Value of FirmKeWACC10%Kd (0. 90%)Debt-to-Equity Ratio (D/E)Source Adapted From: Fox (1977) ‘ Leverage in UK companies 1967–1973—an empirical investigation’. From the above calculations, it can be seen that WACC remains constant (10%) despite the change in leverage. Originally, equity is 45. 90 and debt is 11. 40 leading to a WACC of 10%. In Scenario 1 and 2, there is an impact on leverage as the level of debt changes. However, being in a perfect market, the WACC remains at 10% similar to the original figure. Hence, the constant WACC demonstrate that in a perfect world, the choice of capital structure is irrelevant. The original stock price (given) is £ 27 at total debt 11. 4 and shareholders` equity of 45. 9 In fact, as can be seen from the above calculations, the tax shield cannot be ignored and the stock prices increases as debt increases. The WACC also changes in contrast with Task 1 (A) where WACC remains constant irrespective of the changes in debt. In fact (from the above calculations), the WACC falls from 9. 20 to 8. 97 as leverage increases. Figure 2 shows WACC in an imperfect market (MM II, 1963).
CostReTax ShieldWACCRdGearingSource from Cornelius, I., 2002. ‘ WACC attack’ CIMA Insider. Task 1(B) projects us in an imperfect market where there is a tax rate of 40%. The firm value will fluctuate with the leverage hence recalling MM II which states that the firm`s value depends on the rate of return on the firm`s assets, the cost of debt of the firm and the debt-to-equity ratio. Figure 3 below illustrates how the tax shield raises firm value.
Firm ValueValue of firm with debtPV of Tax ShieldFirm value with only equity financing/ without debtDebt/Firm ValueSource Adapted From Moles (2011) Fundamentals of Corporate Finance ‘ Exhibit 16. 6: How Firm Value Changes’. The issuance of £1 billion in new debt creates a PV tax shield of 4. 96 for new increased debt of 12. 4 and increases the stock price to £ 29. 92. The firm value will be 62. 26 (49. 86 + 12. 4). The issuance of £5 billion in new debt creates a PV tax shield of 6. 5 for the new raised debt of 16. 4 and increases the stock price to £ 30. 86. Firm value will rise to 63. 86 (47. 46 + 16. 4). In Task 1(A) the share price remains unchanged as new share price can be calculated as follows: No. of shares that can be purchased with 1 billion: 1/ 27 = 0. 037. New no. of shares: 1. 7 – 0. 037 = 1. 663. Hence, new share price is MV Equity/ 1. 663 i. e. £ 27. Hence, from the above calculations it can be demonstrated that higher leverage firms indeed imply higher firm value in an imperfect market (contrast with share price for Task 1(A) which remains unchanged). Figure 3 illustrates the trade-off between benefits and debts and how it affects firm value and the optimum capital structure (point at which firm value can be maximised).
Market Value of FirmCost of Financial distressPV Tax shieldvalue of firm no debtoptimum DebtSource Adapted from Myers, S. C, 1993 ‘ Still searching for optimal capital structure’.
TASK 1 (C)
Trade-off theory (1973) (TOT)
One of the MM (1958) theory assumptions is that debt is risk-free. This is unrealistic as there are costs and benefits to debt finance. The TOT of capital structure which was pioneered by Kraus and Litzenberger (1973) can be said to be consequence of the intense debates surrounding the MM (1958) theory of capital structure. The TOT underlines the impact of the debt tax shield and the costs of bankruptcy. In his research on capital structure, Myers (2001) observed that the TOT provides a justification for moderate debt ratios. In fact, Brealey et al. (2011) observed that the TOT, unlike MM (1958), ‘ avoids extreme predictions and rationalizes moderate debt ratios’ (Brealey et al., 2011: 458). Coteil et al. (2011) observe that the benefits of the TOT (as it predicts that firms will seek to benefits and costs of debt) include the tax shield, less free-cash-flow problems and reduced potential conflicts between managers and shareholders/stockholders whereas the costs relate to ‘ expected financial distress’, ‘ underinvestment’ and ‘ asset substitution problems’ (Coteil et al., 2011: 718). The trade-off of the benefits against the costs of debt finance to identify the optimal capital structure of a company (Moles et al., 2011: 644) is referred to as the static TOT. According to the static TOT (Myers, 1977) the firm is supposed to substitute debt for equity, or equity for debt until the value of the firm is maximised (Myers 1984). Lee and Moon (2011) state that optimal capital structure is achieved at the point where marginal tax benefit of debt and the marginal cost of financial distress equate. The authors also state that the TOT shows that corporations can raise firm value by ‘ levering up to certain point’ and thus moderate use of leverage by corporations should be made (Lee and Moon, 2011: 872). Myers (2001) describes the optimal point as where the marginal value relating to the debt issues exactly offsets the rise in the present value of the costs following the issue of more debt. According to Pandey (2005) the TOT can be explained by the costs of financial distress and agency costs. The dynamic TOT was proposed by Fischer, Heinkel and Zechner (1989) who argued that a firm`s capital structure may not always tally with their target leverage ratios. The authors suggested that instead of the optimal capital structure, companies will be able to allow capital structure to fluctuate within an optimal capital structure range. The TOT makes room for taxes and bankruptcy costs which are in juxtaposition to MM`s perfect markets. The concept of optimal capital structure reached by advantages (tax benefits) and drawbacks (financial distress and bankruptcy costs) of debt (Karadeniz et al., 2009) clearly draws a demarcation line between these two theories. One common criticism of the TOT is that it is not always realistic to reach optimal capital structure. An empirical study carried by Graham (2000) has showed that firms are not following the trade-off model of capital structure in making their debt and equity decisions.
Agency cost theory (1976)
Opposing the assumption that managers always act in the best interests of shareholders, the agency cost theory was developed by Jensen and Meckling (1976). Jensen and Meckling find the corporation as a nexus of contracts amongst different individuals (principal and agent). The authors identify two types of agency costs that arise out of the conflicts between managers and other stakeholders: Equity-holders and managersConflicting interests and objectives of stakeholders (managers, employees and creditors) and shareholders give rise to the agency problem (Brealey et al., 2011: 13). Brealey et al. (2011) state that as a result of managers not motivated by maximising the value of the firm and the costs incurred by shareholders in monitoring the managers, agency costs arise. Equity-holders and debt-holdersEquity-holders have an agency relationship with debt-holders. The most severe conflict between them is their claim to cash flows (Jensen and Meckling, 1986). Debt-holders have a fixed claim over the cash flow (interest on their debt) whilst equity- holders will have a residual claim (Zhang and Li, 2008). Debt-holders may limit the firm investing in high risk (high returns) projects (Kalcheva and Lins, 2007) whilst equity-holders will favour such projects. Parrino and Weisbach (1999) have showed through empirical evidence that the agency costs from equity-holders and managers conflicts only have marginal consequence on the firm`s leverage decision. The impact of equity-holders and debt-holders conflicts on leverage decision is far more serious as rightly observe Childs et al. (2005). There is empirical literature and evidence to show that agency costs can be minimised or mitigated (Easterbrook, 1984). However, it can be observed that a major failure of the agency cost theory remains that it fails to identify the optimal capital structure.
Signalling theory (1977)
In their assumption of perfect markets, MM assumed that investors and managers have the same information. This is called ‘ information symmetry’ (Besley and Bigham, 2008: 601), the opposite of information asymmetry. The most realistic is asymmetric information as we know that insiders have better information. The signalling theory was made popular by Ross (1977) who states that capital structure acts as a signal of private information. Similar to the pecking order theory, the signalling theory is based on the assumption of asymmetric information in other words, that managers have better knowledge of a company`s investment opportunities than investors (Ehrhardt & Brigham, 2003: 491). The concept of the signalling theory is that by sending a ‘ costly signal’ to investors, a manager who believes that his firm has been undervalued on the market can attract investors (De Wet, 2006: 13). Leland and Pyle (1977) and Myers and Majluf (1984) state that asymmetric information between the firms and lenders can create underinvestment. To avoid this problem, managers should send the correct signal to investors by issuing high leverage (Ross, 1977). Leyland and Pyle (1977) had also devised a signalling model which similar to Ross (1977) draws a correlation between leverage and the firm`s value. By raising the firm`s leverage to signal investors that the firm is of good quality, it can be said that the signalling theory will help mitigate the firm`s agency costs/ asymmetric information. Some may argue against that as some authors, for instance, Rajan and Zingales (1995) find that there is an inverse relationship between leverage and a firm`s value.
Pecking-order theory (1984) (POT)
As we have seen above, asymmetric information between different stakeholders has various repercussions. The POT (first suggested by Donaldson (1961)) developed by Myers and Majluf (1984) seeks to address that. The concept of the POT is that firms prefer to finance their capital structure using internally rather than externally generated funds (Myers, 1984). Pandey (2005) agrees with Myers (1984) stating that managers will prioritise internal financing and that the issue of shares will be a last resort measure. Tirole (2006: 246)) rightly observes that the POT places debt as the preferred course of external financing. Some authors believe the POT to be an alternative to the trade-off model (Qian et al. (2007), Karadeniz et al. (2009)). The asymmetric information hypothesis has been used when explaining the POT (Myers and Majluf, 1984). Shyam-Sundar and Myers (1999) state that the POT involves ‘ hierarchical financing’ which recalls the observation made by Brealey et al. (2011: 460) about the pecking order (that is the finance of investment by first the use of internal funds; then new issues of debt and lastly with new issues of equity). Myers and Majluf (1984) assume perfect financial markets except for the presence of asymmetric information (Constantinides, 2004: 233). The POT considers how information asymmetry affects the financial decisions of a firm. Brealey et al. describes asymmetric information as a ‘ fancy term’ illustrating that managers have better knowledge of their company`s ‘ prospects, risks, and values than do outside investors’ (Brealey et al., 2011: 460). For this reason there can be a difference between the market and actual values of the firm`s securities as outsiders/ investors will have less information about the firm`s assets than insiders/managers such that this can misprice equity (Myers and Majluf, 1984). Empirical studies have showed that one of the similarities between the TOT and the POT is the implication of the inverse relationship between non debt tax shields and leverage ratio as observed by Sayılgan et al. (2006) who tested a sample of 123 manufacturing firms listed on the Islanbul Stock Exchange. The difference between the trade-off and the pecking order theories has been tested by numerous academics and practitioners. For instance, Fama and French (2002) find that there is an indirect relationship between debt and profitability according to the POT whilst the TOT indicates a correlation between the leverage and profitability. Karadeniz et al. (2009) summarises the difference between the two theories as he observes that whilst the TOT emphasises on taxes, the POT underlines asymmetric information. Both theories hence differ from the MM theory.
Market timing theory (2002) (MTT)
Baker and Wurgler (2002: 1) observe that market timing is ‘ issuing shares at high prices and repurchasing at low prices to exploit temporary fluctuations in the costs of equity’. Baker and Wurgler found a link between capital structure and the equity market timing and a negative relationship between leverage and market value of equity (2002: 10). The MTT considers market-to-book ratios whose historic nature Baker and Wurgler have questioned. MTT has been criticised by many academics such as Leary and Roberts (2005). Alti (2006) argues that market timing does not have a lasting impact on capital structure. It is still unclear whether the market can really be timed (by managers) as empirical studies have shown.
Each of the above theories provides an overview of why companies choose a certain model of capital structure. However, there is no certainty as to whether the capital structure theories are realistic but the developments that occurred show that academics and practitioners are attempting to find a more realistic approach. As Ross et al. (2008: 479) rightly observe, the theories of capital structure are ‘ amongst the most elegant and sophisticated in the field of finance’ but their practical implications are ‘ less than fully satisfying’.
TASK 2 (A)
Using an excel spreadsheet, IRR and NPV have been calculated using the following formulas: IRR (CF year 0: CF year 5, cost of capital)NPV (cost of capital, CF year 1: CF year 5) + CF year 0IRR for project Y (18. 71%) is greater than X (15. 62%). NPV for X (£29. 20) is greater than Y (£18. 55). If the projects were independent, IRR and NPV would lead to the same capital budgeting decisions that is, both projects would be accepted (NPV > 0 and IRR > cost of capital). For mutually exclusive projects, the scenario is different as will be illustrated below.
TASK 2 (B)
X and Y being mutually exclusive projects (i. e both projects cannot be undertaken simultaneously), IRR and NPV methods can provide different accept or reject signals. NPV is a better method of capital budgeting decision for mutually exclusive projects as IRR can provide more than one result (conflicting results also known as multiple IRR) when cash flows are unconventional. The project with the highest NPV will raise the firm`s value by the largest amount and will add greater value to shareholder wealth (Brealey et al., 2010: 238). Hence, I would undertake Project X as it has the highest NPV at discount rate 10%.
TASK 2 (C)
From the above calculations, the finance director would choose project X (higher NPV) whereas the managing director would opt for Y (higher IRR). IRR will lead to faulty/misleading rankings due to the: Reinvestment assumption. NPV rightly assumes that the cash flows generated from an investment will be reinvested at the cost of capital (here 10%) whereas IRR wrongly assumes that cash flows will be reinvested at the IRR. Scale issue. If the size of a project doubles, NPV will follow the same trend but IRR fails to compare projects of different scales. Timing issue. Where two mutually exclusive projects` cash flows have different timings (for e. g here X receives its largest cash flows early (year 1-3) unlike Y) IRR may produce conflicting results. Multiple IRRs can occur as a result of unconventional cash flows which will lead to conflicting decisions.
TASK 2 (D)
Net After Tax CF
Cross over rate using IRR
Cross over rate using NPV/scatter
Project X (£’000)
Project Y (£’000)
Difference in CF X and CF Y
0-200-200013%0%100. 0045. 00135218-183
2. 50%79. 4937. 762801070
5%61. 0130. 973901080
7. 50%44. 3224. 58475471
10%29. 2018. 55520317
12. 50%15. 4512. 86
15%2. 937. 48
15. 61918. 71117. 50%-8. 512. 38
20%-18. 99-2. 47
29. 19718. 55422. 50%-28. 60-7. 0725%-37. 45-11. 4627. 50%-45. 60-15. 6430%-53. 13-19. 63Reversing my recommendation in (B) would mean that I would undertake project Y instead of X. From the scatter diagram, it can be observed that the crossover rate (where NPV X = NPV Y) is 13%. This means that between discount rates 0% and 13%, NPV X is higher than NPV Y such that project X should be favoured. Beyond the crossover rate NPV Y is greater than NPV X, hence at discount rates above 13% project Y will be chosen. Hence, my recommendation in (B) will be reversed at the crossover point where the cost of capital is 13%. From the above table, Project Y will be chosen at cost of capital above 13%. For example, at discount rate 15%, NPV Y is greater than NPV X. Although Y will be favoured at cost of capital above 13%, it is important to note that above 18. 5% discount rate, the NPV Y becomes negative. The NPV rule states that a project with NPV less than zero i. e. negative NPV should be rejected. Hence, above 18. 5% or above IRR Y project Y will not be undertaken. NPV X becomes negative beyond IRR X hence only at discount rates between 0% and 15. 62% will project X be accepted as NPV will be positive. Despite the fact that from a mathematical point of view the negatives of the NPV of X are larger than those of NPV Y, both projects would still be rejected above 18. 5%.