F3 Chapter 6

Financing- Capital Structure
Chapter 6
Several studies have focused on this link between capital structure

and company value. The key question is:
“What capital structure should the company aim for in order to

maximise the company's value?”
The main studies are:
a) the traditional view;

b) the Modigliani-Miller view, ignoring taxation;
c) the Modigliani-Miller view, taking into account the tax relief
on debt interest payments.
2 opposing forces which affect WACC:
Downward force:
Interest is an obligation; interest is tax deductible. As an entity

increases its gearing, the greater proportion of debt finance which
is cheaper it exerts a downward force on the WACC.
Upward force:
As gearing increases likelihood of dividends to shareholders

reduces. This increases the risk perception of shareholders thus
making them demand higher returns to compensate for the
increased risk. This increase in cost of equity exerts an upward
force on WACC.
Net effect:
Clearly, the two factors identified have opposing impacts on the
weighted average cost of capital. The key questions are:
a) Which of the two forces is stronger?

b) What is the net effect of these two factors?
Common points= if return is higher than the cost of the fund’s

capital gearing could increase. Depends on type of industry,
business, opportunities in the market and to what extent the
company can continue to benefit from the tax shield.
Traditional view=
According to the 'traditional' view of gearing and the cost of capital,

as an organisation introduces debt into its capital structure the
weighted average cost of capital will fall because initially the benefit
of cheap debt finance more than outweighs any increases in the cost
of equity required to compensate equity holders for higher financial
risk.
a) As an organization introduces debt into its capital structure

the WACC will fall because initially the benefit of cheap
debt finance more than outweighs any increases in the cost
of equity required to compensate the equity holders for
higher financial risk.
b) As gearing increases equity holders will ask for more

returns so as gearing rises, cost of equity rises as well.
c) The traditional view therefore claims that there is an

optimal capital structure where the WACC is at the
minimum normally denoted by point X.
d) At point X overall return required by debt or equity
investors is minimized.
e) Also, at this point the combined market value of the

entity’s debt and equity securities is maximized because
WACC and value of entity’s debt and equity capital are
inversely related.
f) Discounting future operating cash flows at a lower WACC

will give higher returns.
Mondigliani and miller without tax=
a) They assume 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.
b) Value of the company depends solely on the post-tax that

is pre-financing operating income generated by the assets.
c) The way in which funding is split should make no difference

to the total value of the company.
d) Investors are indifferent between personal and corporate

gearing.
e) This means WACC will be the same at all levels of gearing.

f) Follows the assumption that any benefit from the cheaper
debt finance is exactly offset by the increase in the cost of
equity.
g) Assume that market pressures will ensure that the two

companies identical in every aspect apart from their
gearing level will have the same overall market value.
Mondigliani and miller with tax=
a) After noting differences that interest has over dividends M

and M concluded that geared companies have an
advantage over ungeared companies, i.e. they pay less tax
and will therefore have a greater market value and a lower
WACC.
b) As the gearing increases the WACC decreases and hence

value of company increases.
c) In the presence of tax downward force on WACC is greater

than the upward force.
d) The introduction of taxation suggests that the higher the

level of taxation the lower the combined cost of capital.
(Source: Kaplan F3 Textbook)
Without tax:
Company value (Vg = Vu)
The graph showed a horizontal line for company value in the M &
M without tax theory.
This is backed up by the formula, which shows that if T=0, the

values of an ungeared company and an equivalent ungeared
company are the same.
WACC (kadj = keu)
The graph also showed a horizontal line for WACC in the M & M
without tax theory.
Again, the formula backs this up. If t=0, the formula reduces to
kadj = keu.
This shows that the WACC of the geared company is always the
same as the WACC of an equivalent ungeared company,
irrespective of the level of gearing.
With tax:
Company value (Vg = Vu + TB )
The graph showed an upward sloping line for company value in the
M & M with tax theory.
This is backed up by the formula, which shows that the higher the
value of B (value of debt), the greater the value of the entire
company should be.
As the company increases its gearing, the value of the entire
company (debt plus equity) increases.
Cost of equity (keg = keu + (keu – kd) VD (1 – t) / VE):
The cost of equity slopes upwards as gearing increases under M &

M's assumptions, because shareholders face higher risk so demands
higher returns.
We can see from the formula that the keg increases as the amount
of debt (VD) increases relative to the value of equity (VE).
Note that the inclusion of (1 – t) in the formula has the impact of

reducing the slope of the line if the tax rate increases. Most
importantly, this means that the cost of equity in the M & M with
tax theory will always increase less steeply than in the without tax
theory. This helps to explain why the upward force on WACC is
smaller in the with tax theory, and hence why the downward force
on the WACC caused by the (net of tax) cheap debt finance is the
net stronger force in the with tax theory.
WACC [kadj = keu(1 – VD) t / (VE + VD)]
The formula shows that WACC will reduce as gearing (measured by

debt divided by (debt + equity)) increases. This is seen on the graph
as a downward sloping line.
Key assumptions=
More detail on practical considerations:
The company's ability to borrow money (the company's 'debt

capacity'):
a) The maximum level of borrowing that a company can

comfortably support is referred to as its debt capacity.
b) A company can only increase its gearing if it can find a lender

who will provide it with debt finance. In recessionary times, this
should not be taken for granted.
c) A company's capacity to borrow is increased if it is able to offer

good quality, valuable assets as collateral.
d) Debt capacity is function of a company’s credit-worthiness
Existing debt covenants:
a) Debt covenants reduce the flexibility of management. Existing

debt covenants may even prevent the company from
borrowing more.
b) Management must keep the company well within the terms of

the existing covenants (keeping plenty of 'leeway' or
'headroom') to ensure that the flexibility of the company is
maximised. Increasing costs of debt finance as gearing rises.
c) M & M assumed that debt was risk free, and that kd would be
constant at all levels of gearing. In reality, an increased level of
gearing is likely to be perceived as risky by lenders, so the
interest rates on borrowings generally increase as gearing
increases. Views of other stakeholders and rating agencies
Tax exhaustion:
a) M & M's with tax theory suggests that the benefits of tax relief
on debt interest will help to reduce the company's cost of
capital at all levels of gearing. This is not the case in practice.
b) At some level of gearing the interest payable will be so high

that taxable profit will be reduced to zero. Beyond this point,
there will be no further benefit of raising debt finance.
c) However, in order for tax exhaustion to apply, the company

must be making a loss and will have breached any interest
cover covenants. The company is therefore likely to have much
greater problems to contend with than the loss of tax relief.
The impact on financial ratios of a change in capital

Structure:
Continuation of chapter 1. Same formulae.
(Source: Kaplan F3 Textbook)

General considerations for group of companies=
a) Tax issues= international transfer pricing.

b) Country risk= Matching concept
c) Type of finance provided by parent
Thin capitalization=
Companies prefer to be financed by borrowing. Thin capitalization

rule aims to stop companies from getting excessive tax relief on
interest.
This occurs because they have entered into a borrowing with a

related party that exceeds the amount a third-party lender would
be prepared to lend.
Excess amount borrowed which an independent third party would

not lend is not allowed as expense.
Factors determining thin capitalisation:
The tax authorities will usually look at two areas to determine

whether they believe a company is thinly capitalised:
a) Gearing:
This is measured as the ratio of debt to equity. A higher

proportion of debt could cause thin capitalisation problems. In
the UK a limit of around 50:50 is considered by the tax
authorities to be reasonable.
b) Interest cover:
This is the ratio of earnings before tax and interest to interest

on borrowings-It measures how risky the loan is for the lender.
Many commercial lenders will look for a ratio of around 3, so
this is the figure considered by the tax authorities to be
reasonable.

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Financing- Capital Structure

Several studies have focused on this link between capital structure

“What capital structure should the company aim for in order to

The main studies are:

a) the traditional view;

2 opposing forces which affect WACC:

Interest is an obligation; interest is tax deductible. As an entity

As gearing increases likelihood of dividends to shareholders

a) Which of the two forces is stronger?

Common points= if return is higher than the cost of the fund’s

According to the 'traditional' view of gearing and the cost of capital,

a) As an organization introduces debt into its capital structure

b) As gearing increases equity holders will ask for more

c) The traditional view therefore claims that there is an

e) Also, at this point the combined market value of the

f) Discounting future operating cash flows at a lower WACC

a) They assume that companies which operate in the same

b) Value of the company depends solely on the post-tax that

c) The way in which funding is split should make no difference

d) Investors are indifferent between personal and corporate

e) This means WACC will be the same at all levels of gearing.

g) Assume that market pressures will ensure that the two

a) After noting differences that interest has over dividends M

b) As the gearing increases the WACC decreases and hence

c) In the presence of tax downward force on WACC is greater

d) The introduction of taxation suggests that the higher the

Company value (Vg = Vu)

This is backed up by the formula, which shows that if T=0, the

WACC (kadj = keu)

Company value (Vg = Vu + TB )

Cost of equity (keg = keu + (keu – kd) VD (1 – t) / VE):

The cost of equity slopes upwards as gearing increases under M &

Note that the inclusion of (1 – t) in the formula has the impact of

WACC [kadj = keu(1 – VD) t / (VE + VD)]

The formula shows that WACC will reduce as gearing (measured by

More detail on practical considerations:

The company's ability to borrow money (the company's 'debt

a) The maximum level of borrowing that a company can

b) A company can only increase its gearing if it can find a lender

c) A company's capacity to borrow is increased if it is able to offer

d) Debt capacity is function of a company’s credit-worthiness

Existing debt covenants:

a) Debt covenants reduce the flexibility of management. Existing

b) Management must keep the company well within the terms of

b) At some level of gearing the interest payable will be so high

c) However, in order for tax exhaustion to apply, the company

The impact on financial ratios of a change in capital

Continuation of chapter 1. Same formulae.

(Source: Kaplan F3 Textbook)

a) Tax issues= international transfer pricing.

Companies prefer to be financed by borrowing. Thin capitalization

This occurs because they have entered into a borrowing with a

Excess amount borrowed which an independent third party would

The tax authorities will usually look at two areas to determine

This is measured as the ratio of debt to equity. A higher

This is the ratio of earnings before tax and interest to interest

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