Chapter-18 Capital Structure

Operating Gearing
It is a measure of the extent to which a firm’s operating costs are fixed rather
than variable as this affects the level of business risk in the firm. Operating
gearing can be measured in a number of different ways including:
Fixed Costs/Variable costs (or) Fixed costs/Total costs (or) % change in EBIT/%
change in revenue (or) Contribution/EBIT
Thus, if the sales of a company vary:
➢ The greater the operating gearing the greater the EBIT variability
➢ The level of operating gearing will be largely a result of the industry in
which the firm operates
Financial Gearing
Financial gearing is a measure of the extent to which debt is used in the capital
structure. It can be measured in a number of ways:
a. Equity gearing (D/E) = Long-term debt plus preference share capital/ Ordinary
share capital and reserves.
b. Total or capital gearing (D/(D+E)) = Long-term debt plus preference share
capital/ Total long-term capital
c. Interest gearing = Debt interest/ Operating profits before debt interest and tax
All three ratios measure the same thing, but:
➢ For comparison purpose, the same ratio must be used consistently
➢ Capital gearing (D/(D+E)) is used more often than equity gearing (D/E)
➢ Interest gearing is a statement of profit or loss measure rather than a
financial position statement.
➢ It considers the percentage of the operating profits absorbed by interest
payments on borrowings and as a result measures the impact of gearing
on profits.
➢ It is more normally seen in its inverse form as the interest cover ratio
Nominal or market values
The ratios can be calculated using either nominal or market values of debt and
equity. There are arguments in favour of both approaches:

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Market values:
➢ Are more relevant to the level of investment made
➢ Represent the opportunity cost of the investment made
➢ Are consistent with the way investors measure debt and equity
Nominal values:
➢ Are imposed gearing restrictions are often exposed
➢ Are not subject to sudden change due to market factors
➢ Are readily available
Impact of financial gearing
➢ Where two companies have the same level of variability in earnings, the
company with the higher level of financial gearing will have increased
variability of returns to shareholders.
➢ The role of financial manager is to balance these different risk factors to
ensure that the overall risk faced by equity investors is acceptable.
➢ It is the level of overall risk that will determine the rate of return on equity
investor demands.
➢ A finance manager can do to alter the business risk and there may only be
limited opportunities for altering operating gearing.
➢ It is risk associated with how the company is financed that is most easily
controlled.
➢ A firm must consider the volatility but cannot avoid and ensure the
gearing decisions and avoid increasing risks to unacceptable levels.
An optimal capital structure – Company value and the cost of capital
The objective of management is to maximise shareholder wealth. If altering the
gearing ratio could increase the wealth, then finance managers would have a
duty to do so.
Reasons for increase shareholder wealth by changing the gearing ratio/level-
➢ The market value of a company is the sum of the MVs of its various forms
of finance. This equates to the MV of the company’s equity plus debt.
➢ The MV of each type of finance is known to be the PV of the returns to the
investor, discounted at their required rate of return.
➢ If a company distributes all its earnings, it follows that the total MV of the
company equates to the present value of the future cash flows available
to investors, discounted at their overall required return or WACC.
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If it can reduce the WACC, this result in a higher MV of the company and increase
in shareholder wealth as they own the company. The WACC is a weighted
average of the various sources of finance used by the company.
Debt cheaper than equity:
➢ Lower risk
➢ Tax relief on interest
Increasing levels of debt make equity more risky:
➢ Fixed commitment paid before equity- finance risk
➢ So, increasing financial gearing increases the cost of equity and would
increase the WACC.
The traditional view of capital structure
Also known as the intuitive view, the traditional view has no theoretical basis but
common sense. Taxation is ignored in the traditional view.
At low levels of gearing-
Equity holders perceive risk as relatively unchanged and ke may rise but not by
very much, so the increase in the proportion of cheaper debt will have the
greater effect and the WACC will fall as gearing is increased.
At higher levels of gearing-
Equity holder increased volatility returns as more debt interest must be paid out
of shareholder profits. This leads to:
➢ Increased financial risk
➢ Increase in Ke outweighs the benefit of the extra debt being introduced
➢ WACC starts to rise
At very high levels of gearing-
Serious bankruptcy risk worries equity and debt holders alike. Ke and Kd rise.
WACC rises further.
Modigliani & Miller (M&M) – 1958 theory with no taxation
M&M argued that:
➢ As investors are rational, the required return of equity is directly
proportional to the increase in gearing.

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 ➢ There is a linear relationship between Ke and gearing measured as D/E.
➢ The increase in Ke exactly offsets the benefit of the cheaper debt finance
and therefore the WACC remains unchanged
Conclusion-
The WACC and the value of the firm are unaffected by changes in gearing levels
and gearing is irrelevant.
Implication for finance-
➢ Choice of finance is irrelevant to shareholder wealth- company can use
any mix of funds
Assumptions underpinning M&M’s theory-
➢ No taxation
➢ Perfect capital markets where the investors have the same information
upon which they react rationally
➢ No transaction costs
➢ Debt is risk free
M&M – 1963 theory with tax
A number of practical criticisms were levelled at M&M’s no tax theory, but the
most significant was the assumption that there were no taxes. Since debt
interest is tax-deductible, the impact of tax could not be ignored. In 1963, M&M
modified their model to reflect the fact that the corporate tax system gives tax
relief on interest payments.
The starting point for the theory is as before that-
➢ The investors are rational
➢ The required return of equity is directly linked to increase in gearing – as
gearing increase
➢ Ke increases in direct proportion
However, this is adjusted to reflect the fact that-
➢ Debt interest is tax deductible so the overall cost of debt (Kd*(1-T)) to the
company is lower than in M&M – no tax (kd).
➢ Lower debt costs result in less volatility in returns for the same level of
gearing which leads to lower increases in Ke.

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 ➢ The increase in Ke doesn’t offset the benefit of the cheaper debt finance
and therefore the WACC falls as gearing increases.
Conclusion-
Gearing up reduces the WACC and increases the MV of the company. The
optimal capital structure is 99.9% gearing.
Implications for finance-
The company should use as much debt as possible.
The problems of high gearing
Firms are rarely found with very high levels of gearing. This is because of:
1. Bankruptcy risk
2. Agency cost
3. Tax exhaustion
4. The impact on borrowing/debt capacity
5. Difference in risk tolerance levels between shareholders and directors
6. Restriction in the articles of association
7. Increase in the cost of borrowing as gearing increases
1. Bankruptcy risk- As gearing increases, it is possibility of bankruptcy. If
shareholder become concerned, this will increase ke even further along with the
WACC of the company and will reduce the share price.
2. Agency cost- In order to safeguard their investments, lenders/debentures
holders often impose restrictive conditions in the loan agreements that constrain
management’s freedom of action, e.g. restrictions:
➢ On the level of dividends
➢ On the level of additional debt that can be raised
➢ On management from disposing of any major fixed assets without the
debenture holder’s agreement.
3. Tax exhaustion- After a certain level of gearing, companies will discover that
they have no tax liability left against which to offset interest charges. Kd(1-T)
simply becomes Kd. Debt is no longer so cheap as to outweigh the effect of the
rising ke and WACC no longer falls with increasing debt.
4. The impact on borrowing/debt capacity- High levels of gearing are unusual
because companies run out of suitable assets to offer as security against loans.

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Companies with assets that have an active second-hand market and the low
levels of depreciation such as property companies have a high borrowing
capacity.
5. Difference in risk tolerance levels between shareholders and directors-
Business failure can have a far greater impact on directors than on a well-
diversified investor. It may be argued that directors have a natural tendency to
be cautious about borrowing.
6. Restrictions in the articles of association- It may specify limits on the
company’s ability to borrow.
7. Increase in the cost of borrowing as gearing increases- Due to lender’s views
on the business – even they will see it as a more risky investment at high gearing
levels. As a result, debt becomes less attractive as it is no longer so cheap.
Pecking order theory
In this approach, there is no search for an optimal capital structure through
theorised process. Instead, it is argued thar firms will raise new funds as follows:
➢ Internally-generated funds
➢ Debt
➢ New issue of equity
Firms simply use all their internally-generated funds first then move down the
pecking order to debt and finally issuing new equity. Firms follow a line of least
resistance that establishes the capital structure.
Internally-generated funds-
➢ Already have the funds
➢ Do not have to spend any time persuading outside investors of the merits
of the project.
➢ No issue costs
Debt-
➢ The degree of questioning and publicity associated with debt is usually
significantly less than that associated with a share issue.
➢ Moderate issue costs
New issue of equity-
➢ Perception by stock markets that it is possible sign of problems.

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 ➢ Extensive questioning and publicity associated with a share price.
➢ Expensive issue costs
Summary of gearing theories-
Theory Net effect as gearing Impact on WACC Optimal finance
increases method
Traditional theory The WACC is U- At optimal point, Find and maintain
shaped WACC is optimum gearing
minimised. ratio.
M&M (no tax) Cheaper debt = WACC is Choice of finance is
Increase in Ke constant irrelevant – use any
M&M (with tax) Cheaper debt > WACC falls As much debt as
Increase in Ke possible
The pecking order No theorised No theorised Simply line of least
process process resistance. First
internally-generated
funds, then debt and
finally new issue of
equity.

Capital structure and the choice of discount rate

Use of the WACC in investment appraisal-
It was based upon the firm’s current costs of equity and debt. Therefore, it is
appropriate for use in investment appraisal provided:
➢ The historic proportions of debt and equity are not to be charged.
➢ The operating risk of the firm will not be changed
➢ The finance is not project-specific, i.e. projects are financed from pool of
funds
➢ The project is small in relation to the company so any changes are
insignificant.
Using CAPM in project appraisal-
The CAPM can be used to help to find a discount rate when the project risk is
different from the company’s normal business risk. The logic behind the CAPM
is as follows:
➢ Objective is to maximise shareholder wealth

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 ➢ Rational shareholders will hold well diversified portfolios
➢ Any new project is just another investment in a shareholder’s portfolio
➢ CAPM can be set the shareholder’s required return on the project
CAPM and gearing risk-
To evaluate a project with a different risk profile, a company will need to find a
suitable beta factor for the new investment and that are estimated with
reference to existing companies operating in the business areas. The reason for
approach works is:
➢ Those companies paying above average returns are assumed to have a
correspondingly higher than average systematic risk and their beta is
extrapolated accordingly.
➢ The extrapolated beta is considered a measure of the risk of the business
area.
Understanding betas-
Firms must provide a return to compensate for the risk faced by investors and
even for a well-diversified investor, this systematic risk will have two causes:
➢ The risk resulting from its business activities
➢ The finance risk caused by its level of gearing
Using betas in project appraisal-
1. Find an appropriate asset beta- An appropriate asset beta will reflect the
correct systematic risk of the business area that the project relates in it. It will
normally be a proxy beta from a business that already operates in this business
area. The formula of asset beta is:
βa = (Ve/ (Ve + Vd(1-T)) * βe + (Vd(1-T)/ (Ve + Vd(1-T)) * βd )
βd will always be assumed to be zero. This means the formula of asset beta can
be simplified to be:
βa = βe * (Ve / Ve + Vd(1-T))
2. Adjust the asset beta to reflect the gearing level of the company making the
investment-
Re-gear the asset beta to convert it to an equity beta based on the gearing levels
of the company undertaking the project.

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3. Use the re-geared beta to find Ke. This is done using the standard CAPM
formula of-
Ke = Rf + β*(Rm-Rf)
Where:
Rf → risk free rate
Rm → average return on the market
(Rm-Rf) → equity risk premium
β→ the beta factor