Optimal Capital Structures

The purpose of this assignment is to explore the theories relating to "Optimal Capital Structure". These theories will be covered in detail limited to the extent of the availability of word content allowed for in this assignment. This will then lead to a practical analysis of the capital structures of two well known Australian companies being:

• Wesfarmers Pty Ltd (asx code: WES)

• Publishing and Broadcasting Limited (asx code: PBL)

Specifically, I will compare and contrast differences and similarities that may be applicable and provide possible explanations utilising appropriate theoretical models as to why these companies have different capital structures

Firstly, let's explore what is meant by "Optimal Capital Structure". Why would this be important?

Many companies exist to purely maximise the wealth of shareholders. However the reality is that companies are faced with numerous forces which both dictate and or influence key decisions and or resulting structural (financial/organisational/strategic) decisions. These forces are primarily 3 distinct "constituencies"(Bruce et al 1991 Pg 2)

1. Market Constituency (companies customers)

2. Organisational Constituency (employees)

3. Capital Market Constituency (Investors/Lenders).

These constituencies can enforce or effect outcomes that can conflict inhibit or maximise returns to all. Constraints and or hurdles may be placed on the company by either of these forces which could and can create "risks" in the company achieving a desired outcome. Primarily decisions could be made that can make or break companies. These risks can constitute either "Business Risk- "the equity that comes from a firms operating activity or "Financial Risk- The equity risk that comes from the financial policy - the proportion of debt and equity utilised". (Ross et al, Pg 546/547)

The use of debt and equity and understanding of the risks and consequences involved are key to the ongoing viability of any company in meeting its objectives. Over the last two decades numerous companies have made errors of judgment based on their capital structural decisions (Bond Corp, Enron, WorldCom etc. So what constitutes the optimal capital structure in order to at least minimise risks of failure?

Optimal capital structure (Petty et al, Pg 448) is described as being “the capital structure that minimises the firms composite cost of capital (maximises the ordinary share price) for raising a given amount of funds. Specifically ensuring that depending upon the nature of the investment (permanent or short term) the right mix of funding is achieved i.e. Short term assets financed with short term debt and long term or permanent assets financed with permanent capital.

In 1958, Franco Modigliani and Merton Miller (M&M) proposed the first theorem on optimal capital structure. The theory proposed that "nothing matters or irrelevance" theorem. That is that it did not matter in an efficient market that the "value of the firm is independent of its capital structure (that is the debt/equity ratio)" (Hamminga 1994 pg1). That is providing the absence of taxes, bankruptcy costs and other noise factors the theorem appears to hold true.

For example we have two firms which are expressed as pies. The first company we will call Blue Pty Ltd and the second company being Red Pty Ltd.

BLUE PTY LTD RED PTY LTD

BONDS + STOCKS = TOTAL ASSETS

Each Company has the same value of assets and does not matter how its debt or equity is structured. That is it does not matter you cut the pie the value of assets will remain the same.

Now suppose you are choosing which firm to invest in. Both firms have the same assets however the mix of debt verses equity is not. Blue being unleveraged (Vu) and Red being leveraged (VL). That is it’s the same cost of buying either firms as total value is the same. In the absence of taxes the investor could replicate the borrowing of say RED Pty Ltd (VL) and borrow at the same amount of money to purchase Blue Pty Ltd (Vu). The returns would be the same as the investor has been able to replicate the same conditions as Red with the same return. This is assuming that the interest costs are the same for both.

So Vu = VL

This theorem though obviously has drawbacks specifically that the market would need to be purely efficient on all fronts which in reality are not possible.

The second part of this theory (Proposition 2) elaborates further. That is that it recognises that the cost of equity depends on three things (Ross et al, Pg 544) that are:

1. The required rate of return on the firm assets

2. The firms cost of debt

3. The firms debt to equity ratio

As the company raises its debt to equity ratio so does it raises its risk to return on equity.

Although the mix of debt verses equity may differ if the total value of the company is the same so will the weighted average cost of capital. For example:

M&M proposition 2 states (Ross et al, Pg 544) the cost of equity (Re) =

Re = Ra + (Ra-Rd) x (D/E)

If Blue Company had an average cost of capital of 14% and it can borrow at 9% and it had a target capital structure of 100% equity what would the cost of equity be?

Re=14% + (14%-9%) x 0%

=14%

As per the previous example the Red company had a capital structure of 30% equity and 70% Debt what would the cost of equity be?

Re=14% + (14%-9%) x 2.33%

=25.65%

Now assuming that the tax rate is zero what would the weighted average cost of capital (WACC) of these two companies?

WACC= (E/V) x Re = (D/V) x Rd)

Blue: = 1 x 14% + 0% x 9%

=14%

Red = .30