Gearing & Capital

Structure

Effects of capital structure

What proportion of debt and equity an entity should use. Debt finance can
create valuable tax savings which can reduce cost of capital and increase
shareholders wealth. However, too much debt increases financial risk.

CAPITAL STRUCTURE refers to the way in which an organisation is financed,

by a combination of long-term capital (ordinary shares and reserves, preferred
shares, bonds, bank loans, convertible bonds and so on) and short-term
liabilities, such as a bank overdraft and trade payables. The mix of finance
can be measured by gearing ratios.

Gearing
Ratios that look at debt and gearing are a crucial way of assessing the risk
They will therefore be used extensively by financial managers when taking
financing decisions as well as by current and potential investors when
assessing the amount of financing to offer and the level of return to demand.

Financial gearing

Financial gearing is a measure of the extent to which debt is used in the

capital structure.

Note that preference shares are usually treated as debt (see chapter on
sources of finance for logic).

Equity gearing = Preference shares capital plus long term debt

Ordinary share capital and reserves

Total or capital gearing = Preference shares capital plus long term debt
Total long-term capital

Gearing ratios based on market values:

Market value of long-term debt plus preference shares

Market value of long-term capital

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 Gearing & Capital
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Capital structure theories 6/09, 6/11, 12/13
Some commentators believe that an optimal mix of finance exists at which the
company's cost of capital will be minimized.

A company should seek to minimize its weighted average cost of capital. By

doing so, it minimizes its cost of funds. The weighted average cost of capital is
an average cost of all the different sources of finance that a company uses.
By changing the proportions of each type of finance, it will alter its WACC.

So how can a company adjust its financing structure in such a way that its
WACC is minimized?

There are different views on the answer to this question. One is the so-called
'traditional' view. Another is a view proposed by Modigliani and Miller.

The traditional view concludes that there is an optimal capital mix of equity
and debt at which the weighted average cost of capital is minimized.

However, the alternative view of Modigliani and Miller (assuming no tax) is

that the firm's overall weighted average cost of capital is not influenced by
changes in its capital structure.

Both views agree that:

 The cost of equity is higher than the cost of debt.

 As the level of gearing increases, the larger proportion of debt in the
capital structure means that there is a larger proportion of lower-cost
finance.
 However, as the level of gearing rises, the cost of equity also rises to
compensate shareholders for the higher risk.
 As gearing increases, the higher proportion of low-cost debt but the
rising cost of equity pull the WACC in opposite directions.

The traditional view of capital structure

Also known as the intuitive view, the traditional view has no theoretical basis
but common sense. Taxation is ignored in the traditional view.

The traditional view is as follows.

1. As the level of gearing increases, the cost of debt remains unchanged up
to a certain level of gearing. Beyond this level, the cost of debt will
increase.

2. The cost of equity rises as the level of gearing increases and financial risk
increases. There is a non-linear relationship between the cost of equity
and gearing.

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 Gearing & Capital
Structure 3.
T
he weighted average cost of capital does not remain constant, but rather
falls initially as the proportion of debt capital increases, and then begins to
increase as the rising cost of equity (and possibly of debt) becomes more
significant.
4. The optimum level of gearing is where the company's weighted average
cost of capital is minimized.

Test your understanding 1

A Co's gearing is 1:1 debt: equity. The industry average is 1:5. A Co are
looking to raise finance for investment in a new project and they are
wondering whether to raise debt or equity.
According to the traditional view:

A. They should take on debt finance as to do so will save tax.

B. They should take on equity finance as their gearing is probably beyond
optimal.
C. It doesn't matter, as it won't affect the returns the projects generate.
D. More information is needed before a decision can be made.

Net operating income view of WACC: Modigliani-Miller (MM)

The net operating income approach takes a different view of the effect of
gearing on WACC. In their 1958 theory, Modigliani and Miller (MM) proposed
that the total market value of a company, in the absence of tax relief on debt
interest, will be determined only by two factors.
 The total earnings of the company
 The level of operating (business) risk attached to those earnings

The total market value would be computed by discounting the total earnings at
a rate that is appropriate to the level of operating risk. This rate would
represent the WACC of the company.

Thus Modigliani and Miller concluded that the capital structure of a company
would have no effect on its overall value or WACC.

Assumptions of net operating income approach

Modigliani and Miller made various assumptions in arriving at this conclusion,

including:
1. A perfect capital market exists, in which investors have the same
information, on which they act rationally, to arrive at the same expectations
about future earnings and risks.
2. There are no tax or transaction costs.

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 Gearing & Capital
Structure 3.
D
ebt is risk free and freely available at the same cost to investors and
companies alike.
Modigliani and Miller justified their approach by the use of arbitrage.

Arbitrage is when a purchase and sale of a security takes place

simultaneously in different markets, with the aim of making a risk-free profit
through the exploitation of any price difference between the markets.

If Modigliani and Miller's theory holds, it implies:

a) The cost of debt remains unchanged as the level of gearing increases.
b) The cost of equity rises in such a way as to keep the weighted average
cost of capital constant.

M&M – 1963 theory with tax

A number of practical criticisms were leveled at M&M’s no tax theory, but the
most significant was the assumption that there were no taxes. Since debt
interest is tax-deductible the impact of tax could not be ignored.

M&M therefore revised their theory (perfect capital market assumptions still
apply):

In 1963, M&M modified their model to reflect the fact that the corporate tax
system gives tax relief on interest payments.

However this is adjusted to reflect the fact that:

 Debt interest is tax deductible so the overall cost of debt to the company is
lower than in M&M – no tax
 Lower debt costs results in less volatility in returns for the same level of
gearing which leads to lower increases in Ke
 The increase in Ke does not offset the benefit of the cheaper debt finance
and therefore the WACC falls as gearing increases.

Conclusion
Gearing up reduces the WACC and increases the MV of the company. The
optimal capital structure is 99.9% gearing.

Test your understanding 2

Why do Modigliani-Miller (with tax) assume increased gearing will reduce the
weighted average cost of capital (WACC)?
A. Debt is cheaper than equity.
B. Interest payments are tax deductible.
C. Reduced levels of expensive equity capital will reduce the WACC.
D. Financial risk is not pronounced at moderate borrowing levels.

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The problems of high gearing
Bankruptcy risk
As gearing increases so does the possibility of bankruptcy. If shareholders
become concerned, this will increase the WACC of the company and reduce
the share price.

Agency costs: restrictive conditions

In order to safeguard their investments, lenders/debentures holders often
impose restrictive conditions in the loan agreements that constrain
management’s freedom of action, e.g. restrictions:
I. on the level of dividends
II. on the level of additional debt that can be raised
III. on management from disposing of any major fixed assets without the
debenture holders’ agreement.

Tax exhaustion
After a certain level of gearing, companies will discover that they have no tax
liability left against which to offset interest charges.
Kd (1 – t) simply becomes Kd.

Borrowing/debt capacity
High levels of gearing are unusual because companies run out of suitable
assets to offer as security against loans. Companies with assets, which have
an active secondhand market, and with low levels of depreciation such as
property companies, have a high borrowing capacity.

Difference risk tolerance levels between shareholders and directors

Business failure can have a far greater impact on directors than on a well-
diversified investor. It may be argued that directors have a natural tendency to
be cautious about borrowing.

Restrictions in the articles of association may specify limits on the

company’s ability to borrow.

The cost of borrowing increases as gearing increases.

As a
result, debt becomes less attractive as it is no longer so cheap.

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

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 Gearing & Capital
Structure

new issue of equity.

Firms simply use all their internally generated funds first then move down the
pecking order to debt and then 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 the 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.

New issue of equity

 Perception by stock markets that it is a possible sign of problems.
Extensive questioning and publicity associated with a share issue.
 Expensive issue costs.

Reasons for using pecking order theory

a) It is easier to use retained earnings than go to the trouble of obtaining

external finance and have to live up to the demands of external finance
providers.
b) There are no issue costs if retained earnings are used, and the issue
costs of debt are lower than those of equity.
c) Investors prefer safer securities; that is, debt with its guaranteed
income and priority on liquidation.
d) Some managers believe that debt issues have a better signalling effect
than equity issues

Limitations of pecking order theory

a) It fails to take into account taxation, financial distress, agency costs or

how the investment opportunities that are available may influence the
choice of finance.
b) Pecking order theory is an explanation of what businesses actually do,
rather than what they should do.

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 Gearing & Capital
Structure
Studies suggest that the businesses that are most likely to follow pecking
order theory are those that are operating profitably in markets where growth
prospects are poor.

Test your understanding 3

SD Co increased its gearing and its weighted average cost of capital reduced.
Which of the following theories might explain this?

1 Modigliani-Miller (with tax)

2 The traditional view
3 Pecking order theory
4 Modigliani-Miller (no tax)

A. 1,2 and 3 only

B. 1 and 4 only
C. 1 and 2 only
D. 2 and 4 only

Test your understanding 4

Director A believes there is an optimal balance of debt: equity whereas
director B doesn't believe the gearing decision affects the value of the
business.

Which theories are the directors subscribing to?

Director A Director B

A. MM (with tax) MM (no tax)

B. Traditional view MM (no tax)
C. Traditional view MM (with tax)
D. MM (no tax) traditional view

Test your understanding 5

Pecking order theory suggests finance should be raised in which order?

A. Internal funds, rights issue, debt

B. Internal funds, debt, new equity
C. Debt, internal funds, new equity
D. Rights issue, internal funds, debt

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Test your understanding 6
Answer the following questions:
a) If a company, in a perfect capital market with no taxes, incorporates
increasing amounts of debt into its capital structure without changing its
operating risk, what will the impact be on its WACC?
b) According to M&M why will the cost of equity always rise as the company
gears up?
c) In a perfect capital market but with taxes, two companies are identical in all
respects, apart from their levels of gearing. A has only equity finance, B
has 50% debt finance. Which firm would M&M argue was worth more?
d) In practice a firm, which has exhausted retained earnings, is likely to select
what form of finance next?

Tutorial note: examination questions concerning the capital structure that

minimises the WACC, or maximises the value of the firm are basically asking
the same question. Maximising MV and minimising WACC are identical
concepts.

Impact of cost of capital on investments 6/08, 12/08

The relationship between company value and cost of capital

The market value of a company depends on its cost of capital. The lower a
company's WACC, the higher the net present value of its future cash flows will
be and therefore the higher its market value.

Using the WACC in investment appraisal

The weighted average cost of capital can be used in investment appraisal if:
1. The project being appraised is small relative to the company.
2. The existing capital structure will be maintained (same financial risk).
3. The project has the same business risk as the company.

Arguments against using the WACC 6/10

 Businesses may have floating rate debt whose cost changes frequently,
and as we have seen only an estimate is used to calculate the cost of this
type of finance. Thus the company's cost of capital will not be accurate
and will need frequent updating.
 The business risk of individual projects may be different to that of the
company and will thus require a different premium included in the cost of
capital.
 The finance used for the project may alter the company's gearing and thus
its financial risk too.

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 Gearing & Capital
Structure
Using CAPM in investment appraisal 6/13
We looked at how the CAPM can be used to calculate a cost of equity
incorporating risk in previous chapter . It can also be used to calculate a
project-specific cost of capital.

The CAPM produces a required return based on the expected return of the
market E(rm), the risk-free interest rate (Rf) and the variability of project
returns relative to the market returns (). Its main advantage when used for
investment appraisal is that it produces a discount rate which is based on the
systematic risk of the individual investment.

It can be used to compare projects of all different risk classes and is therefore
superior to an NPV approach which uses only one discount rate for all
projects, regardless of their risk.

CAPM and MM combined – geared betas

When an investment has differing business and finance risks from the existing
business, geared betas may be used to obtain an appropriate cost of capital
and required rate of return for an investment.
Geared betas are calculated by:
 Ungearing industry betas
 Converting ungeared betas back into a geared beta that reflects the
company's own gearing ratio

Beta values and the effect of gearing

The gearing of a company will affect the risk of its equity. If a company is
geared and its financial risk is therefore higher than the risk of an all-equity
company, then the β value of the geared company's equity will be higher than
the β value of a similar ungeared company's equity.

The earnings of a company with gearing are more volatile than the earnings of
an all-equity company. This means that the β factor (a measure of its
systematic risk) is larger for a geared company than an ungeared company.

Similarly, the beta factor of a high-geared company is greater than the beta
factor of a low-geared company, because the volatility in its earnings is
greater.

The CAPM is consistent with the propositions of Modigliani and Miller. MM

argue that as gearing rises, the cost of equity rises to compensate
shareholders for the extra financial risk of investing in a geared company. This
financial risk is an aspect of systematic risk, and ought to be reflected in a
company's beta factor.

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 Gearing & Capital
Structure
Geared betas and ungeared betas
The connection between MM theory and the CAPM means that it is possible
to establish a mathematical relationship between the β value of an ungeared
company and the β value of a similar, but geared, company. The β value of a
geared company will be higher than the β value of a company identical in
every respect except that it is all-equity financed. This is because of the extra
financial risk. The mathematical relationship between the 'ungeared' (or asset)
and 'geared' betas is as follows.

This is the asset beta formula on the exam formula sheet.

Where βa the asset beta or ungeared beta

βe is the equity beta or geared beta
βd is the beta factor of debt in the geared company
Vd is the market value of the debt capital in the geared company
Ve is the market value of the equity capital in the geared company
T is the rate of corporate tax

Debt is often assumed to be risk free and its beta (β d) is then taken as zero, in
which case the formula above reduces to the following form.

Test your understanding 7

A company's debt:equity ratio, by market values, is 2:5. The corporate debt,
which is assumed to be risk free, yields 11% before tax. The beta value of the
company's equity is currently 1.1. The average returns on stock market equity
are 16%.

The company is now proposing to invest in a project which would involve

diversification into a new industry, and the following information is available
about this industry.

a) Average beta coefficient of equity capital = 1.59

b) Average debt:equity ratio in the industry = 1:2 (by market value)

The rate of corporation tax is 30%. What would be a suitable cost of capital to
apply to the project?

HINT
 Convert the geared beta for the new industry into an ungeared beta.
 Use the ungeared beta to calculate a geared beta that reflects the
company's own capital structure.

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 Gearing & Capital
Structure

Use this geared beta to calculate an appropriate cost of equity for the
investment. This cost of equity should be used to determine an
appropriate weighted cost of capital to use as the discount rate.

Weaknesses in the formula

The problems with using the geared and ungeared beta formula for
calculating a firm's equity beta from data about other firms are as follows.
a) It is difficult to identify other firms with identical operating characteristics.
b) Estimates of beta values from share price information are not wholly
accurate. They are based on statistical analysis of historical data and, as
the previous example shows, estimates using one firm's data will differ
from estimates using another firm's data.
c) There may be differences in beta values between firms caused by:

 Different cost structures (eg the ratio of fixed costs to variable costs)
 Size Differences between firms
 Debt capital not being risk free
d) If the firm for which an equity beta is being estimated has opportunities for
growth that are recognised by investors, and which will affect its equity
beta, estimates of the equity beta based on other firms' data will be
inaccurate, because the opportunities for growth will not be allowed for.

Test your undesrstanding 8

Backwoods is a major international company with its head office in the UK,
wanting to raise $150 million to establish a new production plant in the
eastern region of Germany. Backwoods evaluates its investments using NPV,
but is not sure what cost of capital to use in the discounting process for this
project evaluation.

The company is also proposing to increase its equity finance in the near future
for UK expansion, resulting overall in little change in the company's market-
weighted capital gearing.
The summarised financial data for the company before the expansion are
shown below.

STATEMENT OF PROFIT OR LOSS (EXTRACTS) FOR THE YEAR ENDED

31 DECEMBER 20X1
$m
Revenue 1,984
Gross profit 432
Profit after tax 81
Dividends 37
Retain earnings 44

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 Gearing & Capital
Structure
STATEMENT OF FINANCIAL POSITION (EXTRACTS) AS AT 31
DECEMBER 20X1
$m
Non currents assets 846
Currents assets 350
Total assets 1,196

Issues ordniary shares of $0.50 each nominal value 225

Reserves 761

Meduium and long term loans (see note below ) 210

Total equity and liablities 1,196

Note on borrowings
These include $75m 14% fixed rate bonds due to mature in five years' time
and redeemable at par. The current market price of these bonds is $120 and
they have an after-tax cost of debt of 9%. Other medium- and long-term
loans are floating-rate UK bank loans at LIBOR plus 1%, with an after-tax
cost of debt of 7%.
Company rate of tax may be assumed to be at the rate of 30%. The
company's ordinary shares are currently trading at 376p.
The equity beta of Backwoods is estimated to be 1.18. The systematic risk of
debt may be assumed to be zero. The risk-free rate is 7.75% and market
return is 14.5%.
The estimated equity beta of the main German competitor in the same
industry as the new proposed plant in the eastern region of Germany is 1.5,
and the competitor's capital gearing is 35% equity and 65% debt by book
values, and 60% equity and 40% debt by market values.

Required
Estimate the cost of capital that the company should use as the discount rate
for its proposed investment in eastern Germany. State clearly any
assumptions that you make.

Test your understanding 9

Four companies are identical in all respects, except for their capital structures,
which are as follows:

A plc B plc C plc D plc

% % % %
Equity as a proportion of total market
capitalisation 70 20 65 40
Debt as a proportion of total market

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 Gearing & Capital
Structure
capitalisation 30 80 35 60

The equity beta of A plc is 0.89 and the equity beta of D plc is 1.22.

Within which ranges will the equity betas of B plc and C plc lie?
A. The beta of B plc and the beta of C plc are both higher than 1.22.
B. The beta of B plc is below 0.89 and the beta of C plc is in the range 0.89 to
1.22.
C. The beta of B plc is above 1.22 and the beta of C plc is in the range 0.89
to 1.22.
D. The beta of B plc is in the range 0.89 to 1.22 and the beta of C plc is
higher than 1.22.

Test your understanding 10 (HW)

Katash is a major international company with its head office in the UK. Its
shares and bonds are quoted on a major international stock exchange.

Katash is evaluating the potential for investment in an area in which it has not
previously been involved. This investment will require $900 million to
purchase premises, equipment and provide working capital.

Extracts from the most recent (20X1) statement of financial position of Katash
are shown below:

$m
Non current assets 2,880
Current assets 3,760

Equity
Share capital ( Shares of $1 ) 450
Retained earnings 2,290

Non current liabilities

10% secured bonds repayable at par 20X6 1,800
Current liabilities 2,100

Current share price ( pence ) 500

Bond price ( $100 ) 105
Equity beta 1.2

Katash proposes to finance the $900 million investment with a combination of

debt and equity as

 $390 million in debt paying interest at 9.5% per annum, secured on the
new premises and repayable in 20X8.

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 $510 million in equity via a rights issue. A discount of 15% on the
current share price is likely.

A marginally positive NPV of the proposed investment has been calculated

using a discount rate of 15%. This is the entity's cost of equity plus a small
premium, a rate judged to reflect the risk of this venture. The Chief Executive
of Katash thinks this is too marginal and is doubtful whether the investment
should go ahead. However, there is some disagreement among the Directors
about how this project was evaluated, in particular about the discount rate that
has been used.

Director A: Suggests the entity's current WACC is more appropriate.

Director B: Suggests calculating a discount rate using data from Chlopop, a

quoted entity, the main competitor in the new business area. Relevant data for
this entity is as follows:

 Shares in issue: 600 million currently quoted at 560 cents each

 Debt outstanding: $525 million variable rate bank loan
 Equity beta: 1.6

Other relevant information

The risk-free rate is estimated at 5% per annum and the return on the market
12% per annum. These rates are not expected to change in the foreseeable
future.

Katash pays corporate tax at 30% and this rate is not expected to change in
the foreseeable future.

 Issue costs should be ignored.

Required

a) Calculate the current WACC for Katash. (7 marks)

b) Calculate a project specific cost of equity for the new investment. (5

marks)

c) Discuss whether financial management theory suggests that Katash

can reduce its WACC to a minimum level.

Test your understanding 11(HW)

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Structure
Card Co has in issue 8 million shares with an ex dividend market value of
$7.16 per share. A dividend of 62 cents per share for 2013 has just been paid.
The pattern of recent dividends is as follows:

Year 20X0 20X1 20X2 20X3

Dividends per share (cents) 55.1 57.9 59.1 62.0

Card Co also has in issue 8.5% loan notes redeemable in five years’ time with
a total nominal value of $5 million. The market value of each $100 loan note is
$103.42. Redemption will be at nominal value.

Card Co is planning to invest a significant amount of money into a joint

venture in a new business area. It has identified a proxy company with a
similar business risk to the joint venture. The proxy company has an equity
beta of 1.038 and is financed 75% by equity and 25% by debt, on a market
value basis.

The current risk free rate of return is 4% and the average equity risk premium
is 5%. Card Co pays corporation tax at a rate of 30% per year and has an
equity beta of 1.6.

Required:

a) Calculate the cost of equity of Card Co using the dividend growth

model. (3 marks)
b) Calculate a project‐specific cost of equity for Card Co for the planned
joint venture. (4 marks)
c) Discuss whether changing the capital structure of a company can lead
to a reduction in its cost of capital and hence to an increase in the
value of the company. (8 marks)

Practice questions

1.What are the main problems in using geared and ungeared betas to

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 Gearing & Capital
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calculate a firm's equity beta?

2.Assuming debt is risk free ßa = ?

3.To use WACC as the discount rate in an investment appraisal, the project
must have the same business risk as the overall company. Why is this?

4.Why, in the real world, do businesses not adopt the Modigliani and Miller
(with taxation) theory that a business should be solely funded by debt?

5. A company whose shares currently sell at $7.50 each plans to make a

rights issue of one share at $6.00 for every four existing shares.

What is the theoretical ex-rights price of the shares after the issue?

6. A company’s ex-div market price of an ordinary share is 184c. Assuming a

dividend of 16c per share has just been paid, and a growth rate of 10% per
annum, what is the company's cost of equity capital?

7. A company has just declared a dividend of 41c per share. Previous

dividends have been
4 years ago 30.00c
3 years ago 33.40c
2 years ago 34.50c
1 year ago 36.50c
What is the estimated cost of equity capital if the ex-div share price is
810c?

8. Sultan Pepper Co issued its 12% irredeemable bonds at $102. The current
market price is $95. The company is paying corporation tax at a rate of
40%.

The current cost of capital to the company of these bonds is

9. The following data relates to the ordinary shares of Lye Cheese Co.

Current market price, 31 December 20X1 250c

Market price one year ago, 31 December 20X0 227c
Earnings per share, 20X1 57.73c
Dividend per share, 20X1 35c

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Expected growth rate in dividends and earnings 10% per annum
Average market return 20%
Risk-free rate of return 13%
Beta factor of Lye Cheese Co's equity 1.5

The estimated cost of Lye Cheese Co's equity, using the dividend growth
model and market price, is

10. Kahn Flowers Co's equity has a beta factor of 0.9. The company is
financed by a mixture of equity, preference shares and irredeemable long-
term debt capital, as follows.

Ordinary shares:7% 40 million shares, market value $2 per share

7 % Preference shares of $1 each: 20 million shares, market value 50c per

share

12% Debt capital: $20 million nominal, market value $80%

If the market rate of return is 18%, the risk-free rate of return is 12% and
the rate of corporation tax 35%, what is the company's weighted average
cost of capital?

11. The dividends and earnings of Bayle Eaves Co over the last five years
have been as follows:

Dividends Earnings

Year

20X1 300,000 713,000

20X2   316,500 735,000

20X3   334,500 764,000

20X4   361,000 794,000

20X5   379,000 834,000

The company is financed entirely by equity and there are 2,000,000

shares in issue, each with a market value of $1.18 ex-div.

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On the assumption that the data for 20X1 – 20X5 provides a basis for
estimating future trends, what is the cost of equity?

12. Extreme Wildlife Co is branching out into the pet accessory market. A
company in this market, Gould Fisher Pond Co’s has a beta factor of 1.20
and a debt:equity ratio of 1:4.

Extreme Wildlife Co has a beta factor of 1.50 and is ungeared. The rate of
corporate tax is 28%, the risk free return is 4% and the market return is
8%. Assume that the debt beta is zero.

What would be the cost of capital for Extreme Wildlife to use in this NPV
appraisal?

13. Using the data in Q12, what would the cost of capital be if Extreme Wildlife
has a debt: equity ratio of 1:2. Assume that the debt beta is zero.

What would be the cost of capital for Extreme Wildlife to use in this NPV
appraisal?

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