Capital
structure refers to the way that a company finances its assets
through some collection of equity, debt or some other securities. A
firms capital structure is then the arrangement or structure of its
liabilities. In reality the capital structure may be a highly complex
arrangement and consist of many sources. Gearing ratio (or leverage)
is that part of the capital employed by a firm which comes from the
outside of the business. The Modigliani-Miller theorem forms the
basis for modern thinking about capital structure, although it is
generally considered to be a purely theoretical system since it
disregards many important factors in the capital structure decision
making process.
When a
company needs to expand or replace some expensive machinery it may
not have enough liquid assets and therefore needs to borrow
additional finance. Financing a company through borrowing is cheaper
than issuing shares. This is because lenders require a lower rate of
return than shareholders and the debt can be offset against pre-tax
profit thereby reducing the tax bill. The relationship between debt
and equity is the gearing ratio, also called leverage.
The two
main feature are explained as follows:
The
first feature to consider is that, since interest expense is tax
deductible, then the more debt used by the firm, the more wealth
created via lower tax payments. This is called a tax shield, which
has an evident cash value to shareholders, a ready and apparent gain
to gearing. As a firm uses more and more debt, the tax shield will
become larger and larger, adding value to the firm. the initial value
of the firm is the value of the equity, since at zero debt, the firm
is financed totally by equity. As debt is added to the capital
structure (the debt ratio increases), the value of the firm rises
proportionally because of the tax shelter benefit.
The
second feature is that risk increases as the firm adds debt to the
capital structure. Debt would be very beneficial at low levels, since
it is so much cheaper and provides the tax shield. But as large
proportions of debt are taken on, the firm begins to be financially
distressed by trying to meet interest payment obligations. The more
debt the firm adds, the more financially distressed it becomes, less
able to service interest expenses for extreme debt levels. Financial
distress costs would include higher returns from both creditors and
shareholders, as well as costs directly involved with avoiding
bankruptcy and costs associated with financial distress and
bankruptcy. These costs, at some point, begin to offset the positive
effects of the tax shield, and the value of the firm begins to level
off, and then to decline.
If the
gearing ratio is too high then there is a risk of financial distress
so it is better to keep the ratio low. But to obtain the best return
it is assumed that there is an optimal level of gearing that could be
calculated and maximise shareholder wealth. The problem is what
information needs to be used to obtain the this optimum level. Firms
would want to use debt, up to the point where the value of the firm
is maximized, the optimal capital structure (optimal debt ratio).
This is what we would conclude to be a fully rational capital
structure decision. Deviations away from this optimal point will
result in a sub-optimal capital structure, and the firm would no
longer be maximizing shareholder wealth. The idea of maximizing the
value of the firm can also be perceived in terms of minimizing the
firm's weighted average cost of capital (WACC). As the firm begins
to add debt to its capital structure, the WACC falls because the firm
is using more of the cheaper form of financing, debt. At some point,
however, the WACC will begin to rise as both creditors and
shareholders begin requiring ever-increasing returns as risk rises.
Soureces: Arnold, G., Stretcher, R. and Johnson, S. 'Capital Structure: professional management guidance'
Source: Google finance
