Exam ANSWER - Optimal Gearing Level of a Firm PDF

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Q. ‘The consultants I spoke to yesterday explained that some academic theorists advance the idea that, if your objective is the maximisation of shareholder wealth, the debt to equity ratio does not matter. However, they did comment that this conclusion held in a world of no taxes. Even more strangely, these theorists say that in a world with tax it is best to “gear-up” a company as high as possible. Now I may not know much about academic theories but I do know that there are limits to the debt level which is desirable. After listening to these consultants, I am more confused than ever. ’You step forward and offer to write a report for the managing director both outlining the A) theoretical arguments and B) explaining the real-world influences on the gearing levels of firms.

Gearing refers to the relationship, or ratio, of a company's debt to equity. Gearing shows the extent to which a firm's operations are funded by lenders versus shareholders—in other words, it measures a company's financial leverage. The Neoclassical financial theory is based on the assumption that firms are governed by shareholders and therefor pursuing the goal of maximizing shareholders wealth by maximizing the market value of equity. Thus, companies have to find the optimal point at which the marginal benefit of debt equals the marginal cost. Modigliani & Miller •

Modigliani and Miller created a simple capital structure model by making some assumptions.

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Given these assumptions, they concluded that Capital structure has no impact on corporate value (in a perfect market with perfect knowledge) – value of firm remains constant regardless of debt levels.

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As proportions of debt increase (cheaper finance), the price of equity will rise just enough to leave the WACC constant.

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Some of the assumptions that underpin these results include: No tax. Perfect capital markets with perfect info available to all. Low trans costs. No costs of financial distress. Individuals can borrow as cheaply as corporations.Firms can be classified into distinct risk classes.

If the WACC is constant, then the only factor that can influence company value is cash flow. C.S = irrelevant.

Scenario 1: World without tax Proposition 1: Total market value is independent of CS: Total market value is the NPV of the income stream. For a firm with constant perpetual income stream : V= CF/WACC WACC is constant because the cost of equity rises to exactly offset the price of cheaper debt and therefore SH value is not affected by changing the gearing level. WACC = kE WE + kD WD Numerical e.g -

Cost of WACC remains constant . Cost of debt is constant. Cost of equity raises just enough to leave the overall cost of capital constant.

Proposition 2: The expected rate of return on equity increases proportionately with the gearing ratio. The geared firm pays a risk premium for financial risk As SH’s see the risk of their investment increase because the firm is taking on increased debt levels they demand a higher level of return. The increase in the cost of equity capital exactly offsets the benefits to WACC of cheaper debt.

Proposition 3: The WACC may not rise as much as the benefits of cheaper debt. Therefore the company becomes more valuable. Cost of equity CAPM is a way of working out the cost of equity. It tells you the required return based on the risk and could be an easier way of finding the WACC. Proposition 4: Alternatively, The cost of equity raises more than the benefits of cheaper debt. Shareholders may question why you are looking for more money – are we in financial distress? And demand a higher return.

Scenario 2: World with tax- gear up? However, the real world is somewhat different from that created for the purpose of MM original 1958 model. One of the most significant difference is that the introduction of taxation brings an additional advantage to using debt capital: it reduces the tax bill. In a 30 per cent corporate tax environment, a profitable firm’s cost of debt falls from a pre-tax 10 per cent to only 7 per cent after the tax benefit. Value of the firm increases as debt is substituted for equity, as long as the firm has taxable profits. After adjusting for one real-world factor - companies should be as highly geared as possible. WACC (KEWE +KDATWD)

ere are limits to debt level which is desirable

TRADE-OFF MODEL

However, there is most definitely a limit to this as using debt increases financial distress. MM plus financial distress analysis = the ‘trade-off model’ There are many costs of financial distress as a result of gearing up. Uncertainties in customer’s minds and in suppliers minds are examples of indirect costs and direct costs include lawyers’ fees and management’s

time etc. The risk of incurring the costs of financial distress has a negative effect on the firms value which offsets the value of tax relief of increasing debt levels. The costs become considerable at high gearing levels. If you have a lot of gearing -> you have to honour those interest payments = higher risk of liquidation. At low gearing levels the risk of financial distress is low, but the cost of capital is high; this reverses at high gearing levels.

The important issue is finding the optimal level of gearing for your firm. The characteristics of the underlying business influences the risk of liquidation/distress, and therefore WACC, and the optimal gearing level. Likely acceptable gearing ratio can be dependent on the industry and activities of the firm. For a food retailer is high due to liquid assets, stable cash flow and insensitivity to economic

fluctuations. Whereas a steel producer should have a low gearing ratio because of irregular cash flow, inflexible assets and sensitivity to the external environment. It has been found that successful firms in mature industries should optimally have a lot of debt. For e.g cigarettes. This is because the industry has peaked out, lots of cash coming in but not much room for expansion. So, better to use cheaper capital. In the early stages of a company, cash flow can be irregular or slow at the beginning and having a lot of debt puts huge pressure on them to pay back the debt which may result in short-term vision (not thinking long-run). A firm with flexible assets can afford to be more geared than one with specialised assets. As the ability to sell off assets to stay liquid in the case of financial distress can be an important factor. An open factory space will sell quicker and for more than a highly specialised production line that was designed just to make your products. Operating and strategic efficiency A firm with high gearing cannot afford to have any value-destructive activities. It is desirable to have a certain amount of debt also because it gives senior management an incentive to work hard as debt must be repaid. It reduces the principal agent problem, as in an all-equity structure managers may have lots of cash hanging around and decide to buy private jets to make travel easier for them. Not in the interest of the SH. Debt forces pay-off, equity gives scope to perform gluttony. Thomas cook - Britain’s oldest travel company. Thomas Cook only narrowly survived a near-death experience in 2011. Its debt pile had already reached £1.1bn, and it stayed afloat only after an emergency additional cash injection - but it also meant even more debt to service. This year, they needed their debtors and didn’t have it. No one wanted to lend to them due to the financial distress they were under, which everyone was aware of. They went into compulsory liquidation. They became insolvent and couldn’t recapitalise. Anglo-German group Tui, Thomas Cook’s biggest rival, has suffered from similar difficulties, issuing several profit warnings during 2019. But it has much smaller debts, owning many of its own hotels and cruise ships.

To conclude, a world without taxes is unrealistic. In a world with taxes, debt is cheaper but there is a limit to the amount of debt your company should have. There is a limit to the optimal gearing level as if you gear up too much there are considerable financial distress costs. A company should look at their liquidity, sensitivity to economic condition and cash flow and other factors mentioned in order to estimate their individual optimal level....