Capital Structure

2. Workshop 2: Capital Structure
Reading: Chapter 18
Corporate Finance
Tutor:

3. So why don’t we see firms with high levels of debt?
 Tax exhaustion
 Debt capacity
 Agency costs
 Financial distress (bankruptcy)

4. Tax Exhaustion & Debt Capacity
 Tax exhaustion
 Only deduct interest if you have profit
 First unit of debt adds more to Vf than later ones
 Vf rises until Marginal Cost (MC) of debt = Marginal Cost
(MC) of equity
 Debt capacity
 Level of debt relates to level of security
 Security relates to asset availability & type
 Affected by second hand market (& resale value) and rate of
depreciation

5. Agency Costs..
 Managers are agents for S/H
 Managers adopt strategies to benefit S/H – can be at
expense of D/H
 Strategies = agency costs
 Costs = higher interest rates, restrictive covenants
 Covenants: limit asset sales, restrict additional debt,
restrict dividends
 Managers may avoid debt to avoid such restrictions

6. Financial Distress
 M&M did not recognise cost of bankruptcy as assume assets
can be disposed of quickly at full value.. but…
 Costs:
 Administration/legal costs of wind up
 Reduction in asset value
 & rising debt increases risk of bankruptcy
 There is a chance that a firm will go under in any year
so Vf is reduced by: PV of Expected (value of bankruptcy)
 Also known as Trade off Theory

7. Trade off Theory
Vf
Optimum D/E
D/E
PV of B/K
PV of Tax
Optimum D/E: Increase in PV of tax shield = Increase in PV of E (Bankcruptcy B/K costs)

8. Summary: Value of the firm can be altered by changing the
gearing level

9. Activity
 Attempt the following question:
 Workshop Question D2W2 Q1
 This question asks you to consider M&M and the trade
off theory
 Chapter 18 p806-809 may help with this question

10. Observations
 Pecking Order Theory: Finance is selected in an order of
preference
 Retained earnings first (changing dividends as needed)
 Then debt
 Then equity
 Asymmetric Information
 Managers have insight into profitability & prospects of the firm
 When shares are issued – prices drop
 When debt is issued – little impact on share prices

11. Activity
 Attempt the following question:
 Workshop Question D2W2 Q2 & Q3
 These two questions consider the Pecking Order Theory,
firstly considering the theory itself (you may refer back
to discussion on day 1 about equity financing) and the
application in a company.
 Ch 18 p. 814-816 may help.

12. Capital Structure Considerations
 Tax position
 Agency costs
 Managers avoid strategies that may endanger their post
 Type of firm
 R & D firms often have low debt
 Industry averages
 ‘group norms’
 Impact on financial statements
 EPS (business risk) & gearing (financial risk)
 Interest cover
 How easily can interest payments be covered

13. Impact of debt
Two companies, same business risk, but different capital structures
Alpha plc Gamma plc
£m £m
£1 ordinary shares 200 340
12% pref shares 100 50
10% debentures 100 10
400 400
Currently both generate £80m profit before interest & tax and corporate
tax is at a rate of 30% …calculating their EPS

14. EPS
Alpha plc Gamma plc
£m £m
PBIT 80.0 80.0
Less interest 10.0 1.0
PBT 70.0 79.0
Less CT (30%) 21.0 23.7
PAT 49.0 55.3
Less pref div 12.0 6.0
Avail to ord s/h 37.0 49.0
EPS 18.5p > 14.5p
Activity:Consider EPS if PBIT is only
£40m?
Alpha plc Gamma plc
£m £m
£1 ordinary shares 200 340
12% pref shares 100 50
10% debentures 100 10
400 400

16. Result

17. In summary
 Can we change Ko & Vf by changing D& E
 It appears so
 Is there an optimum level of debt
 Managers behave as though there is
 How do we find it?
 Not sure, no rules, no models, no easy answer…
 But firms must consider the decision with respect to risk
(business & financial), investment plans, dividend policy,
industry, asset backing, tax etc..

18. Activity
 Please use the rest of this workshop time to work on
Coursework TASK 2
 Post any questions you may have in the Discussion
Board

19. And now…
 Reading
 Arnold & Lewis (2019) Chapter 18
 Arnold (2013) Chapter 18
 Articles – capital structure