1. Paper F9 Financial Management
Cai Ji-fu
Accounting School 1

2. Chapter 16
Capital Structure 2

3. Exam guide Discussion questions
Gearing and ungearing a beter is an essential technique to master using the formula which will be given to you in exam 3

4. Topic list Capital structure theories
Impact of cost of capital on investment

5. The Evolution of capital structure theories
Early capital structure theory
Operating income theory
Net Operating income theory
Traditional theory
Modern capital structure theory
MM theory
1958 and 1963
Tradeoff theory
Static; Dynastic
Signalling theory
Pecking order theory
Agency theory
Corporate governance theory

6. 1 Capital structure theories
Fast forward
Some commentators believe that an optimum mix of finance exists at which the company’ cost of capital will be minimised.
Capital structure-The mix (or proportion) of a firm’s permanent long term financing represented by debt, preferred stock, and common share equity.

7. 1 Capital structure theories
Traditional view
There is an optimal capital mix at which the average cost of capital, weighted according to the different forms of capital employed, is minimized.
MM theories
MM theories argues that the firm’s overall weighted average cost of capital is not influenced by changes in its capital structure.

8. 1.1 The traditional view Fast forward
Under the traditional theory of cost of capital, the cost declines initially and then rises as gearing increases. The optimal capital structure will be the point at which WACC is lowest.
Optimal capital structure-the capital structure that minimises the firm’s cost of capital and thereby maximises the value of the firm

9. The traditional view
The assumptions on which this theory is based are as follows:
The company pays out all its earnings as dividends.
The gearing of the company can be changed immediately by issuing debt to repurchase shares, or by issuing shares to repurchase debt. There are no transaction costs for issues.
The earnings of the company are expected to remain constant in perpetuity and all investors share the same expectations about these future earnings.
Business risk is also constant, regardless of how the company invests its funds.
Taxation, for the time being, is ignored.

10. Capital structure on WACC
(1-Tc)rf
Level of gearing kb
WACC ke
Cost of capital P

11. 1.1 The traditional view
The traditional approach to capital structure implies that (1) the cost of capital is dependent on the capital structure of the firm, and (2) there is an optimal capital structure.

12. 1.2 the net operating income (MM) view of WACC
Fast forward
MM stated that, in the absence of tax, a company’s capital structure would have no impact upon its WACC.
Net operating income (NOI) approach (to capital structure)
A theory of capital structure in which the WACC and the total value of the firm remain constant as financial leverage is changed.

13. 1.2.1 Assumptions of NOI approach
A perfect capital market exists, in which investor have the same information, upon which they act rationally, to arrive at the same expectations about future earnings and risks.
There are no tax or transaction costs.
Debt is risk-free and freely available at the same cost to investor and company alike.

14. 1.2.1 Assumptions of NOI approach
If MM theory holds, it implies:
The cost of debt remains unchanged as the level of leverage increases.
The cost of equity rises in such a way as to keep the weighted cost of capital constant.
There is no one optimum capital structure, and the mix of debt and equity financing is unimportant.

15. 1.2.1 Assumptions of NOI approach
If MM (1958) theory holds, it implies:

16. 1.2.1 Assumptions of NOI approach
Cost of capital
Level of gearing Kd Ke Ko

17. Modified MM (1963) Theory Ke Cost of capital Ko Kd after tax
100% Level of gearing
Modified MM theory (considering the existence of company tax)

18. Modified MM (1963) Theory
If Modified MM (1963) theory holds, it implies:

19. Modified MM (1963) Theory
If Modified MM (1963) theory holds, it implies:

20. 1.4 Market imperfections Bankruptcy costs Agency costs Tax exhaustion
Costs associated with monitoring management to ensure that it behaves in ways consistent with the firm’s contractual agreements with creditors and shareholders.
Tax exhaustion

21. Market imperfections Present Value of tax shield benefits of debt
levered firm
Present value of bankruptcy and agent costs
Value of
unlevered firm = + -

22. Market imperfections Required rate of return
Ke with bankruptcy costs
Premium for financial risk
Ke without bankruptcy costs
Premium for business risk
Ke with no leverage Rf
Risk-free rate
Level of gearing
Required rate of return for equity capital when bankruptcy costs exist

23. Market imperfections Cost of capital
Tax, bankruptcy, and agency costs combined
Net tax effect
Level of gearing
Optimal

24. Market imperfections (Trade off theory)
V without bankruptcy and agency costs
Present value of bankruptcy and agent costs
Firm Value
Present Value of tax shield benefits of debt
V witht bankruptcy and agency costs VU
Value of
unlevered firm
Level of gearing
Optimal

25. 1.5 Pecking order theory
Pecking order theory states that firm will prefer retained earnings to any other source of finance, and then will chooses debt, and last of all equity. The order of preference will be:
Retained earnings
Straight debt
Convertible debt
Preference share
Equity shares

26. 1.5 Pecking order theory Reasons for following pecking order
Consequence of pecking order theory

27. 1.5 Pecking order theory Limitation of pecking order theory
It fails to take account taxation, financial distress, agency cost or how the investment opportunities that are available may influence the choice of finance.
Pecking order theory is an explanation of what firm actually do, rather than what they should do.

28. 2 impact of cost of capital on investment
Fast forward
The lower a company’s WACC, the higher the NPV of its future cash flows and the higher its market value.

29. impact of cost of capital on investment
The relationship between company value and cost of capital
The lower a company’s WACC, the higher will be the NPV of its future cash flows and therefore the higher will be its market value.

30. impact of cost of capital on investment
Using the WACC in investment appraisal
The project being appraised is small relative to the company.
The existing capital structure will be maintained (same financial risk)
The project has the same business risk the company.

31. impact of cost of capital on investment
Arguments against using the WACC
Different business risk
Financial risk
Floating rates

32. impact of cost of capital on investment
Using CAPM in investment appraisal
CAPM can be used to compare projects of all different risk classes and is therefore superior to an NPV approach which use only one discount rate for all projects, regardless of their risk.

33. impact of cost of capital on investment
Limitations of using CAPM in investment decisions
Hard to estimate returns on projects and market returns, and the probability of various environments.
Single period model
Hard to determine the risk-free rate of return.
Beta is estimated incorrectly.

34. 2.7 CAPM and MM combined - geared betas
Fast forward
when an investment has differing business and finance risks from the existing business, geared betas may be used to obtain an appropriate required return
Geared beta are calculated by:
Ungeared industry betas
Converting ungeared betas back into a gear that reflects the company’s own gearing ratio

35. 2.7 CAPM and MM combined - geared betas
Beta values and the effect of gearing
if a firm is geared and its financial risk is therefore higher than the risk of all-equity firm, then the β value of the geared firm’s equity will be higher than the value of a similar ungeared firm’s equity.
The CAPM is consistent with the propositions of MM. MM argue that as gearing rises, the cost of equity rises to compensate shareholders for extra financial risk of investing in a geared firm. This financial risk is an aspect of systematic risk, and ought to be reflected in a company’s beta factor.

36. 2.7 CAPM and MM combined - geared betas
Geared betas and ungeared betas

37. 2.7 CAPM and MM combined - geared betas
Geared betas and ungeared betas
Debt is often assumed to be risk-free and its beta(d )is then taken as zero, so:

38. 2.7 CAPM and MM combined - geared betas
Using the geared betas and ungeared betas formula to estimate a beta factor
1. Get an estimate of the systematic risk characteristic of the project’s operating cash flows by obtaining published beta values for firms in industry into which the firm is planning to diversity.
2. Adjust these beta values to allow for the firm gearing level;
Convert the  value of other firms in the industry to ungeared betas

39. 2.7 CAPM and MM combined - geared betas
Using the geared betas and ungeared betas formula to estimate a beta factor
3. Having obtained an ungeared beta value a , converted it back to a geared beta e , which reflects the firm’s own gearing ratio:
4. Having estimated a project-specific geared beta, use the CAPM to estimate:
A project-specific cost of equity, and
A project-specific cost of capital, based on a weighting of this cost of equity and the cost of the firm’s debt capital

40. 2.7 CAPM and MM combined - geared betas
Weakness in the formula
It is difficult to identify other firms with identical operating characteristics,.
Estimates of beta values from share price information are not wholly accurate.
There may be differences in beta values between firms caused by:
Different cost structures
Size differences between firms
Debt capital not being risk-free
Failing to consider the effect of opportunities for growth on the beta value.

41. 2.7 CAPM and MM combined-geared betas
Weakness in the formula
The consequence of making the assumption that debt is risk-free is that the formula tend to overstate the financial risk in a geared firm and to understate the business risk in geared and ungeared firms by a compensating amount.