shareholders given their opportunity cost of capital k D and the return needed to satisfy lenders given their opportunity cost of capital k D. WACC = k E W E 1 k D W D where:W E = proportion of equity finance to total finance; W D = proportion of debt finance to total finance. Assume: the cost of equity capital is 20 per cent the cost of debt capital is 10 per cent the equity and debt weights are both 50 per cent the overall cost of capital is 15 per cent WACC = 20%  The firm is expected to generate a perpetual annual cash flow of £1m. The total value of the firm is: C 1 £1m WACC 0.15 V = = = £6.667m

15. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.15 DOES WACC DECREASE WITH HIGHER DEBT LEVELS? Scenario 1 The cost of equity capital remains at 20 per cent If shareholders remain content with a 20 per cent return, the WACC decreases: WACC = k E W E 1 k D W D WACC = 20%   0.3 + 10%  0.7 = 13% The value of the firm increases: C 1 £1m WACC 0.13 Scenario 2 The cost of equity capital rises due to the increased financial risk to exactly offset the effect of the lower cost of debt In this case the WACC and the firm’s value remain constant. WACC = k E W E + k D W D WACC = 26.67%  0.3 + 10%  0.7 = 15% V == = £7.69m

16. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.16 DOES WACC DECREASE WITH HIGHER DEBT LEVELS? Scenario 3 The cost of equity capital rises, but this does not completely offset all the benefits of the lower cost of debt capital Assume that equity holders demand a 22 per cent return at a 70 per cent gearing level: WACC= k E W E + k D W D WACC= 22%  0.3 + 10%  0.7 = 13.6% C 1 £1m WACC 0.136 Scenario 4 The cost of equity rises to more than offset the effect of the lower cost of debt Assume that a return of 40 per cent is required by shareholders: WACC = k E W E + k D W D WACC = 40%  0.3 + 10%  0.7 = 19% C 1 £1m WACC 0.19 V = = £7.35m= V === £5.26m

17. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.17 MODIGLIANI AND MILLER’S ARGUMENT IN A WORLD WITH NO TAXES Proposition 1 The total market value of any company is independent of its capital structure The assumptions 1There is no taxation. 2There are perfect capital markets, with perfect information available to all economic agents and no transaction costs. 3There are no costs of financial distress and liquidation (if a firm is liquidated, shareholders will receive the same as the market value of their share prior to liquidation). 4Firms can be classified into distinct risk classes. 5Individuals can borrow as cheaply as corporations.

18. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.18 MODIGLIANI AND MILLER’S NO-TAX CAPITAL STRUCTURE ARGUMENT An example: Pivot plc £1m capital needed to buy machines, plant and buildings The required return on that level of systematic risk for an all-equity firm is 15 per cent The expected annual cash flow is a constant £150,000 in perpetuity This cash flow will be paid out each year to the suppliers of capital Consider three different finance structures: Structure 1 All equity (1,000,000 shares selling at £1 each). Structure 2 £500,000 of debt capital giving a return of 10 per cent per annum. Plus £500,000 of equity capital (500,000 shares at £1 each). Structure 3 £700,000 of debt capital giving a return of 10 per cent per annum. Plus £300,000 of equity capital (300,000 shares at £1 each).

19. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.19 Exhibit 18.12 Pivot plc capital structure and returns to shareholders Structur e 1Structur e 2Structure 3 £££ Annual cash flows150,000 less interest payments 050,00070,000 Dividend payments150,000100,00080,000 Return on debt, kD kD 050,000/500,000 = 10%70,000/700,000 = 10% Return on equity, kE kE 150,000/1m = 15%100,000/500,000 = 20%80,000/300,000 = 26.7% Price of each share,15p20p26.7p d1d1 0.15 = 100p 0.20 = 100p 0.267 = 100p kEkE WACC15  1.0 + 0 = 15%20  0.5 + 10  0.5 = 15%26.7  0.3 + 10  0.7 = 15% (k E W E + k D W D ) Total market value of debt, V D 0500,000700,000 Total market value of equity,VEVE 150,000100,00080,000 0.15 = 1m 0.2 = 0.5m 0.267 = 0.3m Total value of the firm, V=VDVD +VEVE £1,000,000

20. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.20 Exhibit 18.13 The cost of debt, equity and WACC under the MM no-tax model Returns to shareholders (%)Return % 15 10 Debt/Equity k E k D WACC Return %

21. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.21 WACC If the WACC is constant and cash flows do not change, then the total value of the firm is constant: V = V E + V D = £1m C 1 £150,00 WACC 0.15 Exhibit 18.14 Value of the firm under the MM no-tax model Returns to shareholders (%)Return %Value £m Debt/Equity V Value £m V == = £1m

22. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.22 MODIGLIANI AND MILLER’S ARGUMENT IN A WORLD WITH NO TAXES Proposition 2 The expected rate of return on equity increases proportionately with the gearing ratio Proposition 3 The cut-off rate of return for new projects is equal to the weighted average cost of capital – which is constant regardless of gearing

23. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.23 THE CAPITAL STRUCTURE DECISION IN A WORLD WITH TAX Exhibit 18.15 MM with tax Exhibit 18.16 Value of the firm, MM with tax Returns to shareholders (%)Return %Value £m 15 7 Return % Debt/Equity k E k D (1 –T) WACC Return % Returns to shareholders (%)Return %Value £mReturn %Value Debt/Equity V Value

24. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.24 FINANCIAL DISTRESS Financial distress: where obligations to creditors are not met or are met with difficulty Exhibit 18.18 Costs of financial distress Indirect examples Direct examples Lawyers’ fees. Accountants’ fees. Court fees. Management time. Uncertainties in customers’ minds about dealing with this firm – lost sales, lost profits, lost goodwill. Uncertainties in suppliers’ minds about dealing with this firm – lost inputs, more expensive trading terms. If assets have to be sold quickly the price may be very low. Delays, legal impositions, and the tangles of financial reorganisation may place restrictions on management action, interfering with the efficient running of the business. Management may give excessive emphasis to short-term liquidity, e.g. cut R&D and training, reduce trade credit and stock levels. Loss of staff morale, tendency to examine possible alternative employment. To conserve cash, lower credit terms are offered to customers, which impacts on the marketing effort. Temptation to sell healthy businesses as this will raise the most cash.

25. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.25 Exhibit 18.20 The cost of capital and the value of the firm with taxes and financial distress, as gearing increases Debt/Equity Value of geared firm with tax effect only considered Optimal gearing level Debt/Equity k E k DAT WACC Value of firm with taxes and financial distress costs Costs of financial distress Value Return %

26. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.26 SOME FACTORS INFLUENCING THE RISK OF FINANCIAL DISTRESS COSTS 1 The sensitivity of the company’s revenues to the general level of economic activity 2 The proportion of fixed to variable costs 3 The liquidity and marketability of the firm’s assets 4 The cash-generative ability of the business

27. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.27 Exhibit 18.21 The characteristics of the underlying business influences the risk of liquidation/distress, and therefore WACC, and the optimal gearing level CharacteristicFood retailerSteel producer Sensitivity to economicRelatively insensitive toDependent on general activityeconomic fluctuationseconomic prosperity Operational gearingMost costs are variableMost costs are fixed Asset liquidityShops, stock, etc., easily sold Assets have few/no alternative uses. Thin secondhand market Cash-generative abilityHigh or stable cash flowIrregular cash flow Likely acceptableHIGHLOW gearing ratio

28. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.28 OTHER FACTORS AFFECTING LEVELS OF DEBT (1) 1 Agency costs Agency costs are the direct and indirect costs of ensuring that agents act in the best interest of principals. 2 Borrowing capacity Lenders prefer secured lending, and this often sets an upper limit on gearing. 3 Managerial preferences Managers have a natural tendency to be cautious about borrowing.

29. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.29 OTHER FACTORS AFFECTING LEVELS OF DEBT (2) 4 Pecking order for financing Firms prefer to finance with internally-generated funds. A firm first of all tries to finance investments by using the store of previous years’ profits If still more funds are needed, firms will go to the capital markets Debt market is called on first Only as a last resort will companies resort to raising equity finance. Reasons: 1 The stock markets perceive an equity issue as a sign of problems 2 Managers are following a line of least resistance 3 Ordinary shares are more expensive to issue than debt capital, which in turn is more expensive than simply applying previously generated profit

30. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.30 OTHER FACTORS AFFECTING LEVELS OF DEBT (3) 5 Financial slack 6 Signalling 7 Control 8 Industry group gearing

31. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.31 IDEAS ON DEBT FINANCE Motivation Reinvestment risk Operating and strategic efficiency

32. 18 CAPITAL STRUCTURE Glen Arnold: Corporate Financial Management, Second edition © Pearson Education Limited 2002 OHT 18.32 Exhibit 18.25 WACC is U-shaped and value can be altered by changing the gearing level Debt/Equity WACC Major influences: –financial distress/bankruptcy cost –agency costs Major influences: –lower cost of debt –tax relief on debt Debt/Equity Other factors by other factors. In the list below, the direction of the effect is indicated by an arrow. tends to argue for lowering debt level tends to argue for raising debt level uncertain 1 Borrowing capacity 2 Managerial preference 3 Pecking order 4 Financial slack 5 Signalling 6 Control 7 Industry group gearing 8 Motivation 9 Reinvestment risk 10 Operating and strategic efficiency Firm’s value Return % The debt-equity ratio can also be affected