Capital Structure The Long-Term Financing Decision . When making the long-term financing decision, the directors must consider the relative merits and de-merits of equity and debt capital: · Cost - equity is more expensive to service (and issue) than debt · Control - issuing equity dilutes control of existing shareholders · Risk - shareholders cannot force the company into liquidation · Flexibility - equity does not restrict managerial freedom · Life - equity is permanent but debt is finite and thus carries refinancing risk Capital Structure · The relative proportions of a company's equity and debt capital · Defined by (and also known as) financial gearing · Financial gearing is the percentage of the market value of a company's debt capital to its total market value: G = VD + (VD + VE) where: G - Financial gearing VD - Market value of debt VE - Market value of equity The Financial Gearing Effect · An increase in a company's level of financial gearing (debt relative to equity) causes an increase in its cost of equity: · Higher levels of debt mean that relatively small changes in operating profit lead to relatively larger changes in profit attributable to shareholders · Profit attributable to shareholders is therefore more variable / volatile over time . The company is therefore a riskier investment for shareholders · Shareholders thus demand higher returns for this increased risk · The company's cost of equity rises
Capital Structure Theories • Capital structure theories consider the nature of the relationship between financial gearing and a company's weighted average cost of capital (which is inversely related to shareholder wealth) . Modigliani and Miller's no-tax theory (1958) · Modigliani and Miller's with-tax theory (1963) . The trade-of theory · Contemporary theories: · Pecking order (Myers, 1984) · Agency (Jensen, 1986) M&M's No-Tax Theory · As financial gearing (debt) increases: . The cost of equity rises due to increased variability of shareholder returns · The cost of debt remains constant . The rising cost of equity is exactly offset by the lower efective cost of debt • Hence: . The WACC is the same at all levels of financial gearing for all companies and thus capital structure is irrelevant to shareholder wealth 50% 45% 40% 35% WACC is constant at 30% all levels of 25% financial gearing 20% 15% 10% 5% 0% 0% 10% 20% 30% 40% 50% 60% Financial Gearing 70% 80% 90% 100% -WACC -Cost of Debt (Pre-Tax) · Theory based on a number of assumptions: -Cost of Equity V
• No tax · Frictionless markets · Companies and individuals can borrow and lend at a risk free interest rate · No costs of financial distress: · Financial distress occurs when a company is struggling to pay its creditors and may become insolvent · In reality, if a company becomes insolvent: . Lenders usually lose some of the money lent to the company · Shareholders usually lose all of the money invested in the company M&M's With-Tax Theory ·