Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy
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Chapter 18 Capital structure and the required return 495
will provoke shareholders to demand a return of 24 per cent. This would be expressed
by downward pressure on share price until the return on holding Lindley’s shares
became 24 per cent. Now, the project has to meet not only the debt financing costs, but
also the additional returns required by shareholders. The total additional required
income is:
Instead of an apparent cost of just 7 per cent, the true cost of using debt to finance
this project is actually per cent. This figure of 27 per cent is the
Marginal Cost of Capital (MCC).
In the next section, we pinpoint the conditions under which it is acceptable to use
the WACC as the cut-off rate for evaluating new investment.
■ Required conditions for using the WACC
Some major requirements have to be satisfied before use of the WACC can be justified:
1 The project is a marginal, scalar addition to the company’s existing activities, with no
overspill or synergistic impact likely to disturb the current valuation relationships.
2 Project financing involves no deviation from the current capital structure (otherwise
the MCC should be used).
3 Any new project has the same systematic risk as the company’s existing operations.
This may be a reasonable assumption for minor projects in existing areas and per-
haps for replacements, but hardly for major new product developments.
4 All cash flow streams are level perpetuities (as in the theoretical models).
In the short term, at least, firms are almost certain to deviate from the target struc-
ture, especially as market values fluctuate and financial managers perceive and exploit
ephemeral financing bargains, e.g. an arbitrage opportunity in an overseas capital mar-
ket. It is thus unrealistic to expect the hurdle rate for new investment to be adjusted for
every minor deviation from the target gearing ratio. To all intents and purposes, the
capital structure is given – only for major divergences from the target gearing ratio
should the discount rate be altered. Similarly, even where a project is wholly financed
by debt or equity, so long as the project is a minor one with no appreciable impact on
the overall gearing ratio, then it is appropriate to use the WACC as the cut-off rate.
The preceding discussions suggest that the marginal cost of capital (MCC), rather
than the cost of debt or the WACC, should be used as the cut-off rate for new invest-
ment. However, the MCC does have operational limitations. In particular, we are
required to anticipate how the capital market is likely to react to the issue of addition-
al debt. Given that we seem unable to define the WACC profile or pinpoint the opti-
mal gearing ratio at any one time, this presents a problem. We could assume that the
present gearing ratio is optimal, but this prompts the question of why different firms
in the same industry have different gearing ratios.
■ The target capital structure: a solution?
A solution commonly adopted in practice is to specify a target capital structure. For
example, BHP Billiton, the world’s largest mining company, has a target gearing range
of 35–40 per cent, according to its chief financial officer (FT report, 19 Aug. 2004). The
1£2.70 m>£10 m2 27
£2.70 m
£0.70 m £2 m
17% £10 m2 14% £50 m2
Required debt financing extra return required
extra income
costs
on equity
Marginal cost of capital
(MCC)
The extra returns required to
satisfy all investors as a propor-
tion of new capital raised
target capital structure
What the firm regards as its
optimal long-term ratio of
debt to equity (or debt to
total capital)
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496 Part V Strategic financial decisions
Waccing good value
In its Report and Accounts of 1997, the Tomkins plc Chairman answered questions
from shareholders. Two such Qs and As are shown below.
Q What is your weighted average cost of capital (WACC)?
A Some shareholders may not be familiar with this term. WACC is normally defined as the
effective cost, after tax, of all the different sources of capital which fund a business. In order
to add value for shareholders, it is necessary for the return on invested capital (including
that spent on goodwill) to exceed the WACC.
Calculating WACC is not a precise science as it involves a number of assumptions.
However, we believe that gearing of 15 to 20 per cent will achieve a WACC of around
10 per cent.
Q What level of gearing is planned?
A In this financial year, we plan to achieve gearing of 15 to 20 per cent of shareholders’ funds.
We consider a number of factors in determining an appropriate level. They are not static,
but dynamic, and will include the extent to which debt is at fixed or protected rates of
interest, the trend in interest rates, interest cover, the ratio of debt to total market capitali-
sation and to shareholders’ funds, as well as general market conditions. It will also depend
on our immediate acquisition and divestment plans. We are a conservative company when
it comes to the use of debt; however, we are committed to an efficient capital structure
and to lower progressively our WACC. It will also ensure that we are well financed should
there be a recession.
Source: Tomkins plc, Report and Accounts 1997.
firm defines what it regards as the optimal long-term gearing range or ratio, and then
attempts to adhere to this ratio in financing future operations. If the optimal ratio is
deemed to involve 50 per cent debt and 50 per cent equity (i.e. a debt-to-equity ratio of
100 per cent), any future activities should be financed in these proportions. For exam-
ple, a £10 million project would be financed by £5 million debt and £5 million equity,
via retained earnings or a rights issue. The corollary is to use the WACC as the cut-off
rate for new investment. When shareholders require 20% and debt costs 7% post-tax,
the WACC is:
The WACC is recommended because it is difficult to anticipate with any precision
how shareholders are likely to react to a change in gearing. The somewhat pragmatic
solution proposed assumes that the new project will have no appreciable impact on
gearing: in other words, that the company already operates at the optimal gearing
ratio and does not deviate from it. Obviously, the WACC and the MCC will coincide
in this case.
120% 50%2 17% 50%2 110% 3.5%2 13.5%
1cost of equity equity weighting2 1post-tax cost of debt debt weighting2
18.8 WORKED EXAMPLE: DAMSTAR PLC
Damstar plc produces and sells computer modems. The company obtained a market
quotation four years ago, since when it has achieved a steady annual return for its
shareholders of 14 per cent after tax. It has an issued share capital of 2 million 50p ordi-
nary shares. The ordinary shares sell at a P:E ratio of 11:1. In the year ended 31 March
2005, the company sold 20,000 units.
CFAI_C18.QXD 3/15/07 7:15 AM Page 496
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Chapter 18 Capital structure and the required return 497
The profit and loss account for the year to 31 March 2005 is as follows:
£000 £000
Sales 1,600
Less: Variable expenses (880)
Fixed expenses (350) (1,230)
Profit before interest and taxation 370
Less: interest payable (10% loan stock) (150)
Profit before taxation 220
Less: corporation tax (at 30%) (66)
Profit after taxation 154
Dividend (120)
Retained profit 34
In recent months, the company has been experiencing labour problems. As a result,
it has decided to introduce a new highly automated production process in order to
improve efficiency. The production process is expected to increase fixed costs by
£140,000 (including depreciation), but will reduce variable costs by £19 per unit.
The new production process will be financed by additional debt in the form of a
secured £1,000,000 debenture issue at an interest rate of 12 per cent. If the new pro-
duction process is introduced immediately, the directors believe that sales for the
forthcoming year will be unchanged.
Required
(a) Determine how the proposal affects Damstar’s break-even volume.
(b) Assuming no change in P:E ratio, calculate the change in EPS and share price if
Damstar introduces its new production process immediately.
(c) What is the effect of the new process on Damstar’s weighted average cost of capi-
tal using market value weights?
■ Answer to Damstar example
(a) First, we establish the revenue and cost parameters. Currently, the price is
per unit. The average variable cost (£0.88 m/20,000)
= £44. Hence, the gross profit margin
The break-even volume (BEV) can be expressed in operating terms, i.e. before
fixed financing charges, and also after allowing for interest. Ignoring interest, the
BEV is:
Allowing for interest of £0.15 million, the BEV is:
With the new process, the AVC becomes and the GPM
becomes
The new level of fixed operating costs is £0.49 million.
The BEV ignoring units. Allowing for the inter-
est, increased by to the BEV is:
Notice that despite the increase in interest charges and the increase in fixed oper-
ating costs, the BEV has actually fallen due to the substantial fall in AVC. This warns
that higher fixed costs does not always raise the BEV – it depends on what other
changes are occurring at the same time.
(b) Currently, the With the 11:1 P:E ratio, the share price
is 17.7p 112 85p.
EPS £154,000>2 m2 7.7p.
1£0.49 m £0.27 m2>£55 13,818 units.
1£0.15 m £0.12 m2 £0.27 m,112% £0.12 m2
interest 1£0.49 m>£552 8,909
1£80 £252 £55.
1£44 £192 £25,
1£0.35 m £0.15 m>£362 13,889 units.
1Fixed costs of £0.35 m>£362 9,722 units
1GPM2 1£80 £442
£36.
1AVC2 1£1.6 m>20,0002 £80
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498 Part V Strategic financial decisions
EPS now becomes and with the same P:E ratio, the new
share price would be
(c) Based on market value weights, the WACC is:
111.9p 112 £1.31.
1£238,000>2 m2 11.9p,
Comment: In this example, the increase in borrowing hardly affects the WACC, as
the equity value increases to compensate. This result, of course, depends on the
P:E ratio remaining at 11:1. Note also that the market value of the existing debt
falls if interest rates rise. If the market rate of interest is now 12 per cent, existing
debt with a coupon of 10 per cent must sell at a discount.
17.6% 1.8% 1.7% 2 11.1%
WACC 114% 54%2 110% 31 30% 4 26%2 112% 31 30% 4 20%2
Predicted profit and loss account for year ending 31 March 2006
££
Sales 1,600
Variable Costs (500)
Fixed Costs (490) (990)
PBIT 610
Interest (270)
PBT 340
Taxation @ 30% (102)
PAT 238
1£0.15 m £0.12 m2
1£0.35 m £0.14 m2
120,000 £252
18.9 MORE ON ECONOMIC VALUE ADDED (EVA)
In Chapter 4, we explained the concept of EVA, a popular tool for assessing the
amount of value created by a firm. In that chapter, we confined the analysis to all-
equity-financed firms. In that form, the resulting EVA measured the wealth created
for the owners of the business. EVA can also be calculated in a broader sense. Instead
of focusing on wealth creation for the owners, one can focus on total value added for
distribution to all the investors in the business. As such, for a geared firm, the EVA
is arguably a better way of assessing managers’ performance, i.e. the efficiency with
£ Weight
1.7 m 53
1.5 m 47
(unknown market value, so book value used)
Total 3.2 m 100
Value of debt 1£150,000>0.12
Value of equity 1£0.85 2 m2
After the issue of £1 million debt at 12 per cent interest, there are now two cat-
egories of debt, senior and junior.
17.4% 3.3%2 10.7%
114% 53%2 110% 31 30% 4 47%2
WACC 1cost of equity % of equity2 1post-tax debt cost % of debt2
£ Weight
2.62 m 54
1.25 m 26
1.00 m 20
Total 4.87 m 100
Value of junior debt
Vaue of senior debt 110>12 £1.5 m2
Value of equity 1£1.31 2 m2
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Chapter 18 Capital structure and the required return 499
which they utilise financial resources, because it is not distorted by the particular
method of financing the business.
The adjustment is simple. Instead of applying the cost of equity to the Net Assets,
we apply the WACC to the total capital employed to measure the capital cost, and
deduct this from the NOPAT. For consistency, since the cost of debt appears in the
WACC, the returns to debt should appear in the NOPAT, i.e. in this case the NOPAT is
before charging interest.
The EVA formula thus becomes:
It is usual to apply the WACC to long-term capital, given the relative volatility of
short-term assets and liabilities.
Example
EVA plc’s assets have a total book value of £900 million. It is financed by 60 per cent
equity and 40 per cent debt. The costs of equity and debt are 12 per cent and 7 per cent
respectively. Operating profits are £100 million, and the tax rate is 30 per cent.
As this result is negative, EVA plc appears to have destroyed value.
Readers may notice that under the traditional view of gearing, as a firm raises the
debt/equity ratio, the EVA is likely to increase, so long as the WACC declines.
EVA £70 million 19.16% £900 million2 1£70 m £82.44 m2 £12.44 m
7.2% 1.96% 9.16%
WACC
160% 12%2 140% 7% 31 30% 42
NOPAT 1Operating profit tax2 £100 m 11 30% 2 £70 million
EVA NOPAT 1WACC Capital Employed2.
18.10 FINANCIAL DISTRESS
This is an appropriate stage to clarify our terminology. Up to this point, we have
implied that the reason for the upturn in the WACC profile is the threat of ‘bankrupt-
cy’ resulting in ‘liquidation’, i.e. a company that fails to meet its debts will be forced by
its creditors to liquidate. The term ‘bankruptcy’ in the UK strictly applies to personal
insolvency. Individuals go bankrupt, and firms become insolvent. But what happens to
a firm in severe financial distress? Broadly speaking, there are two main forms of treat-
ment. The first is called ‘receivership’.
Creditors – and it only takes one of many – may apply to a court to appoint a
‘receiver’ to recover the debt if the firm defaults on interest or capital repayments.
Burning before earning
Although accountancy firms often do well from insolvencies, they are not immune from
failure themselves. Ascot Drummond is a case in point. It pioneered the concept of online
accountancy services including company formation, accounts, payroll, book-keeping and taxa-
tion accessible on clients’ computers. It obtained financing of over £6 million from venture
capitalists Mercury Private Equity in October 2001, yet having burnt its way through the first
tranche of £3 million, it was in receivership less than a year later. After pitching for a client
base of over 10,000 by end-2001, it failed to break the 1,000 mark, and was unable to turn
this into significant revenues, let alone profit.
Source: Based on an article by L. Meall, ‘Dot.com dot.gone’, Accountancy, August 2001
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500 Part V Strategic financial decisions
Trump to stay as hotels group files for Chap 11
FT
Trump Hotels & Casino Resorts
on Sunday filed a voluntary
petition for Chapter 11 in a
New Jersey bankruptcy court,
according to a plan announced
last month.
Real estate mogul Donald
Trump, star of the hit TV show
The Apprentice, will retain his
position as chairman and chief
executive of the loss-making
company, but will cut his stake to
27 per cent from 56 per cent.
Operating losses at Trump
Hotels have ballooned in the
past few years from $25.3 m in
2001 to $87.3 m in 2003, due pri-
marily to interest on its heavy
debt load. Losses for the first
nine months of 2004 totalled
$91.5 m.
Francis McCarthy, chief finan-
cial officer, said in the court fil-
ing that Trump Hotels was ‘cur-
rently over-leveraged and losing
market share and revenue to
other competitors’.
Under the recapitalisation
plan, Trump Hotels expects to
significantly reduce its $1.8 bn
in bond debt by $400 m with a
reduced interest rate represent-
ing savings in annual interest of
$98 m.
Trump Hotels has secured
$100 m in financing that will be
used to pay wages and vendor
contracts, as well as capital
expenditure likely in the form of
much-needed renovation.
Morgan Stanley has also
agreed to provide a $500 m loan,
secured by the company’s assets,
to help Trump Hotels help fund
operations, subject to court
approval.
A majority of bondholders
agreed to swap debt for equity,
cash and new bonds after
months of protracted negotia-
tions. Mr Trump said the process
‘has been a very constructive one
and should reap great benefits
for everyone in the years to
come’.
The company expects to
emerge from Chapter 11 in
60–90 days.
Trump Hotels announced in
August that it would seek bank-
ruptcy protection in connection
with a refinancing plan with
DLJ, private equity arm of
CSFB. However, that fell through
in September, along with a crucial
$400 m cash infusion.
Source: Amy Yee, Financial Times, 23 November
2004.
The receiver may sell the business, or parts of it, as a going concern, which contin-
ues to trade in a different guise, often involving a reduced scale of operation.
However, the receiver’s primary duty is to the appointing bank, and once sufficient
funds have been realised to repay the loan, the receiver is under no obligation to max-
imise the proceeds of the sale of the remaining assets, or even to keep them operating.
The receiver may choose to liquidate them in toto and disburse the net proceeds to
remaining creditors and then any residue to shareholders.
The Insolvency Act 1986 introduced a new procedure, administration, as an
attempt to rescue ailing companies and to protect employment. The company is
allowed to continue trading under the overall control of an Administrator, who will
attempt to reorganise the company’s finances and its operating structure. The
Administrator is appointed by a court at the request of the directors and has an
equal duty to all creditors. In effect, administration, rather like filing for Chapter 11
bankruptcy under the US Bankruptcy Code, is an attempt to protect the company
from its creditors, thus giving the Administrator a breathing space during which it
can attempt to secure the company’s survival as a reorganised going concern. The
main difference compared with the US equivalent is that Chapter 11 bankruptcy
allows the incumbent managers and owners to retain control. In addition, Chapter
11 enables the firm to impose a moratorium on interest payments on existing debts
for a specified period and also to borrow more funds as money lent after the filing
has a prior claim on assets.
administration
An attempt to re-organise an
insolvent firm under an admin-
istrator, rather than liquidate it
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Chapter 18 Capital structure and the required return 501
Any visitor to an auction of bankrupt stock will have no difficulty in appreciating
the importance of postponing the break-up decision. Similarly, when repossessed
assets, such as consumer durables and houses, are sold by creditors, they rarely fetch
‘market values’. This is partly because the vendor often only needs, and expects, to
recover an amount less than the market value, having deliberately set the loan itself at
less than the market value of the asset upon which it is secured. The vendor is inter-
ested in a quick sale to minimise depreciation, interest and other carrying costs.
Moreover, when it is generally known that the assets are offered under distressed con-
ditions, asset values usually head South! In January 2002, Britain’s BG Group plc
announced it would pay distressed US energy firm Enron $350 million for its stake in
oil and gas fields off the coast of India. The 30 per cent stake in the Tapti and Panna-
Mukta fields plus 63 per cent of a further untapped field, was valued by Dutch bank
ABN AMRO at $450 million, 30 per cent above the agreed price.
Not everyone likes Chapter 11 (nor 22, and 33, and 44)
The Chapter 11 arrangements are not universally admired. Of particular concern is that in
industries such as airlines and telecoms, which seem, in the US at least, particularly prone to
insolvency, bankrupt firms will reappear with more manageable debts and thus be better able
to compete with the industry survivors. This means they could drive healthier rivals into fail-
ure in turn.
Europeans are often aghast at a procedure that puts the debtor in control of the insolven-
cy procedure. Few managers in such a situation are likely to opt for full liquidation, resulting
in many ‘walking dead’ firms living on to haunt their competitors. In the US, there are also
strong suspicions that judges in the bankruptcy courts tend to identify more closely with
incumbent executives than with creditors, especially if they view the latter as being over-
assertive of their rights.
In principle, it is desirable to keep an essentially sound business in operation if it is still
capable of creating wealth, positive operating profits often being taken as an indicator of this.
However, few if any ‘zombie’ firms have emerged from Chapter 11 sufficiently reinvigorated
to challenge the leading players in their industries. Indeed, many firms have gone bust twice
(the so-called Chapter 22s), or even three times, for example, the now defunct airline TWA.
Harvard Industries, an electronics firm that started life as a brewery, holds the record with
four bankruptcies, before going into liquidation in 2002, apparently to avoid pension and
healthcare obligations.
Some of the material quoted here appeared in an article in The Economist, ‘The Night of the Killer Zombies’, 14 December 2002.
BA to raise £435 m in sale of Qantas stake
FT
British Airways is selling its
18.25 per cent stake in Australia’s
Qantas Airways to reduce its debt
and take advantage of consolida-
tion in the European aviation
market.
The sale of the cornerstone
stake, held by Europe’s second
biggest air carrier for 11 years, is
expected to raise about A$1.12
bn with analysts pre-
dicting strong interest in Qantas
from institutions seeking greater
exposure to one of the world’s
most profitable and resilient air-
lines.
The deal raised speculation
that BA is preparing for a fur-
ther round of consolidation in
Europe, following the Air France
and KLM tie up and the ongoing
crisis talks at Alitalia. But Rod
Eddington, chief executive, said
BA was not interested in the
1£435 m2,
Continued
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502 Part V Strategic financial decisions
The costs incurred at and during liquidation are called the ‘direct’ costs of financial
distress. Empirical studies (e.g. van Horne, 1975; Sharpe, 1981) have suggested that
liquidation costs, including legal and administrative charges, may lower the resale
value of distressed companies by 50 per cent or more.
However, a recent US study suggests that distress costs of this magnitude may be
an overestimate. In a study of 31 Highly Leveraged Transactions (HLTs) occurring
between 1980 and 1989, Andrade and Kaplan (1998) tried to differentiate between the
costs of dealing with economic distress, e.g. reacting to loss of contracts, and direct
costs of financial distress. Comparing enterprise values at the date of the HLT and at
the date of resolution of the distress, they estimated an average loss in firm value of 38
per cent, of which 26 per cent was due to economic distress and 12 per cent due to
financial distress.
A more insidious form of financial distress is the impact of increasing gearing on
managerial decision-making and the performance of the firm – the so-called ‘indirect’
costs. As a firm’s indebtedness begins to look excessive, it may develop an overriding
concern for short-term liquidity. This may be manifested in reduced investment in
Italian airline and gave little
away about the relationship with
Spanish carrier Iberia.
The Australian flag carrier
reported an 89 per cent increase
in net annual profits to a record
A$648 m in August. Since last
year’s war in Iraq and the severe
acute respiratory syndrome out-
break in Asia, shares in Sydney-
based Qantas have risen from a
low of A$3.07 to a closing price of
A$3.33 on Tuesday.
The stock is subject to a trad-
ing halt for two days until the
sale is completed. It is under-
stood that Citigroup has won the
mandate to conduct the book-
build.
British Airways has received
A$600 m dividends for its share-
holding in Qantas, which it
acquired before the Australian
government floated the carrier in
1995. Its initial 25 percent stake
has since been diluted as Qantas
raised additional capital to repay
debt and fund its fleet expansion.
The sale would not affect com-
mercial relations between the
two airlines, which are both
members of the Oneworld mar-
keting alliance, senior company
executives said.
‘The share sale will have no
impact on the existing business
relationship between the two air-
lines and is not linked to our
joint services agreement, which
continues,’ said Mr Eddington.
Qantas chief executive Geoff
Dixon said the airlines ‘have
formed a strong and construc-
tive commercial relationship.
Neither airline now believes the
shareholding is necessary for
the ongoing conduct of that rela-
tionship.
‘To that extent, the joint servic-
es agreement that provides for
joint schedules, sales and opera-
tions between Australia, South
East Asia, the UK and Europe
will continue, as will other forms
of cooperation.’
British Airways said it would
use the Qantas sale proceeds to
reduce its of debts.
While the UK flagship carrier
has persistently denied any plans
to sell its stake, it has struggled
in recent years in an increasingly
competitive European aviation
market, which is undergoing
another bout of consolidation fol-
lowing the recent merger of Air
France and Dutch airline KLM.
‘A strong balance sheet will
place British Airways in a robust
position for any future European
consolidations,’ Mr Eddington
said.
The UK flag carrier has a 9
per cent stake in Spanish airline
Iberia, which is also a member of
the Oneworld alliance.
Mr Dixon said Australia was
too far away to participate in a
European shakeup. ‘We will, how-
ever, seek to further our commer-
cial position to enable us to take
a leading role in any suitable con-
solidation opportunities that may
arise in the Asia Pacific region.’
British Airways’ move comes
two weeks after the Australian
government said it would not lift
a 49 per cent foreign ownership
cap placed on Qantas because it
should remain ‘quintessentially
Australian’.
Source: Leora Moldofsky, Financial Times,
8 September 2004.
£5.6 bn
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Chapter 18 Capital structure and the required return 503
training and R&D, thus damaging long-term growth capability, and reducing credit
periods and stock levels, which may hamper marketing efforts. Supplier power trig-
gered the collapse of US discount retailer, K-Mart in January 2002. Its sole supplier of
grocery products suspended payments after K-Mart failed to make a regular weekly
payment.
More obviously, a distressed firm may sell established operations at bargain prices,
sell or abandon promising new product developments, and, to the extent that it does
continue to invest, may express a preference for short-payback, cash-generating proj-
ects, rather than strategic activities. Troubled companies often cut their dividends to
preserve liquidity, but this often signals to the market the extent of their difficulties.
Finally, there may be a pervasive ‘corporate gloom effect’, which saps morale inter-
nally and damages public image externally.
Such costs are likely to be encountered well before the trigger point of cash flow cri-
sis, and, of course, many firms have successfully surmounted them, but not without an
often prolonged dip in the value of the company. In other words, both actual and antic-
ipated liquidation costs detract from company value, lowering the effective limit to debt
capacity.
The practical importance of the facility to appoint an Administrator before creditors
can appoint receivers may now be seen. Administration enhances the probability of
survival of a company unable to meet its immediate liabilities and may thus lead to
lower costs of financial distress. However, there may be an element of ‘moral hazard’
to the extent that financial managers might undertake more dangerous levels of debt,
knowing that there is a more relaxed legal procedure in the event of insolvency.
Self-assessment activity 18.11
Identify examples of distressed behaviour by highly geared firms from your reading of the
financial press.
(Answer in Appendix A at the back of the book)
Courting disaster
Administration may not always do the trick, merely
postponing the evil hour, and sometimes by not
very long.
In November 2004, Courts, the 154-year-old chain
of furniture stores, went into administration after
its bankers had called in loans worth £280 million.
Courts shares had been trading at over 300p at
the start of 2004, but were priced at just 13.5p
when they were suspended on the announcement.
Over the year, its market capitalisation had fallen
from £188 million to £8 million, having peaked in
1997 at £376 million. Courts, beset by falling UK
sales, had announced four profit warnings during
2004, and was now close to breaching the terms of
its debt covenants. It was believed to have tried to
induce its bankers to accept a debt-for-equity swap
in order to buy time, but its bankers decided to pull
the plug by appointing accountants KPMG as
administrators.
However, no White Knight was forthcoming. Just
two weeks later, and following violent scenes as
angry customers confronted Courts staff when it
tried to re-open, KPMG disclosed that it could
not sell the company as a going concern. SB
Capital, owner of Furnitureland and a specialist
in retail turnarounds, undertook to trade the
stores until existing customer orders had been
fulfilled. It retained an option to buy 14 stores,
expected to trade under the Furnitureland label,
and representing some 20 per cent of Courts’
sales, thus preserving around 300 jobs from a
total of 2,500 employees.
Source: Based on articles in the Financial Times by Elizabeth Rigby
(30 November 2004) and Kate Burgess (14 December 2004).
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504 Part V Strategic financial decisions
18.11 TWO MORE ISSUES: SIGNALLING AND AGENCY COSTS
An unexpected reduction in indebtedness is usually greeted with pleasure by the mar-
ket, whereas a debt increase can be regarded in a favourable or unfavourable light
depending on the accompanying arguments. According to Ross (1977), managers nat-
urally have a vested interest in not making the company insolvent, so an increase in
gearing might be construed by the market as signalling a greater degree of managerial
confidence in the ability of the company to service a higher level of debt. This argument
relies on asymmetric information between managers and shareholders, and reflects the
pervasive principal/agent problem.
Financial managers, as appointees of the shareholders, are expected to maximise
the value of the enterprise, but it is difficult for the owners to devise an effective, but
not excessively costly, service contract to constrain managerial behaviour to this goal.
In the context of capital structure theory, the financial manager acts as an agent for
both shareholders and debt-holders. Although the latter do not offer remuneration,
they do attempt to limit managers’ freedom of action by including restrictive
covenants in the debt contract, such as restrictions on dividend payouts, to protect the
asset base of the company.
Such restraints on managerial decision-making may adversely affect the develop-
ment of the firm and, together with the monitoring costs incurred by the shareholders
themselves, may detract from company value. Conversely, it is possible that the close
monitoring by a small group of creditors, aiming to protect their capital, may induce
managers to pursue more responsible policies likely to enhance the wealth of a widely-
diffused group of shareholders.
18.12 CONCLUSIONS
What conclusions does this body of analysis lead to, and how does it help financial
managers?
1 Gearing can lower the overall or weighted average cost of capital that the company
is required to achieve on its operations, and can raise the market value of the enter-
prise. However, this benign effect can be relied upon only at relatively safe gearing
levels. Companies can expect the market to react adversely to ‘excessive’ gearing
ratios. The implications for project appraisal are reasonably clear. Strictly, the appro-
priate cut-off rate for new investment is the marginal cost of capital, but if no
change in gearing is caused by the new activity, the WACC can be used.
2 Considerable care should be taken when prescribing the appropriate use of debt
that will enhance shareholder wealth without ever threatening corporate collapse.
Levels of gearing that look quite innocuous in calm trading conditions may sud-
denly appear ominous when conditions worsen. Corporate difficulties do not usu-
ally occur singly, and highly geared companies are relatively less well placed to
surmount them.
3 The capital structure decision, like the dividend decision, is a secondary decision –
secondary, that is, to the company’s primary concern of finding and developing
wealth-creating projects. Many people argue that the beneficial impact of debt is
largely an illusion. Clever financing cannot create wealth (although it may enable
exploitation of projects that would not otherwise have proceeded). It may, howev-
er, transfer wealth if some stakeholders are prepared, perhaps due to information
asymmetry, to accept too low a return for the risks they incur, or if the government
offers a tax subsidy on debt interest.
4 The decision to borrow should not be over-influenced by tax considerations. There
are other ways of obtaining tax subsidies, such as investing in fixed assets, which
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