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Chapter Six

Capital Structures (For Home study)

1 Introduction

How should the company decide the mix of equity and debt
capital?

2 Practical Issues

If the company uses Debt capital funding it should consider:

! Credit Rating of the company

! Rate of interest it will pay
! Market conditions- access to Debt capital
! Forecast Cash Flows-to service and repay the debt.
! Level of Tangible Assets on which secure the loans.
! Interest will lead to tax savings i.e. Tax Shield
! Constraints on the level of debt from
! Articles Of Association
! Loan Agreements.
! Effect upon the company gearing ratio - Debt/Equity+Debt OR
Debt/Equity
! Will the debt providers exercise influence over the company?
! The chance of bankruptcy.

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3 Theories of Optimal Capital Structure

3.1 Common Ground-both major views accept two facts:

a) Yield<Ke
b) Gearing causes Ke to rise

3.2 Traditional View

% Ke

Cost

of

Capital

WACC

Kd

0 X Gearing

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Key Points:

1) Ke rises due to financial risk caused by gearing.

2) Kd is initially unaffected by gearing but rises at “high” gearing
levels due to the perception of the possibility of bankruptcy.
3) WACC-trade off of Ke and Kd. Point X is the optimum gearing level
where WACC is lowest.
4) Once point X is reached via trial and error it must be maintained.

3.3 MM and Tax

% Ke

Cost of

Capital

WACC

Kd

0 Gearing

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Key points:

1) Assumption behind the model:

! All debt is risk free

! Only corporation tax exists
! Debt is issued to replace Equity
! All types of debt carry one yield, the risk free rate
! Full distribution of profits
! Perfect Capital Market

2) MM concluded companies should gear up to the maximum

levels.

3.4 Specific Equations can be used under MM+ Tax theory.

Vd=Vu+VDT

WACC=Keu{1-T x Vd}

(Ve+Vd)

Only the latter is given on the formulae sheet.

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4 Pecking Order Theory

In this approach, there is no search for an optimal capital structure

through a theorised process. Instead it is argued that firms will raise
new funds as follows:-

! Internally-generated funds
! Debt
! New issue of equity

Firms simply use all their internally –generated funds first then move
down the pecking order to debt and the finally to issuing new equity.
Firms follow a line of least resistance that establishes the capital
structure.

Internally –generated funds-i.e. Retained earnings.

! Already have funds.

! Do not have to spend any time persuading outside investors
of the merits of the project.
! No issue costs.

Debt

! The degree of questioning and publicity associated with

debt is usually significantly less than that associated with a
share issue.
! Moderate issue costs.

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New issue of equity

! Perception by stock markets that it is possible sign of

problems. Extensive questioning and publicity associated
with a share issue.
! Expensive issue costs.

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