Theories of gearing

This page looks at the question of whether or not an optimal capital structure exists - what split should a company look to achieve between debt and equity finance. As such it is part of a wider discussion on corporate finance.

The basic problem

Directors want to maximise shareholder value and will thus seek an optimal financing package.

Debt is (usually) cheaper than equity:

• Lower risk.
• Tax relief on interest.

so we might expect that increasing proportion of debt finance would be a good idea and would reduce WACC.

BUT:

Second, increasing levels of debt makes equity more risky:

• Fixed commitment paid before equity = finance risk.

so increasing gearing (proportion of finance in the form of debt) increases the cost of equity and that would increase WACC.

The theories attempt to answer the question:

The traditional theory of gearing

Also known as the intuitive view, the traditional view has no theoretical basis but common sense. It concludes that a firm should have an optimal level of gearing, where WACC is minimised, BUT it does not tell us where that optimal point is. The only way of finding the optimal point is by trial and error.

The traditional view explained

At low levels of gearing:

At higher levels of gearing:

At very high levels of gearing:

This can be shown diagrammatically:

where:

K_e is the cost of equity

K_d is the cost of debt, and

K_o is the overall or weighted average cost of capital.

Conclusion:

There is an optimal level of gearing - point X.

Problem

There is no method, apart from trial and error, available to locate the optimal point.

Modigliani and Miller's 1958 theory of gearing - without tax

Basic idea

M&M argued that:

• as investors are rational, the required return of equity is directly proportional to the increase in gearing. There is thus a linear relationship between K_e and gearing (measured as D/E)
• the increase in K_e exactly offsets the benefit of the cheaper debt finance and therefore the WACC remains unchanged.

Conclusion

• The WACC and therefore the value of the firm are unaffected by changes in gearing levels and gearing is irrelevant.
• Implication for finance:
  • choice of finance is irrelevant to shareholder wealth: company can use any mix of funds
  • this can be demonstrated on the following diagram:

Assumptions underpinning M&M's theory

• No taxation
• Perfect capital markets where investors have the same information, upon which they react rationally.
• No transaction costs
• Debt is risk free

The argument that companies these assumptions is as follows:

M&M view is that:

• companies which operate in the same type of business and which have similar operating risks must have the same total value, irrespective of their capital structures.

Their view is based on the belief that the value of a company depends upon the future operating income generated by its assets. The way in which this income is split between returns to debt holders and returns to equity should make no difference to the total value of the firm (equity plus debt). Thus, the total value of the firm will not change with gearing, and therefore neither will its WACC.

Their view is represented in the above diagrams.

If the WACC is to remain constant at all levels of gearing it follows that any benefit from the use of cheaper debt finance must be exactly offset by the increase in the cost of equity.

The essential point made by M&M is that a firm should be indifferent between all possible capital structures. This is at odds with the beliefs of the traditionalists.

M&M supported their case by demonstrating that market pressures (arbitrage) will ensure that two companies identical in every aspect apart from their gearing level, will have the same overall MV.

Modigliani and Miller's 1963 theory with tax

Basic idea

A number of practical criticisms were levelled at M&M's no tax theory, but the most significant was the assumption that there were no taxes. Since debt interest is tax-deductible the impact of tax could not be ignored.

M&M therefore revised their theory (perfect capital market assumptions still apply):

In 1963, M&M modified their model to reflect the fact that the corporate tax system gives tax relief on interest payments.

The starting point for the theory is, as before, that:

• as investors are rational, the required return of equity is directly linked to the increase in gearing - as gearing increases, K_e increases in direct proportion.

However this is adjusted to reflect the fact that:

• debt interest is tax deductible so the overall cost of debt to the company is lower than in M&M - no tax
• lower debt costs results in less volatility in returns for the same level of gearing which leads to lower increases in K_e
• the increase in K_e does not offset the benefit of the cheaper debt finance and therefore the WACC falls as gearing increases.

Conclusion

 Gearing up reduces the WACC and increases the MV of the company. The optimal capital structure is 99.9% gearing.

Implications for finance:

The company should use as much debt as possible.

This is demonstrated in the following diagrams:

Note: Gearing is measured here using V_d / V_e

Key practical arguments against adopting the conclusions of M+M

Bankruptcy risk

As gearing increases so does the possibility of bankruptcy. If shareholders become concerned, this will reduce the share price and increase the WACC of the company.

Agency costs: restrictive conditions

In order to safeguard their investments lenders/debentures holders often impose restrictive conditions in the loan agreements that constrains management's freedom of action.

E.g. restrictions:

• on the level of dividends
• on the level of additional debt that can be raised
• on management from disposing of any major fixed assets without the debenture holders' agreement.

Tax exhaustion

After a certain level of gearing companies will discover that they have no tax liability left against which to offset interest charges.

Borrowing/debt capacity

High levels of gearing are unusual because companies run out of suitable assets to offer as security against loans. Companies with assets, which have an active second-hand market, and low levels of depreciation such as property companies, have a high borrowing capacity.

Difference risk tolerance levels between shareholders and directors

Business failure can have a far greater impact on directors than on a well-diversified investor. It may be argued that directors have a natural tendency to be cautious about borrowing.

Real world approaches to the gearing question

Static trade-off theory

It is possible to revise M and M's theory to incorporate bankruptcy risk and so to arrive at the same conclusion as the traditional theory of gearing - i.e. that an optimal gearing level exists.

Given this, firms will strive to reach the optimum level by means of a trade-off.

Static trade-off theory argues that firms in a stable (static) position will adjust their current level of gearing to achieve a target level:

Above target debt ratio the value of the firm is not optimal:

• Financial distress and agency costs exceed the benefits of debt.
• Firms decrease their debt levels.

Below the target debt ratio can still increase the value of the firm because:

• marginal value of the benefits of debt are still greater than the costs associated with the use of debt
• firms increase their debt.

NB: Research suggests that this theory is not backed up by empirical evidence.

Pecking order theory

Pecking order theory tries to explain why firms do not behave the way the static trade-off model would predict. It states that firms have a preferred hierarchy for financing decisions:

The implications for investment are that:

• the value of a project depends on how it is financed
• some projects will be undertaken only if funded internally or with relatively safe debt but not if financed with risky debt or equity
• companies with less cash and higher gearing will be more prone to under-invest.

If a firm follows the pecking order:

• its gearing ratio results from a series of incremental decisions, not an attempt to reach a target

• there may be good and bad times to issue equity depending on the degree of information asymmetry.

A compromise approach

The different theories can be reconciled to encourage firms to make the correct financing decisions:

(1) Select a long run target gearing ratio.

(2) Whilst far from target, decisions should be governed by static trade-off theory.

(3) When close to target, pecking order theory will dictate source of funds.

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Tags:	gearing;theories of gearing;traditional theroy of gearing;modiglini and miller;M&M;pecking order theory;static trade off theory;gaering drift;bankruptcy risk