Capital Structure II

Transcription

1 Capital Structure II

2 Introduction In the previous lecture we introduced the subject of capital gearing. Gearing occurs when a company is financed partly through fixed return finance (e.g. loans, loan stock & debentures) and partly through equity. We observed that loan financing is a cheap source of finance. It is cheap because there is low risk to lenders and also because it is tax deductible. According to the traditional view this results in a lowering of the WACC.

3 Gearing - Modigliani & Miller s View In 1958 a theory was published by Franco Modigliani and Merton Miller which said that it did not matter whether a company had a level of gearing of 2% debt or 90% debt. The WACC would remain unaltered.

4 Gearing, does not create shareholder wealth. (Modigliani & Miller 1958) They also postulated that the overall value of the company, and hence shareholder value cannot be altered due to the debt to equity ratio. This theory was based on some major assumptions and requires the company to operate in a perfect economy.

5 Quick explanation.. Their idea was that whilst WACC should intuitively decrease as the debt weighting rises, the cost of equity Ke will increase as the gearing increases by exactly the right amount to offset the debt effect and keep WACC constant. Why might this happen?

6 Example - La Mer again La Mer has two Yachts historic cost 1m each. One is financed by equity the other is financed by a 10% debenture. Let us assume that there is another business Sea plc that is identical to La Mer but is financed by 2m ordinary shares of 1 each.

7 Extract balance sheets. La Mer 1,000,000 Ordinary 1 1,000,000 10% Debentures 1,000,000 Total Financing 2,000,000 Sea plc 2,000,000 Ordinary 1 2,000,000 Total Financing 2,000,000

8 La Mer when all equity The return to shareholders was : Earnings 140, Number of ordinary shares 1,000,000 eps = 0.14 per share

9 Return on equity when gearing was 18%! After the second yacht is acquired the return to shareholders is: Profit for 2 yachts (2 x 140,000) 280,000 Less Loan interest at 10% 100, ,000 Shares in issue 1,000,000 eps 18p

10 Consider a shareholder in La Mer. Consider a shareholder who holds 1% of the equity of La Mer (i.e. 10,000 shares). Each share is expected to give a return of 18p. Suppose he decided to sell his shares in La Mer for 10,000, borrow an additional 10,000 at 10% (the current rate for borrowing) and then buy a 1% holding of ordinary shares in Sea plc (i.e. 20,000 shares). The shares in Sea plc will give a return of 14%, as it is all equity.

11 Personal gearing 10,000 La Mer eps 18p 1,800 20,000 Sea plc eps 14p 2,800 20,000 Sea plc eps 14p 2,800 Less loan interest 1,000 1,800 Both of the above investments offer the same risk and return (because in both cases only 10,000 of investor s own funds are at stake.).

12 Which implies that. If the return C is the same, and the risk (WACC) is the same, then the total value of the two companies must be the same as well. MV = C/WACC Vg = Vu

13 And so If in the above example, Sea s shares fell in price below La Mer s shares, the investor could make a switch from La Mer to the alternative, Sea plc and have the same risk and return while making a profit on the switch, because he would, for his 10,000, get more than 10,000 Sea shares, and more than 1,400.

14 But this is an arbitrage However this profit opportunity would be short lived as other rational investors would seek to do the same. The increased demand for shares in Sea plc, and the supply of Le Mar would drive the price of the shares toward equilibrium

15 Hence M&M original proposition The implication of the M & M proposition is that the value of the business is not affected by the financing method. The value of the business and the WACC are only effected by: The cash flows that the business s investments are expected to generate. The business risk.

16 The WACC does not depend on gearing!! The effect suggested by M & M is shown graphically in figure Here we can see that the effect of increased weight of loan finance in reducing WACC is exactly offset by the rising cost of equity. Therefore the WACC is impervious to the level of gearing and there is no optimum level of gearing. Contrast this to the traditional view shown in figure 11.2 in the previous lecture!

17 Or does it??? M&M s proposition may hold for a highly idealised world, a, text book world, perhaps, but relies upon some assumptions which do not hold in reality. The most important of these is probably taxation.

18 The M & M Assumptions M & M s theory relies upon the following assumptions: Shares can be bought and sold without dealing costs; Capital markets are efficient; Interest rates are equal between borrowing and lending; There are no bankruptcy costs; There is no taxation.

19 Traditional View Loan finance cheaper than equity and tax deductible, hence gearing lowers WACC. Shareholders and lenders not concerned about increased risk at lower levels of gearing. But as gearing increases both take fright and the WACC rises. Hence there is an optimum level of WACC

20 Modigliani & Miller Equity cost rises gently with gearing, exactly offsetting the proportion of cheap debt. WACC constant at all levels of gearing. Based upon some very debatable concepts of perfect markets and no tax. They eventually modified the theory.

21 Practical issues Directors sometimes use the assets of the business to their own advantage rather than those of the shareholders this is termed managerialism. Hence shareholders have to bear the agency cost of managerialism and trying to prevent it.

22 Agency Costs If gearing lowers WACC then it is in shareholder interests to gear up, but the loan capital has to be serviced with cash and management may not welcome this constraint. They may prefer equity finance, because the dividend is not compulsory, and this provides more freedom, termed an equity cushion.

23 Signalling It has been suggested that raising loan finance signals confidence that the debt can be serviced.

24 Clientele effects It is possible that particular equity investors might be attracted to a company by its gearing, perhaps due to the risky volatility of eps and potential high returns!!