Question

What are the major considerations that a CFO has to keep in mind as he/she decides on the right capital structure for a company.

Answer 1

The first question to address is what is meant by capital structure. The capital structure of a company refers to the mixture of equity and debt finance used by the company to finance its assets. Some companies could be all-equity-financed and have no debt at all, whilst others could have low levels of equity and high levels of debt. The decision on what mixture of equity and debt capital to have is called the financing decision.

The financing decision has a direct effect on the weighted average cost of capital (WACC). The WACC is the simple weighted average of the cost of equity and the cost of debt. The weightings are in proportion to the market values of equity and debt; therefore, as the proportions of equity and debt vary, so will the WACC. Therefore the first major point to understand is that, as a company changes its capital structure (ie varies the mixture of equity and debt finance), it will automatically result in a change in its WACC.

However, before we get into the detail of capital structure theory, you may be thinking how the financing decision (ie altering the capital structure) has anything to do with the overall corporate objective of maximising shareholder wealth. Given the premise that wealth is the present value of future cash flows discounted at the investors’ required return, the market value of a company is equal to the present value of its future cash flows discounted by its WACC.

Market value of a company = Future cash flows
(perpetuity formula)                            WACC

It is essential to note that the lower the WACC, the higher the market value of the company – as you can see from the following simple example; when the WACC is 15%, the market value of the company is 667; and when the WACC falls to 10%, the market value of the company increases to 1,000.

Market value of a company 100 = 667 100 = 1,000
                                            0.15        0.10

Hence, if we can change the capital structure to lower the WACC, we can then increase the market value of the company and thus increase shareholder wealth.

Therefore, the search for the optimal capital structure becomes the search for the lowest WACC, because when the WACC is minimised, the value of the company/shareholder wealth is maximised. Therefore, it is the duty of all finance managers to find the optimal capital structure that will result in the lowest WACC.

What mixture of equity and debt will result in the lowest WACC?

As the WACC is a simple average between the cost of equity and the cost of debt, one’s instinctive response is to ask which of the two components is the cheaper, and then to have more of the cheap one and less of expensive one, to reduce the average of the two.

Well, the answer is that cost of debt is cheaper than cost of equity. As debt is less risky than equity, the required return needed to compensate the debt investors is less than the required return needed to compensate the equity investors. Debt is less risky than equity, as the payment of interest is often a fixed amount and compulsory in nature, and it is paid in priority to the payment of dividends, which are in fact discretionary in nature. Another reason why debt is less risky than equity is in the event of a liquidation, debt holders would receive their capital repayment before shareholders as they are higher in the creditor hierarchy (the order in which creditors get repaid), as shareholders are paid out last.

Debt is also cheaper than equity from a company’s perspective is because of the different corporate tax treatment of interest and dividends. In the profit and loss account, interest is subtracted before the tax is calculated; thus, companies get tax relief on interest. However, dividends are subtracted after the tax is calculated; therefore, companies do not get any tax relief on dividends. Thus, if interest payments are $10m and the tax rate is 30%, the cost to the company is $7m. The fact that interest is tax-deductible is a tremendous advantage.

Let us return to the question of what mixture of equity and debt will result in the lowest WACC. The instinctive and obvious response is to gear up by replacing some of the more expensive equity with the cheaper debt to reduce the average, the WACC. However, issuing more debt (ie increasing gearing), means that more interest is paid out of profits before shareholders can get paid their dividends. The increased interest payment increases the volatility of dividend payments to shareholders, because if the company has a poor year, the increased interest payments must still be paid, which may have an effect the company’s ability to pay dividends. This increase in the volatility of dividend payment to shareholders is also called an increase in the financial risk to shareholders. If the financial risk to shareholders increases, they will require a greater return to compensate them for this increased risk, thus the cost of equity will increase and this will lead to an increase in the WACC.

In summary, when trying to find the lowest WACC, you:

• Issue more debt to replace expensive equity; this reduces the WACC
• But more debt also increases the WACC as:
  - Gearing
  - Financial risk
  - Beta equity
  - Keg WACC

Remember that Keg is a function of beta equity which includes both business and financial risk, so as financial risk increases, beta equity increases, Keg increases and WACC increases.

The key question is which has the greater effect, the reduction in the WACC caused by having a greater amount of cheaper debt or the increase in the WACC caused by the increase in the financial risk. To answer this we have to turn to the various theories that have developed over time in relation to this topic.

Modigliani and Miller’s no-tax model

In 1958, Modigliani and Miller stated that, assuming a perfect capital market and ignoring taxation, the WACC remains constant at all levels of gearing. As a company gears up, the decrease in the WACC caused by having a greater amount of cheaper debt is exactly offset by the increase in the WACC caused by the increase in the cost of equity due to financial risk. The WACC remains constant at all levels of gearing thus the market value of the company is also constant. Therefore, a company can not reduce its WACC by altering its gearing (Figure 1).

The cost of equity is directly linked to the level of gearing. As gearing increases, the financial risk to shareholders increases, therefore Keg increases. Summary: Benefits of cheaper debt = Increase in Keg due to increasing financial risk. The WACC, the total value of the company and shareholder wealth are constant and unaffected by gearing levels. No optimal capital structure exists.

Modigliani and Miller’s with-tax model

In 1963, when Modigliani and Miller admitted corporate tax into their analysis, their conclusion altered dramatically. As debt became even cheaper (due to the tax relief on interest payments), cost of debt falls significantly from Kd to Kd(1-t). Thus, the decrease in the WACC (due to the even cheaper debt) is now greater than the increase in the WACC (due to the increase in the financial risk/Keg). Thus, WACC falls as gearing increases. Therefore, if a company wishes to reduce its WACC, it should borrow as much as possible (Figure 2).

Summary: Benefits of cheaper debt > Increase in Keg due to increasing financial risk.

Companies should therefore borrow as much as possible. Optimal capital structure is 99.99% debt finance.

Market imperfections

There is clearly a problem with Modigliani and Miller’s with-tax model, because companies’ capital structures are not almost entirely made up of debt. Companies are discouraged from following this recommended approach because of the existence of factors like bankruptcy costs, agency costs and tax exhaustion. All factors which Modigliani and Miller failed to take in account.

Bankruptcy costs

Modigliani and Miller assumed perfect capital markets; therefore, a company would always be able to raise funding and avoid bankruptcy. In the real world, a major disadvantage of a company taking on high levels of debt is that there is a significant possibility of the company defaulting on its increased interest payments and hence being declared bankrupt. If shareholders and debt-holders become concerned about the possibility of bankruptcy risk, they will need to be compensated for this additional risk. Therefore, the cost of equity and the cost of debt will increase, WACC will increase and the share price reduces. It is interesting to note that shareholders suffer a higher degree of bankruptcy risk as they come last in the creditors’ hierarchy on liquidation.

If this with-tax model is modified to take into account the existence of bankruptcy risks at high levels of gearing, then an optimal capital structure emerges which is considerably below the 99.99% level of debt previously recommended.

Agency costs

Agency costs arise out of what is known as the ‘principal-agent’ problem. In most large companies, the finance providers (principals) are not able to actively manage the company. They employ ‘agents’ (managers) and it is possible for these agents to act in ways which are not always in the best interest of the equity or debt-holders.

Since we are currently concerned with the issue of debt, we will assume there is no potential conflict of interest between shareholders and the management and that the management’s primary objective is the maximisation of shareholder wealth. Therefore, the management may make decisions that benefit the shareholders at the expense of the debt-holders.

Management may raise money from debt-holders stating that the funds are to be invested in a low-risk project, but once they receive the funds they decide to invest in a high risk/high return project. This action could potentially benefit shareholders as they may benefit from the higher returns, but the debt-holders would not get a share of the higher returns since their returns are not dependent on company performance. Thus, the debt-holders do not receive a return which compensates them for the level of risk.

To safeguard their investments, debt-holders often impose restrictive covenants in the loan agreements that constrain management’s freedom of action. These restrictive covenants may limit how much further debt can be raised, set a target gearing ratio, set a target current ratio, restrict the payment of excessive dividends, restrict the disposal of major assets or restrict the type of activity the company may engage in.

As gearing increases, debt-holders would want to impose more constrains on the management to safeguard their increased investment. Extensive covenants reduce the company’s operating freedom, investment flexibility (positive NPV projects may have to be forgone) and may lead to a reduction in share price. Management do not like restrictions placed on their freedom of action. Thus, they generally limit the level of gearing to limit the level of restrictions imposed on them.

Tax exhaustion

The fact that interest is tax-deductible means that as a company gears up, it generally reduces its tax bill. The tax relief on interest is called the tax shield – because as a company gears up, paying more interest, it shields more of its profits from corporate tax. The tax advantage enjoyed by debt over equity means that a company can reduce its WACC and increases its value by substituting debt for equity, providing that interest payments remain tax deductible.

However, as a company gears up, interest payments rise, and reach a point that they are equal to the profits from which they are to be deducted; therefore, any additional interest payments beyond this point will not receive any tax relief.

This is the point where companies become tax - exhausted, ie interest payments are no longer tax deductible, as additional interest payments exceed profits and the cost of debt rises significantly from Kd(1-t) to Kd. Once this point is reached, debt loses its tax advantage and a company may restrict its level of gearing.

As the primary financial objective is to maximise shareholder wealth, then companies should seek to minimise their weighted average cost of capital (WACC). In practical terms, this can be achieved by having some debt in the capital structure, since debt is relatively cheaper than equity, while avoiding the extremes of too little gearing (WACC can be decreased further) or too much gearing (the company suffers from bankruptcy costs, agency costs and tax exhaustion). Companies should pursue sensible levels of gearing.

Companies should be aware of the pecking order theory which takes a totally different approach, and ignores the search for an optimal capital structure. It suggests that when a company wants to raise finance it does so in the following pecking order: first is retained earnings, then debt and finally equity as a last resort.