Gearing
1. Operating gearing
- Refer to the percentage of fixed cost in the total cost.
- High operating gearing means high business risk.
- High operating gearing means the fixed cost of the company is high and variable cost is low.
- High fixed cost will bring high risk to company, because company can not cut the fixed cost in short term.
2. Financial gearing
- Use to analysis the value of company actually how many percent is coming from debt.
(i) Capital gearing
Ø Focuses on the total capital is in the form of debt.
(ii) Income gearing
Ø Look at the proportion of income is taken by interest charges to debt holder.
- High financial gearing means high financial risk, because no matter company get profit or loss also necessary to pay fixed amount interest to debt holders in certain period.
- If the company does not have enough cash flow to afford it, it will cause the company bankrupt.
Modigliani-Miller Model
Assumptions of Modigliani-Miller Model
- There is no taxation.
- In prefect capital market everybody have full information and no transaction cost. They know which share is good and no need agency fee and etc.
- No cost of financial distress and bankruptcy.
- Can sell or buy any share immediately will not cost.
- Interest change is same between individual and company borrowing.
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Modigliani-Miller Proposition I
- In a perfect market, the market value of geared firm (VL) is same as ungeared firm (VU). à VL = VU
- The capital structure can not affect the value of company.
- Company can only increase their firm’s value by making good investment decision. Capital structure is financial decision.
- Only expected return and risk will affect the value of firm.
- If there is mispriced, geared firm (VL) not equal to ungeared firm (VU) , investor can sell the overvalue share and buy undervalue share to earn arbitrage profit.
- Therefore, value is not affected by financial decision(capital structure) but investment decision(risk)
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Modigliani-Miller Proposition II
- When the firm increases the debt level (borrowing), the cost of equity will also increase.
- Because shareholders will see the risk of their investment increase when the firm increase the debt level (borrowing), therefore shareholders will require high level of return, so the cost of equity of firm increase.
- kE = k0 + (VD / VE) ( k0 – kD )
² kD : the interest rate (cost of debt)
² kE : the return on (levered) equity (cost of equity)
² k0 : the return on unlevered equity (cost of capital)
² VD : the value of debt
² VE : the value of levered equity
- Expected rate of return of equity (kE) is affected by the DE Ratio
- VD / VE = Debt Equity Ratio (DE Ratio)
- When VD ↑ , VD / VE ↑ à kE ↑, means cost of equity increase. Therefore, the required rate of return increases.
- Invest in gear firms have a higher risk and higher return. It is actually a trade off between risk and return
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Modigliani-Miller Proposition III
- Rate of return new projects = WACC and WACC is constant regardless is geared and ungeared firm.
- Value of firm will remain the same.
- An investment should be accepted when NPV>0.
- Focus on investment decision, not financial decision.
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The MM Propositions I & II (with Corporate Taxes)
- With corporate tax, value of geared firm will increase.
- This is because overall cost of capital (WACC) reduce due to the cost of debt fall after the tax saving.
- Tax saving only occurs for firm that issue debt because interest payment will reduce the profit which lead to a tax deduction. Company cash inflow will increase.
Proposition I
- VL = VU + TC VD
² VL > VU because TCVD > 0
Proposition II
- kE = k0 + (VD/VE)×(1-TC)×(k0 - kD)
² kE1 = k0 + (VD / VE) (k0 – kD)
kE1 ↑ when VD ↑
² kE2 = k0 + (VD / VE) x (1-Tc)(k0 – kD)
kE2 ↑ when VD ↑
² But, kE1 ↑ > kE2 ↑ due to tax benefit.
² Overall cost of capital reducesà value of firm increase.
Additional considerations
- The financing decision (capital structure) can not affect the value of firm. But after tax come in the result will different.
- After the tax come the elements need to consider are:
1. Financial Distress
- The major disadvantage for a company taking high level of gearing (debt) is it will increase the financial distress, and increase probability of bankrupt because the firm is necessary to return the borrowing.
- Although increase debt can increase tax saving, but also will increase cost of financial distress (financial risk) and probability of bankrupt.
2. Agency Costs
- Agency costs are the incremental costs of having an agent make decisions for a principal.
- In a company have shareholders, bond holders and management terms these 3 parties.
- Interest and information that they can get is different. Manager will have more information compare to the shareholders and bondholders because of unequal information between this 3 parties, it lead to manager cheat the other 2 parties to benefit himself.
3. Borrowing Capacity
- Lenders prefer secured lending, and this sets an upper limit on gearing.
- Because if the company was unable to afford the interest payment the lenders can sell company tangible assets to get the compensation.
- Therefore, the borrowing capacity of company is depend on it tangible assets.
- Investors willing to invest more if the company has high tangible assets. It will cause the company easy to issue bond. It will lead to high gearing level.
- Investors not willing to invest more if the company has low tangible assets. It will cause the company difficult to issue bond. It will lead to low gearing level.
4. Managerial Preferences
- The capital structure of the company will impact manager preferences as well.
- Most of the time, the manager will not increase too must borrowing (debt) to cause or increase the probability bankrupt, because when the company bankrupt the manager will lost their jobs.
- Tend to argue for lowering debt level.
5. Pecking Order
- Base on pecking order, when the firm designs to invest in new project they will consider about fist use internal finance, second issues debt and last issues equity.
- The company only will issue debt and equity when the internal finance is not enough.
- Reasons of pecking order view are transaction costs and asymmetric information (adverse selection).
- In the pecking order view, the firm should use the method of financing with the least amount of transaction costs first. Financing methods with higher transaction costs are used next.
- Base on the pecking order the company’s gearing level will low, if the company internal fund is enough.
- Base on the pecking order the company’s gearing level will high, if the company internal fund is not enough.
- Uncertainty.
6. Financial Slack
- Means the company has enough cash and excess debt capacity.
- Therefore, the company will not fully use debt capacity and increase borrowing (debt) until lack level although optimal.
- Tend to argue for lowering debt level.
7. Signaling
- Manager will not let company in risk level. Therefore they will not easy issue bond because they need to pay large amount of interest.
- If they are not confident to generate high cash flow in future they will not issue bond to let company in risk level because they will lost the job if company bankrupt.
- Although some people said manager issue share show the share price of company is overprice in market but in other side we also can describe that the company not able to pay fixed bond interest (do not have enough cash flow).
- Uncertainty.
8. Control
- Most of the time the company will choice to increasing debt financing (issue debt) to increase fund because the shareholders not willing to affect their ownership.
- In order to avoid the share of company will buy by the rival, most of the company may be choice to increasing debt financing.
9. Tax Exhaustion
- Many companies do not have very high debt level because their profits are not high enough to benefit from benefit of tax deduction.
- Tend to argue for lowering debt level.
10. Industry Group Gearing
- There is no prefer formula can be use to establish the best debt to equity ratio for firm in all situation.
- Different industry have different gearing ratio.
- Uncertainty.
Some further thoughts
Motivation
- Debt is fixed payment, it will pressure manager to perform better to generate more cash flow to pay dividend to avoid company bankrupt.
- Tend to argue for raising debt level.
Reinvestment Risk
- High debt will lead to the company pay dividend to debt holders, thereby denying spare cash to the managers.
- Tend to argue for raising debt level.
Operating and Strategic Efficiency
- Geared firm will make decision carefully because they need to measure have enough or stable cash flow to pay bond dividend.
- Tend to argue for raising debt level.
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