Chapter 16 Capital Structure

Answer Test your understanding 1 The traditional view of capital structure (d) M&M without tax (a) M&M with tax (c) Diagram (b) does not accord with any of the theories. Answer Test your understanding 2 The ! "" will remain the same# M&M no tax (see above). $ $ecause the returns to shareholders become more volatile. (%ote# this is not &ust an M&M view but true of all the approaches to gearing). " The company which had geared up# M&M with tax (see above). D Debt 'ec(ing)order theory. Answer Test your understanding 3 The discount rate that should be used is the ! ""* with weightings based on mar(et values. The cost of capital should ta(e into account the systematic ris( of new investment* and therefore it will not be appropriate to use the company+s existing e,uity beta. -nstead* the estimated e,uity beta of the main .erman competitor in the same industry as the new proposed plant will be ungeared* and then the capital structure of $ac(woords applied to find the ! "" to be used for the discount rate. /ince the systematic ris( of debt can be assumed to be 0ero* the .erman e,uity beta can be 1ungeared2 using the following expression.

a = e

Ve Ve + Vd (3 T )

4or the .erman company#

a = 3.;
:5 = 3.567 :5 + 95 (3 758)

The next step is to calculate the debt and e,uity of $ac(woods based on mar(et values.
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=,uity Debt# ban( loans Debt# bonds Total debt Total mar(et value

9;5m shares at 7>:p (635 >;) (>;m x 3.65)

<m 3*:?6.5 37;.5 ?5.5 66;.5 3*?3>.5

The beta can now be re)geared#

g = 3.567
(3*:?6 + 66; (3 758)) = 3.33@ 3*:?6

This can now be substituted into the "' M to find the cost of e,uity. Ae B >.>;8 C (39.;8 >.>;8) x 3.33@ B 3;.758 The ! "" can now be calculated#
3*:?6 37; ?5 3;.78 3*?3> + >8 3*?3> + ?8 3*?3> = 39.98

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Examination Style Questions

Answer 1 (a) "alculation of weighted average cost of capital (! "") Mar(et values Mar(et value of e,uity B ;m x 9.;5 B <66.; million Mar(et value of preference shares B 6.;m x .5>:6 B <3.?5; million Mar(et value of 358 loan notes B ;m x (35;D355) B <;.6; million Total mar(et value B 66.;m C 3.?5;m C ;.6;m B <6?.:;; million 2 mar!s" "ost of e,uity using dividend growth model B E(7; x 3.59)D 9;5F C 5.59 B 36.5@8 2 mar!s" "ost of preference shares B 355 x ?D >:.6 B 33.@38 1 mar!" nnual after)tax interest payment B 35 x 5.> B <>

Gsing interpolation* after)tax cost of loan notes B ; C E(; x >.?9)D(>.?9 C 65.?:)F B :.7>8 2 mar!s" ! "" B E(36.5@ x 66.;) C (33.@3 x 3.?5;) C (:.7> x ;.6;)FD 6?.:;; B 33.5;8 (b) 3. Droxfol "o has long)term finance provided by ordinary shares* preference shares and loan notes. The rate o# return re$uired %y each source o# #inance depends on its ris! from an investor point of view* with e$uity (ordinary shares) being seen as the most ris!y and de%t (in this case loan notes) seen as the least ris!y. -gnoring taxation* the weighted average cost of capital (&ACC) would therefore be expected to decrease as e$uity is replaced %y de%t* since de%t is cheaper than e$uity* i.e. the cost of debt is less than the cost of e,uity. 6. 1 mar!" 2 mar!s"

However* #inancial ris! increases as e$uity is replaced %y de%t and so the cost o# e$uity will increase as a company gears up * o##setting the e##ect o# cheaper de%t . t low and moderate le'els o# gearing* the %e#ore(tax cost o# de%t will %e constant* but
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it will increase at high le'els o# gearing due to the possi%ility o# %an!ruptcy. t high levels of gearing* the cost o# e$uity will increase to re#lect %an!ruptcy ris! in addition to financial ris(. 7. -n the traditional 'iew o# capital structure* ordinary shareholders are relatively indi##erent to the addition o# small amounts o# de%t in terms of increasing financial ris( and so the &ACC #alls as a company gears up. 9. s gearing up continues* the cost o# e$uity increases to include a #inancial ris! premium and the &ACC reaches a minimum 'alue. $eyond this minimum point* the ! "" increases due to the effect of increasing financial ris( on the cost of e,uity and* at higher levels of gearing* due to the effect of increasing ban(ruptcy ris( on both the cost of e,uity and the cost of debt. )n this traditional 'iew* therefore* *rox#ol Co can gear up using de%t and reduce its &ACC to a minimum * at which point its mar!et 'alue (the present value of future corporate cash flows) will be maximised. ;. -n contrast to the traditional view* continuing to ignore taxation %ut assuming a per#ect capital mar!et* +iller and +odigliani demonstrated that the &ACC remained constant as a company geared up* with the increase in the cost o# e$uity due to #inancial ris! exactly %alancing the decrease in the &ACC caused %y the lower %e#ore(tax cost o# de%t . /ince in a pre#ect capital mar!et the possi%ility o# %an!ruptcy ris! does not arise* the &ACC is constant at all gearing le'els and the mar!et 'alue o# the company is also constant . Miller and Modigliani showed* therefore* that the mar!et 'alue o# a company depends on its %usiness ris! alone * and not on its #inancial ris!. In this view* therefore* Droxfol "o cannot reduce its ! "" to a minimum. :. !hen corporate tax was admitted into the analysis of Miller and Modigliani* a different picture emerged. The interest payments on de%t reduced tax lia%ility* which meant that the &ACC #ell as gearing increased* due to the tax shield given to profits. In this view* *rox#ol Co could reduce its &ACC to a minimum %y ta!ing on as much de%t as possi%le. , - mar!s" >. However* a per#ect capital mar!et is not a'aila%le in the real world and at high le'els o# gearing the tax shield offered by interest payments is more than o##set %y the e##ects o# %an!ruptcy ris! and other costs associated with the need to service large amounts of debt. Droxfol "o should therefore be a%le to reduce its &ACC %y gearing up* although it may %e di##icult to determine whether it has reached a capital structure gi'ing a minimum &ACC.
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1 mar!" (c)(i) -nterest coverage ratio "urrent interest coverage ratio B >*555D ;55 B 39 times -ncreased profit before interest and tax B >*555 x 3.36 B <>.@9m -ncreased interest payment B (35m x 5.5?) C 5.;m B <3.9m -nterest coverage ratio after one year B >.@9D 3.9 B ;.: times The current interest co'erage of Droxfol "o is higher than the sector a'erage and can be regarded as $uiet sa#e. 4ollowing the new loan note issue* however* interest co'erage is less than hal# o# the sector a'erage * perhaps indicating that Droxfol "o may not #ind it easy to meet its interest payments. 2 3 mar!s" (c)(ii) 4inancial gearing This ratio is defined here as prior charge capitalDe,uity share capital on a boo( value basis "urrent financial gearing B 355 x (;*555 C 6*;55)D (;*555 C 66*;55) B 6>8 Irdinary dividend after one year B 5.7; x ;m x 3.59 B <3.@6 million Total preference dividend B 6*;55 x 5.5? B <66;*555

.ncome statement a#ter one year <555 'rofit before interest and tax -nterest 'rofit before tax Tax 'rofit for the period 'reference dividends Irdinary dividends Jetained earnings 66; 3*@65 <555 >*@95 (3*955) :*995 (3*?76) 9*;5@ (6*59;) 6*9:7

/inancial gearing a#ter one year B 355 x (3;*555 C 6*;55)D (;*555 C 66*;55 C 6*9:7) B 0-1 The current #inancial gearing o# *rox#ol Co is 231 less (in relative terms) than the sector a'erage and a#ter the new loan note issue it is 241 more (in relative terms). This level of financial gearing may be a cause o# concern #or in'estors and the stoc! mar!et. "ontinued annual growth o# 121* however* will reduce #inancial gearing o'er time. 2 3 mar!s"
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(c)(iii) =arnings per share "urrent earnings per share B 355 x (9*;;5 66;)D ;*555 B @:.; cents =arnings per share after one year B 355 x (9*;5@ 66;)D ;*555 B @;.> cents =arnings per share is seen as a (ey accounting ratio by investors and the stoc( mar(et* and the decrease will not be welcomed. However* the decrease is $uiet small and #uture growth in earnings should $uic!ly eliminate it. 2 3 mar!s" Comment5 3. 6. The analysis indicates that an issue o# new de%t has a negati'e e##ect on the company+s financial position* at least initially. There are #urther di##iculties in considering a new issue o# de%t . The existing non( current assets are security #or the existing 131 loan notes and may not a'aila%le #or securing new de%t* which would then need to be secured on any new noncurrent assets purchased. These are li(ely to be lower in value than the new debt and so there may be insufficient security for a new loan note issue. 7. 6edemption or re#inancing would also pose a pro%lem* with Droxfol "o needing to redeem or re#inance 713 million o# de%t a#ter %oth eight years and ten years . Ten years may therefore be too short a maturity for the new debt issue. 9. n e$uity issue should %e considered and compared to an issue of debt. This could be in the form of a rights issue or an issue to new e,uity investors. 2 3 mar!s" ACCA +ar!ing Scheme

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Answer 2 (a) The cost of debt of $ond can be found by linear interpolation. Gsing 338* the difference between the present value of future cash flows and the ex interest mar(et value B (? x ;K@@?) C (355 x 5K7;6) ?;K5@ B ;7K55 C 7;K65 ?;K5@ B (<:K@@) s the net present value is negative* 338 is higher than the cost of debt. Gsing ?8* the difference between the present value of future cash flows and the ex interest mar(et value B (? x :K93@) C (355 x 5K966) ?;K5@ B ;>K>: C 96K65 ?;K5@ B <9K@@ s the net present value is positive* ?8 is lower than the cost of debt. "ost of debt B ? C ((33 ?) x 9K@@)D(9K@@ C :K@@) B ? C 5K@7 B ?K@78 3 mar!s"

Gsing estimates other than 338 and ?8 will give slightly different values of the cost of debt. (b) Term structure o# interest rates (ey factor here could be the duration of the bond issues* lin(ed to the term structure of interest rates. 3. 6. %ormally* the longer the time to maturity of a debt* the higher will %e the interest rate and the cost of debt. 8ond A has the greater time to maturity and therefore would be expected to ha'e a higher interest rate and a higher cost o# de%t than 8ond 8* which is the case here. 1 2 mar!s" 9i$uidity pre#erence theory 3. Li,uidity preference theory suggests that in'estors re$uire compensation #or de#erring consumption* i.e. for not having access to their cash in the current period* and so pro'iders o# de%t #inance re$uire higher compensation #or lending #or longer periods. 6. The premium #or lending #or longer periods also reflects the way that de#ault ris! increases with time. 1 2 mar!s" Expectations theory 3. 6. =xpectations theory suggests that the shape o# the yield cur'e depends on expectations as to #uture interest rates. -f the expectation is that #uture interest rates will be higher than current interest rates* the yield cur'e will slope upwards. -f the expectation is that future interest rates will be lower than at present* the yield curve will slope downwards.
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1 2 mar!s" +ar!et segmentation theory 3. Mar(et segmentation theory suggests that #uture interest rates depend on conditions in di##erent de%t mar!ets* e.g. the short)term mar(et* the medium)term mar(et and the long)term mar(et. 6. The shape o# the yield cur'e therefore depends on the supply o#: and demand #or: #unds in the mar!et segments. 1 2 mar!s" )ther #actors 3. /ince the two %onds were issued at the same time %y the same company * the %usiness ris! of DD "o can %e discounted as a reason for the difference between the two costs of debt. -f the two bonds had been issued %y di##erent companies* a di##erent %usiness ris! might ha'e %een a reason for the difference in the costs of debt. 6. The si;e o# the de%t could be a contri%utory #actor* since the 8ond A issue is twice the si;e o# the 8ond 8 issue . The greater si0e of the $ond reasons it has the higher cost o# de%t. 1 2 mar!s" (c)(i) "ost of e,uity B 9 C (3K6 x (33 9)) B 9 C @K9 B 36K98 (c)(ii) Dividend growth rate B 355 x ((;6D;5) 3) B 355 x (3K59 3) B 98 per year /hare price using D.M B (;5 x 3K59)D(5K369 5K59) B ;6D5K@9 B :3?c or <:K3? (c)(iii) %umber of ordinary shares B 6; million Mar(et value of e,uity B 6;m x :K3? B <3;9K>; million Mar(et value of $ond issue B 65m x ?;K5@D355 B <3?K53:m Mar(et value of $ond $ issue B 35m x 356K53D355 B <35K653m Mar(et value of debt B <6?K63>m Mar(et value of capital employed B 3;9K>;m C 6?K63>m B <3@7K?:>m "apital gearing B 355 x 6?K63>D3@7K?:> B 3;K?8 (c)(iv) ! "" B ((36K9 x 3;9K>;) C (?K@7 x 3?K53:) C (>K@6 x 35K653))D3@7K?:> B 33K?8 2 mar!s" 2 mar!s" 1 mar!" 2 mar!s" 2 mar!s" issue could be one of the

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(d) *i'idend irrele'ance 3. +iller and +odigliani showed that* in a per#ect capital mar!et* the 'alue o# a company depended on its in'estment decision alone * and not on its di'idend or #inancing decisions. 6. -n such a mar(et* a change in di'idend policy by DD "o would not a##ect its share price or its mar!et capitalisation. They showed that the 'alue o# a company was maximised if it in'ested in all pro<ects with a positi'e net present 'alue (its optimal investment schedule). 7. The company could pay any le'el o# di'idend and i# it had insu##icient #inance * ma!e up the short#all %y issuing new e$uity . /ince in'estors had per#ect in#ormation* they were indi##erent %etween di'idends and capital gains. 9. Shareholders who were unhappy with the le'el o# di'idend declared by a company could gain a Mhome)made dividend+ by selling some o# their shares. This was possi%le since there are no transaction costs in a per#ect capital mar!et. 3 2 mar!s" *i'idend rele'ance gainst this view are several arguments for a lin( between dividend policy and share prices. 3. 6. 4or example* it has been argued that investors pre#er certain di'idends now rather than uncertain capital gains in the future (the M %ird(in(the(hand+ argument). -t has also been argued that real(world capital mar!ets are not per#ect * but semi) strong form efficient. /ince per#ect in#ormation is there#ore not a'aila%le * it is possible for in#ormation asymmetry to exist between shareholders and the managers of a company. *i'idend announcements may gi'e new in#ormation to shareholders and as a result* in a semi)strong form efficient mar(et* share prices may change. 7. The si;e and direction o# the share price change will depend on the di##erence %etween the di'idend announcement and the expectations o# shareholders . This is referred to as the Msignalling properties of dividends+. 9. -t has been found that shareholders are attracted to particular companies as a result o# %eing satis#ied %y their di'idend policies. This is referred to as the Mclientele e##ect+. company with an established dividend policy is therefore li(ely to have an established dividend clientele. The existence o# this di'idend clientele implies that the share price may change i# there is a change in the di'idend policy of the company* as shareholders sell their shares in order to reinvest in another company with a more satisfactory dividend policy. -n a perfect capital mar(et* the existence of dividend clienteles is irrelevant* since substituting one company for another will not incur any
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transaction costs. /ince real)world capital mar(ets are not perfect* however* the existence of dividend clienteles suggests that if DD "o changes its dividend policy* its share price could be affected. 3 2 mar!s" ACCA +ar!ing Scheme

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Answer 3 (a) The discount rate should re#lect the systematic ris! of the individual pro&ect being underta(en. =nless the ris! o# the textile expansion and the di'ersi#ication into the pac(aging industry are the same* their cash flows should not %e discounted at the same rate. The discount rate to be used should not be the cost of the actual source of funds for a pro&ect* but a weighted average of the costs of debt and e,uity which is weighted by the mar(et values of debt and e,uity. -t is possible to estimate an existing weighted average cost of capital for "restlee* but the rate cannot be applied to new pro&ects unless the following assumptions are compiled with# (i) The pro&ect is marginal* i.e. it is small relative to the si0e of the company. Ta(en together the two pro&ects are not marginal* but this is not a crucial assumption as long as the costs of debt or e,uity do not alter because of the si0e of the financing re,uired. (ii) The pro&ect should be financed in a way that does not alter the company+s existing capital structure. The net present value investment appraisal method cannot handle a significant change in capital structure. "restlee+s existing capital structure using mar(et values is# <m 75 million ordinary shares at 7@5 cents <;: million loan stoc( at <359 -f two investments are considered as a Mpac(age+# <m %ew finance being raised is# =,uity Debt ?.3>; 9.>6; 39.555 The company+s capital structure does not change as a result of these two investments. (iii) The pro&ect should have the same level of systematic ris( as the company+s existing operations. s the textile investment is an expansion of existing operations it is reasonable to assume that is has the same systematic ris(. The diversification into pac(aging could have very different ris( characteristics. The company+s existing weighted average cost of capital should not be used a discount rate for the diversification. 8 :: 79 339.55 ;@.69 3>6.69 8 :: 79

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Textile expansion The discount rate may be based upon the company+s ! "" (given that assumptions (iii) and (iv) are not violated). Gsing " 'M* Ae B :8 C (398 :8) x 3.6 B 3;.:8 ! "" B 3;.: 8 x ::D355 C 338 x (3 5.77) x 79D355 B 36.@8 This is the suggested discounted rate for the expansion. >ac!aging di'ersi#ication The systematic ris( of diversifying into the pac(aging industry may be estimated by referring to the systematic ris( of companies within that industry. However* the e,uity beta is influenced by the level of financial ris( (gearing). Gnless the mar(et weighted gearing of "anall and /ealalot is the same as "restlee* it is necessary to Mungear+ the e,uity beta of these companies (to remove the effect of financial ris() and regear to ta(e account of "restlee+s financial ris(. .earing =,uity Debt "anall (<m) >6.5 3:.@ @@.@ These are both significantly different from "restlee. Gngearing "anall (assuming debt is ris( free and d = 5 ) The asset beta (ungeared) is determined by# 8 @3 3? /ealalot (<m) 37@ 37 3;3 8 ?3 ?

Ve a = e (Ve + Vd (3 T ) )
a = 3.7
>6 = 3.369 >6 +3:.@ (3 5.77) 37@ = 3.36? 37@ +37 (3 5.77)

Gngearing /ealalot
a = 3.6

These are very similar. The ungeared e,uity beta of the pac(aging industry will be assumed to be 3.36;.
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Je)gear# solve for e using "restlee+s gearing#

339 339 + ;@.69 (3 5.77)

3.36; = e

e = 3.;3
Ae B :8 C (398 :8) x 3.;3 B 3@.5@8 ! "" B 3@.5@8 x ::D355 C 338 x (3 5.77) x 79D355 B 39.98 3;8 is not an appropriate discount rate for the textile pro&ects. The less ris(y textile expansion has an estimated discount rate of 36.@8. The correct discount rate for the proposed diversification is 39.98 which might be considered to be close enough to 3;8 to &ustify the use of the 3;8 discount rate. (b) The mar(eting director might be correct. -f there is initially a high level of systematic ris( in the pac(aging investment before it is certain whether the investment will succeed or fail* it is logical to discount cash flows for this high ris( period at a rate reflecting this ris(. Ince it has been determined whether the pro&ect will be successful* ris( may return to a Mmore normal+ level* and the discount rate reduced commensurate with the lower ris(. -f the pro&ect fails there is no ris( (the company has a certain failureN) The other board member is incorrect. -f the same discount rate is used throughout a pro&ect+s life the discount factor becomes smaller and effectively allows a greater deduction for ris( for more distant cash flows. The total ris( ad&ustment is greater the further into the future cash flows are considered. -t is not necessary to discount more distant cash flows at a higher rate. Answer 2

(a) The first error made is to suggest using the cost of e,uity* whether estimated via the dividend valuation model or the " 'M as the discount rate. The company should use its overall cost of capital* which would normally be a weighted average of the cost of e,uity and the cost of debt. Errors speci#ic to CA>+ (i) The formula is wrong. -t wrongly includes the mar(et return twice. -t should be
K e = R f + ( Rm R f )

(ii)

The e,uity beta of 4olten reflects the financial ris( resulting from the level of
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gearing in 4olten. -t must be ad&usted to reflect the level of gearing specific to !emere. -t is also li(ely that the beta of an unlisted company is higher than the beta of an e,uivalent listed company. (iii) The return re,uired by e,uity holders* i.e. the cost of e,uity* is inclusive of a return to allow for inflation. Errors speci#ic to the di'idend 'aluation model D3 +g (i) The formula is wrong. -t should be# P5 (ii) Treatment of inflation as for " 'M. (iii) gain the impact of the difference in the level of gearing of !emere and 4olten on the cost of e,uity has not been ta(en into account. 6e'ised estimates o# cost o# capital 4or 4olten

Vd (3 T ) Ve a = e + d (Ve + Vd (3 T ) ) (Ve + Vd (3 T ) )
ssume d = 5* Vd = 9*955 = B 3.7@ x 3*@55 x 9 (B share price x no. of e,uity shares) B <?*?7:*555 a = 3.9
?*?7: = 3.5@> ?*?7: + 9*955 (3 5.7;)

4or !emere ssume d = 5* Vd = 6*955 * e,uity value of <35.: million* debt costs of 378
35*:55 35*:55 + 6*955 (3 5.7;) 3.5@> = 5.@>6 e 3.5@> = e

e = 3.6;

"ost of e,uity B : C (39 :) x 3.6; B 3:.58 ! "" B 3:.58 35*:55 + 6*955 +358(3 5.7;) 35*:55 + 6*955 = 9.68 *i'idend 'aluation model 4olten
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35*:55

6*955

!e calculate the dividend growth rate# ?.67 x (3 C g)9 B 37.57 g B ?8

37.57 (3 + ?8) + 5?8 = 3?.78 37@
35*:55 6*955 +358(3 5.7;) = 3:.?8 37*555 37*555

Ke =

! "" B 3?.78

(b) The estimates of the ! "" are significantly different. Gsing the " 'M to estimate the cost of e,uity results in a ! "" of 39.68. The use of the dividend valuation model results in a ! "" of 3:.?8. They are both based on estimates from another company which has* for example* a different level of gearing. The cost of e,uity derived using the dividend valuation model is based on 4olten+s dividend policy and share price and not that of !emere. The dividend policy of !emere (e.g. the dividend growth rate) is li(ely to be different. " 'M involves estimating the systematic ris( of !emere using 4olten. The beta of 4olten is li(ely to be a reasonable estimate* sub&ect to gearing* of the beta of !emere. " 'M is therefore li(ely to produce the better estimate of the discount rate to use. However* this will be incorrect if the pro&ects being appraised have a different level of systematic ris( to the average systematic ris( of 4olten+s existing pro&ects or if the finance used for the pro&ect significantly changes the capital structure of !emere. (c) /toc( mar(et efficiency usually refers to the way in which the prices of traded financial securities reflect relevant information. !hen research indicates that share prices fully and fairly reflect past information* a stoc( mar(et is described as wea() form efficient. -nvestors cannot generate abnormal returns by analysing past information* such as share price movements in previous time periods* in such a mar(et* since research shows that there is no correlation between share price movements in successive periods of time. /hare prices appear to follow a Mrandom wal(+ by responding to new information as it becomes available. !hen research indicates that share prices fully and fairly reflect public information as well as past information* a stoc( mar(et is described as semi)strong form efficient.
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-nvestors cannot generate abnormal returns by analysing either public information* such as published company reports* or past information* since research shows that share prices respond ,uic(ly and accurately to new information as it becomes publicly available. -f research indicates that share prices fully and fairly reflect not only public information and past information* but private information as well* a stoc( mar(et is described as strong form efficient. =ven investors with access to insider information cannot generate abnormal returns in such a mar(et. Testing for strong form efficiency is indirect in nature* examining for example the performance of expert analysts such as fund managers. /toc( mar(ets are not held to be strong form efficient. The significance to a listed company of its shares being traded on a stoc( mar(et which is found to be semi)strong form efficient is that any information relating to the company is ,uic(ly and accurately reflected in its share price. Managers will not be able to deceive the mar(et by the timing or presentation of new information* such as annual reports or analysts+ briefings* since the mar(et processes the information ,uic(ly and accurately to produce fair prices. Managers should therefore simply concentrate on ma(ing financial decisions which increase the wealth of shareholders.

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