KCB Notes - Theories of Capital Structure Flashcards
Gearing and value
How do you calculate the enterprise value or firm value?
Value of debt + value of equity
OR
Market Value
In addition to systematic and unsystematic risk, what are the three type of risks which should be factored when designing an optimal capital structure?
- Business (or Company) Risk
- Operating Risk / Operating Gearing
- Financial Risk
What does the term ‘business risk’ mean when designing an optimal capital structure?
Business or company risk is the risk of variability of earnings resulting in an inadequate profit, or even a loss, due to uncertainties in the company.
Company risk can be internal as well as external.
Internal risk is caused by poor product mix, inadequate resources, absence of strategic management and so on.
External risk is influenced by numerous factors, including competition, the overall economic climate and government regulations.
In reality, there is little that a financial manager can do to alter the company risk due to external factors.
What does the term ‘operating risk and operating gearing’ mean when designing an optimal capital structure?
Operating risk is the risk of disruption of the core operations of a company resulting from breakdowns in internal procedures, people and systems.
It may be caused by inadequate policies, system failures, criminal activity and
loss faced by litigations against the company. It measures the risk from OPERATING COSTS THAT ARE FIXED.
Operating gearing is the proportion of fixed costs a company has relative to its variable costs.
There may only be limited opportunities for altering operating gearing.
What does the term ‘financial risk’ mean when designing an optimal capital structure?
Financial risk refers to the risk from financing associated with debt.
It is the risk of default when the company may not be able to cover its fixed financial costs. The extent of financial risk depends on the leverage of the company’s capital structure.
A company with debt financing has higher financial risk.
A company should be in a position to meet its obligations in paying the loan and interest charges as and when these fall due.
The risk associated with how the company is financed can be most easily controlled by changing the level of financial gearing.
What is the traditional view in the theory of capital structure?
The capital structure debate surrounds the issue of whether the value of the form will change if the management change the gearing (i.e. the proportion of debt to equity in the company financial structure).
The implication being that is there is an optimal capital structure the management should aim at achieving this level to maximise shareholder wealth.
The traditional view maintains that there is some optimal capital structure.
What are the limitations of Traditional Theory?
- Does not quantify the effects of changes in gearing, it locates the optimal point by trial and error.
- Ignores real world factors e.g corporation tax, habits of investors
- Questionable assumptions
3.1 all earnings are distributed as a dividend
3.2 total assets and revenue are fixed.
3.3 only equity and debt finance is considered.
3.4 investment habits remain rational
3.5 there are no taxes
In contrast to the traditional theory, Modigliani and Miller came up with two theories to capital structure. Name them.
- 1958 approach - The Modigliani and Miller View (Perfect Market - also known as the Capital Structure Irrelevancy Theory) and
- 1963 approach - The Modigliani and Miller View (with Taxation) - also known as the trade-off theory.
Explain the Modigliani and Miller perfect market theory.
The MM view was published in 1958(MMI), and held that a firm which changes the way it is financed, cannot affect its value, under the assumptions of the perfect capital market.
‘if you slice up a pizza you don’t have more pizza as a result’.
Under this approach, the levels of operating income influence market value. It suggests that the valuation of a company and the weighted average cost of capital are irrelevant to the capital structure of a company.
The basic concept of Modigliani and Miller’s (MM) approach is that the value of a company is independent of its capital structure. Market value is determined solely by investment decisions.
What are the assumptions of the Modigliani and Miller (without taxes- perfect market) theory.
- No corporate taxation.
- No transaction costs relating to buying and selling securities or bankruptcy costs.
- Perfect capital markets with a symmetry of information. An investor will have access to same information that a company would and they react rationally.
- The cost of borrowing is the same for investors and companies.
- Debt is risk free.
Explain the Modigliani and Miller with tax theory.
The impact of tax cannot be ignored in the real world, since debt interest is tax deductible.
Modigliani and Miller revised their theory in 1963 to recognise tax relief on interest payments.
The actual cost of debt is less than the nominal cost of debt because of tax benefits. However, the same is not the case with dividends paid on equity.
The trade-off theory advocates that a company can use debt as long as the cost of distress or bankruptcy does not exceed the value of tax benefits.
What are the criticisms of the MM with tax theory?
It ignores bankruptcy risk. In practice, companies never gear up to 99.9%. As gearing increases, so does the possibility of bankruptcy. If the company is considered to be risky, the share price will go down, increasing the company’s WACC.
- Restrictive conditions in the loan agreements associated with debt finance can constrain a company’s flexibility to make decisions (such as paying dividends, raising additional debt or disposing of any major fixed assets).
- After a certain level of gearing, companies may no longer have any tax liability left against which to offset interest charges.
- High levels of gearing may not be possible with companies exhausting assets to offer as security against loans.
- Different risk tolerance levels between shareholders and directors may impact the gearing level.
- It can be argued that directors have a tendency to be cautious about borrowing.
What is the alternative or real world theory in connection with capital structure?
Pecking order theory is an alternative theory to MM and Traditional view.
The ‘pecking order’ theory popularised by Myers and Majluf (1984) was developed as an alternative theory on capital structure.
It states that companies have the following order of preference for financing decisions:
1. retained earnings
2. straight debt
3. convertible debt
4. preference shares
5. equity shares
The reasoning is that as companies are risk averse and will prefer retained earnings to any other source of finance, they will choose debt and equity last of all.
They invariably prefer internal finance over external finance.
The costs of borrowing also follow the same order, equity shares being the most expensive.
The value of a project depends on how it is financed. If a company follows the pecking order approach, only projects funded with internal funds or with relatively safe debt will be accepted.
Risky projects funded by risky debts or equity will be rejected.
What do Capital Structure theories attempt to discover?
Capital structure theories attempt to discover:
* whether an optimal capital structure exists;
* the optimal mix between debt and equity finance; and
* the relationship between WACC, the market value of the company and the level of gearing in the capital structure.
What is systematic and unsystematic risk and why is it important?
It is essential to diversify risk for an investor to earn adequate returns. There are two types of risk: unsystematic risk and systematic risk.
Unsystematic risks are risk factors specific to a particular company or industry which can be eliminated or diversified away in a large portfolio of shares. These risks are not impacted by political and economic factors. These are different for different companies; they might even cancel each other out in some circumstances.
Systematic risk (or market risk) relates to the markets and the economy. It is largely caused by macroeconomic factors and AFFECTS ALL THE SHARES in the market. It is unavoidable and cannot be diversified. An example may be an economic recession affecting both the markets and the economy of the country. The level to which each share will be affected will differ, although it is known that all shares will be affected. It should be noted that, even in a severe recession like that caused by the Covid-19 pandemic, there might be a small
number of companies doing well. This is usually for a specific reason that affects a niche market.
The degree of systematic risk is different in different industries. For instance, the food retailing sector faces lower systematic risk in comparison to the hospitality sector, as food is a necessity. Irrespective of a recession, people will still require their daily essentials. It is possible for an investor to select shares with a low systematic risk. Thus, investors need to select shares that will provide returns over and above its risk-free rate of return.
The CAPM suggests that investors can eliminate the unsystematic risk and thus reduce the overall risk by choosing an optimal portfolio. It assumes that investors will behave rationally.
