(b) To: The Sales and Marketing Director of CLC
From: External Consultant
Briefing document
Issues that might influence capital structure strategy
Capital structure strategy is concerned with the relative proportions of equity and debt financing
a company's operations.
Relative advantages of debt against equity
Advantages of debt
(1) It has a cheaper direct cost than equity, as it is less risky to the funds provider.
(2) It attracts corporate tax relief, which lowers its cost.
Disadvantages of debt
As a counter to this, when a company borrows, debt interest takes precedence over equity
returns, resulting in some disadvantages:
(1) Returns to equity become more volatile, indicating an increase in equity systematic risk
(the gearing, or leverage effect). As a result the cost of equity increases.
(2) At high levels of gearing, the company is at risk of financial distress: the probability of
bankruptcy increases, too much management time is used up managing financial
emergencies, cost of emergency finance may be high, and customers and suppliers may
lose confidence.
Effect on company valuation
Modigliani and Miller
In the 1960s Miller and Modigliani developed a theory that shows that, under the perfect capital
market assumptions that they make, the cheap direct cost of debt will be exactly counterbalanced
by the increased cost of equity due to borrowing. This theory therefore suggests that the
only advantage of borrowing is the corporate tax relief.
Using Miller and Modigliani's theory, the value of a firm (i.e. the value of debt + the value of its
equity) which borrows will therefore exceed the value of an equivalent ungeared firm by the
present value of tax relief on borrowings, which is known as the tax shield. As a result, the firm's
weighted average cost of capital (WACC) is predicted to fall steadily with increased gearing.
Limitations of Modigliani and Miller
However in practice at high levels of gearing, any further fall in WACC is limited by increases to
costs of both equity and debt that set in because of financial distress. The situation is also
complicated by the existence of different personal tax treatments for equity and debt investments
that cause investors to have a preference for one or other type of capital, which varies over time
and location.
Traditional theory and optimal gearing levels
Overall the traditional theory predicts that the weighted average cost of capital falls with increased
borrowing at low gearing levels, reaches a minimum and then rises as borrowing exceeds the
safety level. If this is true, then there should be an optimum level of gearing for each company
at which its cost of capital is lowest, and in theory companies should aim for this gearing.
Limitations of traditional view
In practice companies often have lower gearing than would be predicted by these theories. The
existence of an optimal gearing is difficult to prove or disprove because a company's level of
borrowings is limited by other factors, such as the amount of surplus cash it generates compared
with investment opportunities, the operating risk of its business (high risk will deter too much
borrowing) and the value of tangible assets which it can offer as security for borrowing.
Conclusion
Capital structure has been widely debated for half a century and in general there are no easy
conclusions. It is clear, though, that provided the basic risks of debt are understood and that funds
are obtained at competitive costs, the gains or losses from varying capital structure are not really
significant compared with those that result from capital investment decisions. |
