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1 - IB Exam Opt Capital Struct
1 - IB Exam Opt Capital Struct
optimum
capital
RELEVANT TO ACCA QUALIFICATION PAPER F9
point to understand is that, as a company changes Therefore, it is the duty of all finance managers to
its capital structure (ie varies the mixture of equity find the optimal capital structure that will result in
and debt finance), it will automatically result in a the lowest WACC.
change in its WACC.
However, before we get into the detail of capital What mixture of equity and debt will result in the
structure theory, you may be thinking how the lowest WACC?
financing decision (ie altering the capital structure) As the WACC is a simple average between the cost
has anything to do with the overall corporate of equity and the cost of debt, one’s instinctive
objective of maximising shareholder wealth. Given response is to ask which of the two components is
the premise that wealth is the present value of the cheaper, and then to have more of the cheap
future cash flows discounted at the investors’ one and less of expensive one, to reduce the
required return, the market value of a company is average of the two.
equal to the present value of its future cash flows Well, the answer is that cost of debt is cheaper
discounted by its WACC. than cost of equity. As debt is less risky than equity,
the required return needed to compensate the debt
Market value of a company = Future cash flows investors is less than the required return needed to
(perpetuity formula) WACC compensate the equity investors. Debt is less risky
than equity, as the payment of interest is often a
fixed amount and compulsory in nature, and it is
paid in priority to the payment of dividends, which
are in fact discretionary in nature. Another reason
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79
Studying Paper F9?
Performance Objectives 15 and 16 are linked
structure
why debt is less risky than equity is in the event of a In summary, when trying to find the lowest
always be able to raise funding and avoid bankruptcy. In the real world, a
U-shaped for companies generally, we cannot 2. The time and expense associated with issuing
precisely calculate the best gearing level (ie there debt is usually significantly less than that
is no analytical mechanism for finding the optimal associated with a share issue
capital structure). The optimum level will differ from
one company to another and can only be found by The existence of asymmetrical information
trial and error. This is a fancy term that tells us that managers
know more about their companies’ prospects
Pecking order theory than the outside investors/the markets. Managers
The pecking order theory is in sharp contrast with know all the detailed inside information, whilst
the theories that attempt to find an optimal capital the markets only have access to past and publicly
structure by studying the trade-off between the available information. This imbalance in information
advantages and disadvantages of debt finance. In (asymmetric information) means that the actions
this approach, there is no search for an optimal of managers are closely scrutinised by the markets.
capital structure. Companies simply follow an Their actions are often interpreted as the insiders’
established pecking order which enables them to view on the future prospects of the company. A good
raise finance in the simplest and most efficient example of this is when managers unexpectedly
manner, the order is as follows: increase dividends, as the investors interpret this as
1. Use all retained earnings available; a sign of an increase in management confidence in
2. Then issue debt; the future prospects of the company thus the share
3. Then issue equity, as a last resort. price typically increases in value.
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capital (WACC). this can be achieved by having debt in the capital structure,
As the primary financial objective is to maximise shareholder wealth, then
companies should seek to minimise their weighted average cost of
Keg
Value of
company
WACC Vu Vg
Keu
Kd
10%
Keg Vg
Value of
company
Keu
Vu
WACC
7% Kd (1-t)
Key:
Keu = Cost of equity ungeared Vu = Value ungeared
Keg = Cost of equity geared Vg = Value geared