F3 Financing - Capital Structure (Sources of Long-term Funds)

Value of the firm

is the present value of future cash flows, discounted at the weighted average cost of capital (WACC).

One way managers can increase the value of the firm

is to decrease the WACC

Traditional theory of gearing

• Debt is cheaper than equity as:

  • tax deductible so ‘cheaper’ than equity dividends

  • Highest ranked creditor and must be paid prior to dividends and irrespective of profit levels - lower level of risk for debt holders = lower return

Trad theory - Downward force on WACC

• Initially, as levels of debt in proportion to equity increase, WACC decreases due to the debt being ‘cheaper’ than equity

• Interest is an obligation that has to be paid, regardless of profit - debt holders face fewer risks and accept a lower return

Trad theory - upward force on WACC

• As gearing increases, Ke increases

• Extra interest paid to debt holders leaves less profit to be distributed to shareholders, this increased risk means shareholders demand higher returns

Traditional theory - optimal level of gearing

The level of debt that minimizes WACC and maximizes firm value, balancing the costs of debt and equity.

M&M Theory of Gearing - without tax (1958)

• In the absence of tax, a company is worth the present value of its future cash flows generated by its assets, irrespective how the earnings are returned to fund lends i.e. dividend or interest.

• Therefore, argued that the value of the firm should not be affected by a change in its capital structure.

Under M&M's without tax theory (1958)

• there is no one optimal capital structure; rather the capital structure (the level of debt) does not affect the WACC and thus does not affect the value of the firm. All structures are optimal.

• Two companies exactly the same except for gearing are worth the same amount

• Size of company’s earning stream will determine the value of entity, not how financed

M&M Theory of Gearing - with tax (1963)

• Interest on debt is tax deductible, dividend payments are not

• There is a tax advantage to having debt instead of equity finance

Under M&M's with tax theory (1963)

• The greater the value of debt in the company compared to equity, the greater the value of the company

• Optimal structure would be at 99.9% level of gearing

• The higher the level of taxation, the lower the combined cost of capital

M&M key assumptions

• Debt is risk free and Kd remains constant at all levels of gearing

• Investors are indifferent between personal and corporate gearing

• A perfect capital market exists, in which investors have the same info available, upon which they act rationally to arrive at the same expectations about future earnings and risk

• Investors and companies can borrow at the same rate of interest

The most unrealistic of M&M’s assumptions

• That debt is risk-free, as there is a risk company is unable to service the debt and ends up in distress

• Lenders will ask for higher interest rates if they perceive greater risk

Practical considerations - debt capacity

• Company’s ability to borrow money - can they find someone to lend?

• A company with high debt capacity will have good quality assets to borrow against

Practical considerations - existing debt covenants

• Reduce flexibility - may even prevent further borrowing

• Management must keep up with limits to allow headroom

Practical considerations - increasing cost of debt as gearing rises

Increased risk for lenders, higher interest rate, higher cost of borrowing

Practical considerations - views of other stakeholders and rating agencies

• Increasing gearing is seen as risky

• Customers may not want to be from you, fear of agreements not being honoured

• Suppliers may not be able to be paid

• Employees may want to leave for fear of losing job

Practical considerations - tax exhaustion

• Tax relief can only reduce profits to 0

• No future benefit of debt finance

Capital structure of group companies - tax

Maximise borrowings in regimes with the highest tax rates

Capital structure of group companies - country risk

Less exposure to exchange rate movements if borrowing funds in country where income is generated (mitigate exchange rate risk)

Capital structure of group companies - transfer pricing

• Adjustments may be required if transactions are not carried out on an arm’s length basis

Capital structure of group companies - thin capitalisation rules

• Aim to stop companies getting excessive tax relief on interest

• May happen from borrowing from a related party that a third party would not have entered into (i.e. bank)

• Only interest on the part of the loan that an independent third party would lend on will be allowable

  • Tax authorities will look at gearing and interest cover

Thin capitalisation - gearing

• Too much debt can cause thin capitalisation problems

• In the UK, 50:50 is considered reasonable by tax authorities

Thin capitalisation - interest cover (PBIT/interest)

• A measure of risk for the lender

• Most commercial lenders (i.e. banks) consider a ratio of 3 to be reasonable