Q. Observation of capital structure?

Droxfol Co has long-term funding provided by ordinary shares preference shares and loan notes. The rate of return necessary by each source of finance depends on its risk from an investor point of view with equity (ordinary shares) being seen as the most risky and debt (in this case loan notes) seen as the least risky. Disregard taxation the weighted average cost of capital (WACC) would therefore be expected to decrease as equity is replaced by debt since debt is cheaper than equity that is the cost of debt is less than the cost of equity.

Nevertheless financial risk increases as equity is replaced by debt and so the cost of equity will increase as a company gears up offsetting the effect of cheaper debt. At low as well as moderate levels of gearing the before-tax cost of debt will be constant but it will increase at high levels of gearing due to the possibility of bankruptcy. At elevated levels of gearing the cost of equity will increase to reflect bankruptcy risk in addition to financial risk.

In the traditional observation of capital structure ordinary shareholders are relatively indifferent to the addition of small amounts of debt in terms of increasing financial risk and so the WACC falls as a company gears up. As gearing up persists the cost of equity increases to include a financial risk premium and the WACC reaches a minimum value. Further than this minimum point the WACC increases due to the effect of increasing financial risk on the cost of equity and at higher levels of gearing because of the effect of increasing bankruptcy risk on both the cost of equity and the cost of debt. On this traditional view thus Droxfol Co can gear up using debt and reduce its WACC to a minimum at which point its market value (the present value of future corporate cash flows) will be maximised.

In contrast to the traditional outlook continuing to ignore taxation but assuming a perfect capital market Miller and Modigliani demonstrated that the WACC remained constant as a company geared up with the increase in the cost of equity due to financial risk exactly balancing the decrease in the WACC caused by the lower before-tax cost of debt. Since in a prefect capital market the chance of bankruptcy risk doesn't arise the WACC is constant at all gearing levels and the market value of the company is also constant. Miller and Modigliani showed thus that the market value of a company depends on its business risk alone and not on its financial risk. On this view so Droxfol Co cannot reduce its WACC to a minimum.

When corporate tax was put into the analysis of Miller and Modigliani a different picture emerged. The interest payments on debt decreases tax liability which meant that the WACC fell as gearing increased due to the tax shield given to profits. On this observation Droxfol Co could reduce its WACC to a minimum by taking on as much debt as possible.

Nevertheless a perfect capital market is not available in the real world and at high levels of gearing the tax shield offered by interest payments is more than offset by the effects of bankruptcy risk as well as other costs associated with the need to service large amounts of debt. Droxfol Co should thus be able to reduce its WACC by gearing up although it may be difficult to determine whether it has reached a capital structure giving a minimum WACC.