1. The Capital Structure debate Corporate Finance 35

2. Capital structure: An introduction to the debate Different types of gearing The effect of gearing Differentiate business and financial risk The underlying assumptions, rationale and conclusions of Modigliani and Miller’s models in a world without tax

3. The balance between debt and ordinary share captial Bristol Water announced plans to hand out £50m of cash to shareholders in 2003 –‘Bristol Water was overcapitalised and it was time to do something for the shareholders’ In 2001 BT had accumulated debt of over £30bn –Sir Peter Bonfield recognised that he had allowed the debt to rise too high. ‘We identified the need to introduce new equity capital into the business to support the reduction in the unsustainable level of group debt’ –Raised £5.9bn through a rights issue Next implemented a share buy-back plan for up to 19 per cent of its shares in 2002, following the return of £435m to shareholders through buy-backs in the 2000–2 period –David Jones, chairman, said the share buy-backs represented the best way to enhance earnings per share

4. At low gearing levels the risk of financial distress is low, but the cost of capital is high; this reverses at high gearing levels Note: *This assumption is considered in the text.

5. What do we mean by ‘gearing’? Operating gearing refers to the extent to which the firm’s total costs are fixed Financial gearing concerns the proportion of debt in the capital structure Gearing and leverage are used interchangeably Balance sheet (book) figures Market values of debt and equity Capital gearing focuses on the extent to which a firm’s total capital is in the form of debt Income gearing is concerned with the proportion of the annual income stream (that is, the pre-interest profits) which is devoted to the prior claims of debtholders

6. Capital gearing Capital gearing (1) = Long-term debt Shareholders’ funds Capital gearing (2) = Long-term debt + Shareholders’ funds Long-term debt Capital gearing (3) = All borrowing + Shareholders’ funds All borrowing Capital gearing (4) = Long-term debt Total market capitalisation

7. Income gearing It may be erroneous to focus exclusively on assets when trying to judge a company’s ability to repay debts Interest cover = –––––––––––––––––––––––––––– Profit before interest and tax Interest charges The inverse of interest cover measures the proportion of profits paid out in interest – this is called income gearing

8. The effect of gearing If operating profits are high, the geared firm’s shareholders will experience a more than proportional boost in their returns compared to the ungeared firm’s shareholders Harby plc is shortly to be established Capital structures: –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

9. Probabilities of performance levels * Taxes are to be ignored.

10. The effect of gearing

11. Changes in shareholder returns for ungeared and geared capital structures

12. Expected returns and standard deviations of return to shareholders in Harby plc

13. Expected returns and standard deviations of return to shareholders in Harby plc (continued)

15. 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

16. The value of the firm and the cost of capital V = ––––––– C1C1 WACC Value of the firm, V = V E + V D WACC = k E W E + k D W D Assume the cost of equity capital is 20 per cent, the cost of debt capital is 10 per cent, and the equity and debt weights are both 50 per cent WACC = (20% × 0.5) + (10% × 0.5) = 15% The firm is expected to generate a perpetual annual cash flow of £1m V = –––––––– = ––––– = £6.667m C1C1 £1m WACC 0.15

17. Does the cost of capital (WACC) decrease with higher debt levels? Let us assume that the debt ratio is increased to 70 per cent through the substitution of debt for equity Scenario 1 The cost of equity capital remains at 20 per cent WACC = k E W E + k D W D WACC = (20% × 0.3) + (10% × 0.7) = 13% V = –––––––– = ––––– = £7.69m C1C1 £1m 0.13 WACC 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 WACC = k E W E + k D W D WACC = (26.67% × 0.3) + (10% × 0.7) = 15%

18. Change the WACC Scenario 3 The cost of equity capital rises, but this does not completely offset all the benefits of the lower cost of debt capital WACC = k E W E + k D W D WACC = (22% × 0.3) + (10% × 0.7) = 13.6% C1C1 £1m V = ––––––– = –––––– = £7.35m WACC 0.136 Scenario 4 The cost of equity rises to more than offset the effect of the lower cost of debt WACC = (40% × 0.3) + (10% × 0.7) = 19% V = ––––––– = –––––– = £5.26m WACC0.19 £1m C1C1

19. 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 total market value of the firm is the net present value of the income stream. For a firm with a constant perpetual income stream: V = ––––––– C1C1 WACC The WACC is constant because the cost of equity capital rises to exactly offset the effect of cheaper debt

20. MM: The assumptions 1 There is no taxation 2 There are perfect capital markets, with perfect information available to all economic agents and no transaction costs 3 There are no costs of financial distress and liquidation 4 Firms can be classified into distinct risk classes 5 Individuals can borrow as cheaply as corporations

21. Pivot plc It needs £1m capital to buy machines, plant and buildings Required return is 15 per cent Expected annual cash flow is a constant £150,000 in perpetuity 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)

22. Pivot plc: capital structure and returns to shareholders

24. The cost of debt, equity and WACC under the MM no-tax model

25. If WACC is constant and cash flows do not change, then the total value of the firm is constant V = V E + V D = £1m V = –––––––– = –––––––––– = £1m C 1 £150,000 WACC 0.15

26. MM’s propositions 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

27. Cost of equity capital for a geared firm that becomes an all-equity financed firm in a world with no taxes What would the cost of equity capital be if the firm described below is transformed into being all equity financed rather than geared? Perpetual future cash flow of £2.5m –––––––––––––––––––––––––––––––––––––– = 0.40 Market value of debt Market value of debt + Market value of equity k D = 9% regardless of gearing ratio. At a gearing level of 40%, k E = 22%. WACC = k E W E + k D W D WACC = (22 × 0.6) + (9 × 0.4) = 16.8%

28. Lecture review Financial gearing Operating gearing Capital gearing Income gearing The effect of financial gearing Business risk Financial risk Modigliani and Miller’s perfect no-tax world