how would you decide what amount of leverage to use in building a companys capital structure?

Is it possible to increase shareholder wealth by changing the upper-case letter structure?

The first question to address is what is meant by capital structure. The capital construction 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 accept low levels of disinterestedness and high levels of debt. The decision on what mixture of equity and debt majuscule to accept 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 price of disinterestedness 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, and so will the WACC. Therefore the offset major point to understand is that, as a company changes its capital structure (ie varies the mixture of disinterestedness and debt finance), it will automatically result in a change in its WACC.

All the same, before we get into the detail of capital letter construction theory, yous may be thinking how the financing decision (ie altering the uppercase 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 render, the market value of a company is equal to the nowadays value of its future cash flows discounted past its WACC.

Market value of a company = Future cash flows / WACC

It is essential to note that the lower the WACC, the higher the marketplace value of the company – every bit 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 ten%, the market place value of the company increases to ane,000.

Market value of a company

100/ 0.15 =667

100/0.x =one,000

Hence, if we can modify the uppercase structure to lower the WACC, nosotros 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 visitor/shareholder wealth is maximised. Therefore, it is the duty of all finance managers to detect the optimal capital construction that will upshot in the everyman WACC.

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

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

Well, the answer is that toll of debt is cheaper than price 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, every bit 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. Some other 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 college in the creditor hierarchy (the order in which creditors go repaid), as shareholders are paid out last.

Debt is likewise cheaper than equity from a visitor'south 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 become tax relief on interest. However, dividends are subtracted after the tax is calculated; therefore, companies practice non get whatever tax relief on dividends. Thus, if interest payments are $10m and the taxation rate is 30%, the price to the company is $7m. The fact that involvement 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 past replacing some of the more than expensive equity with the cheaper debt to reduce the average, the WACC. However, issuing more than 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, considering if the company has a poor year, the increased interest payments must still be paid, which may accept an effect the visitor'due south ability to pay dividends. This increase in the volatility of dividend payment to shareholders is also called an increment in the financial take a chance to shareholders. If the fiscal hazard to shareholders increases, they will require a greater return to compensate them for this increased risk, thus the toll of equity will increase and this volition lead to an increase in the WACC.

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

• outcome more debt to replace expensive equity; this reduces the WACC, just
• more debt besides increases the WACC as:
  • gearing
  • financial risk
  • beta disinterestedness
  • keg WACC.
    

Recall that Keg is a office of beta equity which includes both business and financial risk, so as fiscal hazard increases, beta equity increases, Keg increases and WACC increases.

The key question is which has the greater result, 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 take chances. To respond this we have to turn to the various theories that have adult over time in relation to this topic.

The theories of capital construction

1. G + Chiliad (No Tax): Cheaper Debt = Increment in Fiscal Risk / Keg
2. 1000 + M (With Tax): Cheaper Debt > Increase in Financial Risk / Keg
3. Traditional Theory: The WACC is U shaped, ie there is an optimum gearing ratio
4. The Pecking Guild: No theorised procedure; simply the line of least resistance first internally generated funds, then debt and finally new issue of equity
   

Modigliani and Miller's no-taxation model

In 1958, Modigliani and Miller stated that, assuming a perfect capital letter market and ignoring taxation, the WACC remains constant at all levels of gearing. Every bit a visitor gears up, the decrease in the WACC caused past having a greater corporeality of cheaper debt is exactly offset by the increase in the WACC caused by the increase in the cost of equity due to financial gamble.

The WACC remains abiding at all levels of gearing thus the market place value of the company is as well constant. Therefore, a visitor cannot reduce its WACC past altering its gearing (Effigy 1).

The cost of equity is direct linked to the level of gearing. As gearing increases, the fiscal 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 abiding and unaffected by gearing levels. No optimal capital structure exists.

Modigliani and Miller'due south with-tax model

In 1963, when Modigliani and Miller admitted corporate tax into their analysis, their determination contradistinct dramatically. Equally debt became fifty-fifty cheaper (due to the tax relief on interest payments), toll of debt falls significantly from Kd to Kd(1-t). Thus, the subtract in the WACC (due to the fifty-fifty cheaper debt) is now greater than the increase in the WACC (due to the increment in the financial risk/Keg). Thus, WACC falls as gearing increases. Therefore, if a company wishes to reduce its WACC, information technology should borrow as much every bit possible (Figure 2).

Summary: Benefits of cheaper debt > Increment in Keg due to increasing fiscal chance.

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

Market imperfections

At that place is clearly a problem with Modigliani and Miller's with-tax model, because companies' capital structures are not most entirely made upward of debt. Companies are discouraged from following this recommended approach considering of the existence of factors like defalcation costs, agency costs and tax exhaustion. All factors which Modigliani and Miller failed to accept in account.

Defalcation costs

Modigliani and Miller assumed perfect capital letter markets; therefore, a company would always be able to enhance funding and avert bankruptcy. In the real world, a major disadvantage of a visitor taking on loftier 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 increment, WACC will increase and the share price reduces. It is interesting to annotation 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 business relationship the being of bankruptcy risks at high levels of gearing, then an optimal capital construction emerges which is considerably below the 99.99% level of debt previously recommended.

Agency costs

Bureau costs arise out of what is known every bit the 'principal-agent' problem. In nearly 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 deed in ways which are non always in the best interest of the equity or debt-holders.

Since nosotros are currently concerned with the result of debt, we will presume at that place is no potential conflict of involvement between shareholders and the management and that the management'southward 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 depression-take a chance project, simply once they receive the funds they determine to invest in a high take a chance/loftier render project. This action could potentially do good shareholders equally they may benefit from the college returns, but the debt-holders would not get a share of the higher returns since their returns are not dependent on visitor performance. Thus, the debt-holders do not receive a render which compensates them for the level of take a chance.

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

As gearing increases, debt-holders would want to impose more than constrains on the management to safeguard their increased investment. Extensive covenants reduce the visitor'southward operating freedom, investment flexibility (positive NPV projects may take to be forgone) and may atomic number 82 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 burnout

The fact that interest is taxation-deductible means that as a company gears up, it generally reduces its tax neb. The taxation relief on interest is chosen 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 visitor tin reduce its WACC and increases its value past substituting debt for equity, providing that involvement payments remain tax deductible.

Even so, as a company gears upward, 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 whatever taxation relief.

This is the signal where companies get taxation - wearied, 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 bespeak is reached, debt loses its tax advantage and a visitor may restrict its level of gearing.

The WACC volition initially fall, because the benefits of having a greater corporeality of cheaper debt outweigh the increase in cost of equity due to increasing fiscal risk. The WACC will continue to fall until it reaches its minimum value, ie the optimal capital letter structure represented by the betoken X.

Benefits of cheaper debt > increase in keg due to increasing financial risk

If the visitor continues to gear up, the WACC will and so rise as the increase in financial risk/Keg outweighs the benefit of the cheaper debt. At very high levels of gearing, bankruptcy risk causes the cost of equity curve to rise at a steeper rate and also causes the cost of debt to first to ascent.

Increment in Keg due to financial and bankruptcy risk > Benefits of cheaper debt

Shareholder wealth is affected by changing the level of gearing. There is an optimal gearing level at which WACC is minimised and the total value of the company is maximised. Financial managers have a duty to achieve and maintain this level of gearing. While we accept that the WACC is probably U-shaped for companies by and large, we cannot precisely summate the best gearing level (ie there is no analytical mechanism for finding the optimal majuscule structure). The optimum level will differ from one company to some other and tin can just be found by trial and fault.

Pecking order theory

The pecking club theory is in sharp contrast with the theories that attempt to detect an optimal upper-case letter structure by studying the merchandise-off between the advantages and disadvantages of debt finance. In this approach, in that location is no search for an optimal capital construction. Companies but follow an established pecking order which enables them to raise finance in the simplest and about efficient manner, the order is as follows:

1. Employ all retained earnings available;
2. Then issue debt;
3. Then upshot equity, as a final resort.

The justifications that underpin the pecking order are threefold:

• Companies will want to minimise effect costs.
• Companies will want to minimise the time and expense involved in persuading outside investors of the claim of the project.
• The existence of asymmetrical data and the presumed information transfer that result from direction actions. We shall now review each of these justifications in more detail.

Minimise consequence costs

1. Retained earnings accept no result costs as the visitor already has the funds
2. Issuing debt will only incur moderate outcome costs
3. Issuing disinterestedness will incur high levels of issue costs
   

Minimise the fourth dimension and expense involved in persuading outside investors

1. Every bit the company already has the retained earnings, it does non have to spend any time persuading outside investors
2. The time and expense associated with issuing debt is usually significantly less than that associated with a share issue

The existence of asymmetrical information

This is a fancy term that tells us that managers know more about their companies' prospects than the outside investors/the markets. Managers know all the detailed inside data, whilst the markets merely have access to by and publicly available data. This imbalance in information (disproportionate information) means that the actions of managers are closely scrutinised by the markets. Their actions are often interpreted as the insiders' view on the future prospects of the visitor. A adept instance of this is when managers unexpectedly increase dividends, every bit the investors interpret this every bit a sign of an increment in management confidence in the future prospects of the visitor thus the share toll typically increases in value.

Suppose that the managers are because how to finance a major new project which has been disclosed to the market place. All the same managers have had to withhold the inside scoop on the new applied science associated with the project, due to the competitive nature of their industry. Thus the market is currently undervaluing the project and the shares of the company. The direction would not desire to event shares, when they are undervalued, as this would consequence in transferring wealth from existing shareholders to new shareholders. They will want to finance the project through retained earnings so that, when the market place finally sees the true value of the projection, existing shareholders will benefit. If boosted funds are required over and to a higher place the retained earnings, then debt would exist the next alternative.

When managers have favourable inside data, they do not desire to issue shares because they are undervalued. Thus information technology would be logical for outside investors to assume that managers with unfavourable inside information would want to issue share as they are overvalued. Therefore an issue of disinterestedness by a visitor is interpreted as a sign the direction believe that the shares are overvalued. Every bit a result, investors may starting time to sell the visitor's shares, causing the share toll to fall. Therefore the event of equity is a last resort, hence the pecking order; retained earnings, then debt, with the issue of disinterestedness a definite last resort.

Ane implication of pecking order theory that we would look is that highly profitable companies would infringe the to the lowest degree, because they have higher levels of retained earnings to fund investment projects. Baskin (1989) found a negative correlation between high turn a profit levels and high gearing levels. This finding contradicts the idea of the existence of an optimal capital letter structure and gives support to the insights offered by pecking order theory.

Another implication is that companies should hold greenbacks for speculative reasons, they should congenital up cash reserves, so that if at some signal in the future the company has bereft retained earnings to finance all positive NPV projects, they use these greenbacks reserves and therefore not demand to raise external finance.

Decision

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

Companies should be enlightened of the pecking gild theory which takes a totally dissimilar approach, and ignores the search for an optimal capital construction. It suggests that when a company wants to enhance finance it does so in the post-obit pecking society: beginning is retained earnings, then debt and finally equity as a last resort.

Patrick Lynch is a lecturer at Dublin Business Schoolhouse

References

• Watson D and Head A, Corporate Finance: Principles and Practice, 4th edition, FT Prentice Hall
• Brealey and Myers, Principles of Corporate Finance, 6th edition, McGraw Colina
• Glen Arnold, Corporate Financial Management, 2nd edition, FT Prentice Hall
• JM Samuels, FM Wilkes and RE Brayshaw, Financial Management & Conclusion Making, International Thomson Publishing Company
• Power T, Walsh South & O' Meara P, Financial Management , Gill & Macmillan.
  

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