Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy
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Chapter 18 Capital structure and the required return 505
qualify for tax allowances. A highly geared company could find itself unable to
exploit the other tax-breaks offered by governments when a favourable opportuni-
ty is uncovered.
5 Remember that interest rates fluctuate over time. If interest rates move from what
seems a ‘high’ level, financial managers should take advantage of the reduction. For
example, if 10 per cent seems like the ‘normal’ long-term level of interest rates,
when rates next fall below 10 per cent, and bankers are offering variable rate loans
at, say, 9 per cent, one should not be afraid to take a fixed rate loan at, say, 9.5 per
cent. Readiness to work with a slightly higher than minimum rate in the short term
could have significant payoffs in the longer term. Anyone who thinks that rates will
continue to fall should reserve some borrowing capacity to retain flexibility.
6 Firms should avoid relying on too many bankers, as with syndicated loans, despite
the benefits of access to a variety of banking facilities. If the company hits trading
and liquidity problems, it is hard enough to convince one banker that the company
should be saved. But if it has to persuade 10 or 20, and their decision has to be unan-
imous, it is virtually impossible to reach a satisfactory conclusion about capital
restructuring. The UK entertainments group Brent-Walker had to negotiate with
47 banks in its efforts to rebuild its capital structure during 1991, while the liquida-
tors of Polly Peck had to deal with 70. Eurotunnel had to deal with 225 at one stage
of its troubled existence, later reduced to a mere 200.
7 The finance manager should question whether debt is the most suitable form of
funding in the circumstances. For example, there should be a clear rationale to sup-
port the case for debt rather than retentions (i.e. lower dividends) or a rights issue.
He or she should recognise the value of retaining reserve borrowing capacity to
draw upon under adverse circumstances or when favourable opportunities, like
falling interest rates, arise.
8 These considerations are reflected in two popular theories that attempt to explain
how firms address long-term financing decisions. These are:
■ The Trade-off Theory. This recognises that firms seek to exploit the lower cost
benefits of borrowing, especially the tax shield, but at the same time, they are
reluctant to increase the financial risk entailed in entering contractual commit-
ments to make ongoing interest and capital repayments. In other words, they
trade-off the returns (the cost benefits) against the risks. We might thus expect
to find that firms enjoying higher and more stable profit levels, that offer
greater scope to shelter profits from tax, should operate at higher borrowing
levels.
■ The Pecking Order Theory. This suggests that firms have an order of priorities in
selecting among alternative forms of finance:
– First, they prefer to use the internal finance generated by operating cash flow.
– Second, they prefer to borrow when internal sources are drained.
– Third, they regard selling new shares almost as a last resort.
The reason for this order of preference lies in information asymmetry – managers
know far more about the firm’s performance and prospects than outsiders. They are
unlikely to issue shares when they believe shares are ‘undervalued’, but more
inclined to issue shares when they believe they are ‘overvalued’. Naturally, share-
holders are aware of this likely managerial behaviour and thus regard equity issues
with suspicion. For example, they may interpret a share issue as a signal that man-
agement thinks the shares are overvalued and mark them down accordingly – a
very common occurrence – thereby increasing the cost of equity. Investors would
expect managers to finance investment programmes, first, using internal resources,
second, via borrowing up to an appropriate debt/equity combination, and finally
through equity issues. Yet again, signalling considerations are crucial.
information asymmetry
The imbalance between man-
agers and owners of informa-
tion possessed about a firm’s
financial sate and its prospects
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506 Part V Strategic financial decisions
We have explained the meaning of gearing, its likely benefits to shareholders, its dan-
gers and its possible impact on the required return on investment projects.
Key points
■ Borrowing often looks more attractive than equity due to its lower cost of servicing,
tax-deductibility of interest and low issue costs.
■ A company’s indebtedness is revealed by its capital gearing and by its income
gearing.
■ The sum of discounted tax savings conferred by the tax-deductibility of debt inter-
est is called the tax shield.
■ In a geared company, variations in earnings before interest and tax generate a mag-
nified impact on shareholder earnings.
■ The downside of gearing is the creation of a prior charge against profits, which
results in the risk of possible default as well as greater variability of shareholder
earnings.
■ Default risk is likely to impose further costs on the geared company’s shareholders,
referred to as the ‘costs of financial distress’.
■ An insolvent company, i.e. one unable to meet its immediate commitments, is
unlikely to achieve full market value in a sale of assets.
■ For companies using a mixture of debt and equity, there may be an optimal capital
structure at which the overall cost of capital (WACC) is minimised.
■ The WACC is found by weighting the cost of each type of finance by its propor-
tionate contribution to overall financing, and may fall as gearing increases.
■ The increased risks imposed by gearing are likely to cause lenders and sharehold-
ers eventually to demand a higher rate of return, raising the WACC.
■ The WACC is the appropriate cut-off rate for new investment so long as the com-
pany adheres to the optimal capital proportions.
■ When companies deviate from the optimal capital structure, the marginal cost of
capital becomes the correct cut-off rate.
■ Because the optimal gearing ratio is difficult to identify in practice, many firms aim
for a target gearing ratio.
■ In view of the risks of gearing, an increase in borrowing may be a way of signalling
to the market greater confidence in the future.
SUMMARY
Further reading
A good overview of the theoretical ground can be found in Board’s contribution to Firth and
Keane (1986). Brealey, Myers and Allen (2005) devote two chapters to optimal capital structure
at a rather less rigorous level than Copeland and Weston (2004).
It would be useful to look at Rutterford (1992) for a treatment of practical issues such as restric-
tive covenants.
Miller (1991) provides an overview of the capital structure debate in his Nobel lecture.
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Chapter 18 Capital structure and the required return 507
APPENDIX
SLIPPING DOWN THE CREDIT RATINGS
One fallout of European telecoms firms overpaying for third-generation mobile
telephony licences was the huge increase in their indebtedness. The credit rating agen-
cies responded in the obvious way. The credit ratings of the two largest operators, BT
and Deutsche Telekom, were downgraded within a few weeks of each other. In August
2000, Standard & Poor’s reduced BT’s status from its second highest rating, to
A with ‘negative implications’, i.e. pointing to a further downgrade. In October 2000,
S & P cut DT’s long-term rating from to again warning of a possible future
downgrade if asset sales were not forthcoming to repay debt.
The immediate impact of a credit downgrade is to raise interest rates on borrow-
ings. In BT’s case, it faced a 1 per cent (one percentage point) increase in its borrowing
rate, which, applied to its £30 billion debt, implies a rise in borrowing costs of
£300 million.
Standard & Poor’s credit rating system is shown below, together with that of the
other main credit rating agency, Moody’s.
A,AA
AA,
Credit risk S & P Moody’s
Prime AAA Aaa
Excellent AA Aa
Upper Medium A A
Lower Medium BBB Baa
Speculative BB Ba
Very Speculative B, CCC, CC B, Caa
Default C, D Ca, C
Source: www.moodys.com, www.standardpoor.com, www.ratings.com
Both agencies make further differentiation on the quality of bonds within each cat-
egory. Moody’s uses a numerical system (1,2,3) and S & P uses a plus or minus. For
example, a rating of Aa1 from Moody’s is a superior rating than Aa3, and an from
S & P is a better rating than A.
A
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Questions with a
coloured number have solutions in Appendix B on page 712.
1 Using the accounting information provided below, calculate the following measures of gearing:
■ long-term debt (LTD) to equity
■ LTD to LTD plus equity
■ total debt to equity
■ net debt in absolute terms
■ net debt to equity
■ total debt to total assets
■ interest cover
■ income gearing
■ total liabilities to total assets
Shareholders’ funds
Cash
Short-term deposits
Short-term bank borrowing
Debentures and other long-term debts
Total assets
Total liabilities
Profit before interest and tax
Net interest payable
2 Calculate the cost of debt facing a firm that issued £50 million in debentures in £100 units two years ago at a
nominal interest rate of 8 per cent p.a., in each of the following cases:
(i) market value of debt is £45 million; perpetual life.
(ii) as (i), but allowing for Corporation Tax at 30 per cent.
(iii) as for (i), but life span of debt is 8 years.
(iv) as for (iii), but with tax payable at 30 per cent.
3 Darnol plc is currently ungeared and is considering a buy-back of ordinary shares via an open market pur-
chase, borrowing in order to do so. You have been commissioned to report on the likely impact of two alter-
native policies, depending on the level of sales and operating profit for its products. You are given the
following information:
£25 m
£120 m
£300 m
£800 m
£200 m
£50 m
£40 m
£20 m
£500 m
QUESTIONS
508 Part V Strategic financial decisions
Level of sales PBIT Probability
Weak 0.3
Average 0.5
Strong 0.2
£150 m
£50 m
£5 m
Equity is currently £200 million at book value. Tax is paid at 30 per cent. Two alternative share buy-back
programmes are under consideration:
(i) Borrowing £40 million at 8 per cent.
(ii) Borrowing £80 million at 8.5 per cent.
Required
(a) Calculate the current, and potential expected annual return on equity (ROE) under each programme.
(b) Calculate the standard deviation of the ROE in each case.
(c) Using the figures you have obtained, explain and illustrate the distinction between business and financial
risk.
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4 (a) Calculate the value of the tax shield in each of the following cases, all based on borrowing of £100 million
at 10 per cent interest p.a., pre-tax.
(i) Perpetual life debt, tax rate is 30 per cent.
(ii) Debt repayable in full after five years.
(iii) Debt repayable in equal tranches over five years, interest paid on the declining balance.
(b) Specify the factors that determine the value of the tax shield that a firm can exploit.
5 Calculate the weighted average cost of capital for the following company, using both book value and market
value weightings.
Chapter 18 Capital structure and the required return 509
Balance sheet values Cost of finance
Ordinary shares: (par value 50p) 20%
Reserves: 20%
Long-term debt: 10%£15 m
£20 m
£10 m
The debt is permanent and its market value is equal to book value.
The rate of Corporate Tax is 30%.
The ordinary shares are currently trading at £4.50.
6 The directors of Zeus plc are considering opening a new manufacturing facility. The finance director has pro-
vided the following information:
Initial capital investment: £2,500,000.
Dividends for the last five years have been:
The following is an extract from the Balance Sheet of Zeus plc for the year ended December 31 1997:
Creditors due in more than one year
8% Debenture £700,000
Long-term loan (variable rate) £800,000
Capital and reserves
2,000,000 shares of 25p each £500,000
The authorised share capital is 4 million shares, the current market price per share at December 31 1997 is
136p ex-dividend.
The current market price of debentures is £60 (ex-interest) and interest is payable each year on 31
December.
The interest rate on the long-term loan is 1 per cent above LIBOR, which at present stands at 16 per cent.
The debentures are irredeemable.
Ignore taxation.
Required
Calculate the weighted average cost of capital (WACC) for Zeus plc at 31 December 1997.
7 RH plc manufactures machine tools. It has issued two million ordinary shares, quoted at 168 pence each, and
£1 million 10 per cent secured debentures quoted at par. To finance expansion, the directors of the company
want to raise £1 million for additional working capital.
Cash flow from trading before interest and tax is currently £1 million per annum. It is expected to rise to £1.3
million per annum if the expansion programme goes ahead. To simplify placing a valuation on the company’s
equity, you should assume that:
■ The forecast level of cash flow, and a tax rate of 33 per cent, will continue indefinitely.
■ The required rate of return on the market vale of equity, 18 per cent post-tax, will be unaffected by the new
financing.
■ There is no difference between taxable profits and cash flow.
Year 1993 1994 1995 1996 1997
Net dividend per share (pence) 10.0 10.8 11.4 13.2 13.7
Continued
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The company’s directors are considering two forms of finance – equity via a rights issue at 15 per cent
discount to current share price, or 12 per cent unsecured loan stock at par.
Required
(a) Calculate for both financing options, the expected
(i) increase in the market value of equity
(ii) debt/ ratio
(iii) weighted average cost of capital.
(b) Assume you are the financial manager for RH plc. Write a brief report to the board advising which of the
two types of financing is to be preferred. Include in your report brief comments on non-financial factors
which should be considered by the directors before deciding how to raise the £1 million finance.
(CIMA)
8 Celtor plc is a property development company operating in the London area. The company has the following
capital structure as at 30 November 1993:
1debt equity2
510 Part V Strategic financial decisions
£000
£1 ordinary shares 10,000
Retained profit 20,000
9% debentures 12,000
42,000
The equity shares have a current market value of £3.90 per share and the current level of dividend is 20
pence per share. The dividend has been growing at a compound rate of 4 per cent per annum in recent years.
The debentures of the company are irredeemable and have a current market value of £80 per £100 nominal.
Interest due on the debentures at the year end has recently been paid.
The company has obtained planning permission to build a new office block in a redevelopment area. The
company wishes to raise the whole of the finance necessary for the project by the issue of more irredeemable
9 per cent debentures at £80 per £100 nominal. This is in line with a target capital structure set by the company
where the amount of debt capital will increase to 70 per cent of equity within the next two years.
The rate of corporation tax is 25 per cent.
Required
(a) Explain what is meant by the term ‘cost of capital’. Why is it important for a company to calculate its cost
of capital correctly?
(b) What are the main factors which determine the cost of capital of a company?
(c) Calculate the weighted average cost of capital of Celtor plc which should be used for future investment
decisions.
9 Redley plc, which manufactures building products, experienced a sharp increase in operating profit (i.e. prof-
its before interest and tax) from £27 million in 1995–6 to £42 million in 1996–7 as the company emerged from
recession and demand for new houses increased. The increase in profits has been entirely due to volume
expansion, with margins remaining static. It still has substantial excess capacity and therefore no pressing
need to invest, apart from routine replacements.
In the past, Redley has followed a conservative financial policy, with restricted dividend payouts and rela-
tively low borrowing levels. It now faces the issue of how to utilise an unexpectedly sizeable cash surplus.
Directors have made two main suggestions. One is to redeem the £10 million of the secured loan stock issued
to finance investment several years previously, the other is to increase the dividend payment by the same
amount.
Redley’s present capital structure is shown below:
£m
Issued share capital (par value 50p) 90
Reserves 110
Creditors due after more than one year:
9% secured loan stock 2004 30
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Further information
(i) Redley has no overdraft.
(ii) Redley pays corporate tax at a rate of 33%.
(iii) The last dividend paid by Redley was 1.45 pence per share.
(iv) Sector averages currently stand as follows:
dividend cover 2.5 times
gearing (long-term debt/equity) 48%
interest cover 5.9 times
(v) Redley’s P:E ratio is 17:1.
Required
(a) Calculate (i) the dividend cover and (ii) the dividend yield for both 1995–6 and for the reporting year
1996–7, if the dividend is raised as proposed.
(b) You have been hired to work as a financial strategist for Redley, reporting to the Finance Director. Using
the information provided, write a report to your superior, which identifies and discusses the issues to be
addressed when assessing the relative merits of the two proposals for reducing the cash surplus.
(ACCA)
Chapter 18 Capital structure and the required return 511
For a company of your choice, undertake an analysis of gearing similar to that conducted in the text for BAA. Pay
particular attention to the treatment of provisions and other components of long-term liabilities. If you decide to
include short-term indebtedness in your capital gearing measure, would you include trade and other creditors as well?
Try to form a view as to whether your company is operating with high or low gearing.
Practical assignment
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512 Part V Strategic financial decisions
Does capital structure really matter?
19
Learning objectives
This chapter offers a more theoretically-oriented analysis of capital structure decisions. After reading
it, you should:
■ Understand the theoretical underpinnings of ‘modern’ capital structure theory.
■ Appreciate the differences between the ‘traditional’ view of gearing and the Modigliani–Miller
versions.
■ Appreciate how the CAPM is integrated into capital structure analysis.
■ Be able to identify the extent to which a Beta coefficient incorporates financial risk.
Travelling in hope
MyTravel, the package holiday firm, formerly known
as Airtours, was hit heavily by the downturn in travel
following the atrocities of 9/11. This all occurred just
as it had significantly increased capacity via a series
of takeovers, mainly financed by borrowing, resulting
in high costs and many unsold holidays. Despite a
major programme of cost-cutting, and several sell-
offs of underperforming businesses, MyTravel headed
rapidly into the red. Matters were not helped by dis-
covery of a financial black hole in the accounts,
necessitating substantial write-offs, and propelling
the shares on a downward trajectory.
In October 2004, it announced an million debt-
for-equity swap that would virtually wipe out the
equity of the existing shareholders, leaving them with
just a 4 per cent stake in the restructured business.
Creditors agreed to accept 88 per cent of the firm’s
shares and bond-holders 8 per cent. Following the
swap, MyTravel was left with debts of million,
mainly in aircraft leases taken out to finance the
MyTravelLite airline. However, it claimed that it was
on course to break even at the operating level in the
current financial year, and its banks arranged a new
five-year overdraft facility of million.
The ordinary shares which were trading at 140p less
than a year previously now fell further to 4.75p, leav-
ing several pension funds nursing significant losses.
Source: Based on an article in the Financial Times by Matthew Garrahan,
14 October 2004.
£167
£140
£800
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Chapter 19 Does capital structure really matter? 513
19.1 INTRODUCTION
This chapter begins with a question. In the last chapter, we warned that debt could be
lethal to company survival, yet here we find an effectively insolvent firm ‘rising from
the dead’. This survival instinct may thus pose a puzzle – how can insolvent firms be
worthless one moment but still survive?
The answer lies in recognising that insolvency does not necessarily mean total
loss of enterprise value. Insolvency is the formal acceptance that the business entity
cannot meet its financial obligations, whether payment to creditors for supplies, or
payments to lenders. Yet it is possible for insolvent firms to retain value as operat-
ing entities even though their owners’ equity may have been wiped out. A few fig-
ures may help.
XYZ owes million to lenders and its assets are only million, so it is techni-
cally insolvent, unable to cover its debts with its assets, i.e. its net assets are negative –
minus million. However, if its operating activities generate more cash inflows than
outflows, then as a debt-free entity, it would be viable and have value. Hence, it might
look attractive as a restructured going concern to other investors prepared to take
responsibility for the debts. Creditors might be prepared to exchange debt for equity
or preference shares, or take a discount on their principal, accepting, say, 30p in the
pound, just to salvage something from the mess. The equity value has disappeared but
the enterprise still has value as a going concern if investors can be found to re-finance
it and re-organise it into a viable operation.
Even the heavily indebted ( billion at April 2005) Eurotunnel is able to make
operating profits ( million in the first half of 2004). On this basis, it has an enter-
prise value even though the equity has been all but wiped out (share price down by
90 per cent since floatation in 1987).
One might then conclude that indebtedness does not really matter – a firm that can-
not pay its way can be restructured and the jobs of the workers, if not the management,
can be preserved.
A few years ago, the former England football manager Terry Venables bought
Portsmouth FC for – a remarkable bargain, you might think. However, he was buy-
ing the club’s assets encumbered with debts, which he and his backers were hoping to
re-finance or to pay off. The club as a bundle of assets was worth more than and
Venables was really paying far more than this. Had he bought the club free of debt, he
would have had to pay out more.
So long as assets can be sold at their full economic value, i.e. reflecting operating
cash flows, then debt is of most consequence to the hapless owners whose equity is
usually all but obliterated. Meanwhile, the business can proceed, usually under dif-
ferent management, with a new set of backers hoping to do better next time round.
This suggests that the sting of insolvency can be drawn.
The traditional theory of gearing says that debt should be handled with great cau-
tion but there is a body of analysis that proves that, under certain conditions, debt is
truly irrelevant in determining company value and the cost of capital. This is the
famous theory developed by Franco Modigliani and Merton Miller (MM), both Nobel
prizewinners for Economics. Our next task is to explain this theory.
£1,
£1
£108
£6.4
£2
£8£10
19.2 THE MODIGLIANI–MILLER MESSAGE
To Modigliani and Miller (MM), the traditional perception of the impact and desirabil-
ity of gearing seemed unsupported by a theoretical framework. In particular, there
seemed little reason, apart from some form of market imperfection such as information
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514 Part V Strategic financial decisions
deficiency, why merely altering the capital structure of a firm should be expected to
alter its value. After all, neither its earnings stream nor its inherent business risk would alter –
it would remain essentially the same enterprise, operating under the same managers
and in the same industry.
MM contended that, in a perfect capital market, the value of a company depended simply on
its income stream and the degree of business risk attaching to this, regardless of the way in
which its income was split between owners and lenders, i.e. its capital structure. Therefore,
any imbalance between the value of a geared company and an otherwise identical
ungeared company could only be a temporary aberration and would be quickly
unwound by market forces. The mechanism for equalising the values of companies,
identical except for their respective gearing, was the process of ‘arbitrage’, a feature of
all developed financial markets which ensures that assets with the same risk–return
characteristics sell at the same prices.
To support these contentions, some algebraic analysis is required, although readers
will find that it is much less complex than may appear at first sight.
■ The analytical framework
No distinction is made between short- and long-term debt and we assume that all bor-
rowing is perpetual. The company is expected to deliver constant and perpetual esti-
mated annual earnings, described by a normally-distributed range of possible outcomes.
Investors are assumed to have homogeneous expectations, i.e. they all formulate simi-
lar estimates of company earnings, E, the net operating income (NOI) before interest
and tax, or, more simply, revenues less variable costs less fixed operating costs. It is
important to note that we are using free cash flow concept of earnings as explained in
Chapter 4, i.e. income net of any investment required to rectify wear-and-tear on capi-
tal equipment and hence maintain annual earnings at E.
The discount rate applied to the stream of expected earnings depends on the degree
of business risk incurred by the enterprise. MM used the concept of ‘equivalent risk
classes’, each one containing firms whose earnings depend on the same risk factors
and from which the market expects the same return. In terms of the Capital Asset
Pricing Model, this means that the earnings streams from firms in the same risk cate-
gory are perfectly correlated and that member companies have identical activity Betas.
For consistency, we use the same definitions and notation as in Chapter 18. The key
definitions are reproduced in Table 19.1.
The overall rate of return that the company must achieve to satisfy all its investors is
the weighted average cost of capital (WACC), denoted by This can be expressed as:
The WACC equals since net operating income is composed of payments to
shareholders, plus payments to lenders, iB.
Using this set of definitions, we now examine the impact of variations in capital
structure on and The original MM analysis did not apply directly to the UK con-
text, being expressed in terms of substituting debt for equity, i.e. using debt to repur-
chase ordinary shares. This was not generally possible in the UK until the Companies
Act 1981, which enabled firms, subject to shareholder approval, to undertake such
repurchases. Now this is permitted, the original MM analysis is more readily applica-
ble to the capital structure decisions of UK firms. Using debt-for-equity substitution
rather than adding debt to equity has the major advantage of enabling us to hold con-
stant both the book values of assets and capital employed and also the PBIT, a device
used in the Lindley example in Chapter 18. Any gearing change alters only the compa-
ny’s capital structure, with no effect on company size or the level and riskiness of oper-
ating earnings. As a result, we can focus directly on the relationship between and k
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