Glas Cymru Capital Structure.

Summary of the Article

Glas Cymru, a non-profit making organization, headed by the former treasury secretary, Lord Burns is on the front line fighting for the company to be fully financed from external debt instead of the traditional shareholders ownership. Glas Cymru is finalising its plans to acquire the principality’s water supplier at the cost of two billion pounds sterling. For the deal to go through, Glas Cymru needs to raise this amount of money through the sale of long-term bonds to prospective investors. This move intends to keep the firm’s cost of capital within the two percentage points below the recommended level. The major objective of Glas Cymru’s total financing of investment on debt capital as opposed to equity capital is to save the cost of equity capital. These adds to approximately 4 to 4.5% of its regular cost of capital on savings.

Since other similar investments have suffered due to diversification, Glas Cymru will keep the funds squarely in the water sector because it is monopolistic and promises a good return. Another motivator that has led Glas Cymru to this deal is the fact that they are buying at a price that is significantly lower than the regulatory price that is in existence and this gives the company a cushion of at least 150 million pounds at the start of business (Taylor and Duyn, 2002).

Evaluation of Glas Cymru’s actions and objectives in relation to capital structure theory

The capital structure theory was researched and developed by Modigliani and miller. The two professors came up with the capital structure theories that concluded that in perfect markets, the capital structure of a company mattered not so significantly and the choice a company makes regarding its financial operations and financing its activities. The value of a firm is significantly determined by its ability to generate enough income and increase its earning power and also subject to the risk of its future prospects and the underlying assets, and that its immediate value is entirely independent of its choice of selection in investment and the distribution of dividends .

Glas Cymru strategy is to fund the purchase of the principality’s water sector by use of debt capital obtained from bonds floated in the public. These is in relation to cutting down the cost of capital which according to Glas Cymru would be much higher if they opted to finance the investment in the principalities water sector through the shareholders equity capital which are not exempted from taxation and which have long term interest repayment period. These decisions are made by the managers as in the case of Glas Cymru whose management decisions fall under the capital structure theories of Modigliani and miller model trade-off theory, agency theory, and signalling theory. The effect of the debt borrowed by Glas Cymru on its capital structure depends on its impact on WACC feedback to FCF. With no taxes, (MM proposition 1) Glas Cymru value will be independent of its own capital structure. The irrelevance proposition of MM Capital structure assumes a situation of no taxes and no bankruptcy costs, the average weighted cost of capital remains constant even with changes in the company’s capital structure. The capital structure does not affect the company’s stocks since there are no changes or benefits from positive increases in debts therefore irrelevant. Capital can only be viewed as irrelevant under very tight and restrictive assumptions as MM theory concludes.

Where taxes are applicable in the MM Proportion 1, the total value of the unlevered company is equal to its earnings before taxes and interest which eventually adds up as the cost of equity. The value of unlevered company is equal to the company of unlevered firm with its additional taxes capitalized eventually at the cost of its debt. (Burgess, 2006).

Trade-off theory points at the optimal capital structure being attained at the point where its marginal distress costs exceed its marginal tax advantage from the additional debt in the MM model. These costs are only applicable at high levels of debt, otherwise the WACC of many capital structures are mostly unaffected. Glas Cymru intends to save between 4-4.5% of its cost of capital, by replacing the shareholders equity by the debt capital.

Debts can reduce relatively the Equity Agency problem of managers using company finances to fund non essential expenses (such as perks, irregular acquisitions or investment in retarded projects) or invest in low risk due to the undiversified interest in company problem which is common in large companies with diffuse owners or stock holders where management owns very little in the company’s shareholding.

The use of financial leverage like in the case of Glas Cyrmru, in these case Bonds free flow of cash for the firms generating more than enough cash required to fund extra NPV opportunities , reducing their perk consumption and the value destroying positive growth. The managers increases the free cash flow by ensuring there is utmost efficiency in the firms overall operations. Failure means the managers will opt for outside board members, takeover bids or substitution of the existing strategies. The debt holders also controls the diffuse free ridding stock holders hence it reduces the Equity Agency costs.

The signalling Theory MM assumes that the investors and interested parties including the managers have similar information. Where most of the information are mutual, stockholders also assumes that firms will issue new stock where Bonds are overvalued and issued. Where undervalued stocks are issued it indicates lower FCF, unwillingness to commit to increased debt financing service. Leverage-decreasing events indicates overvalued stock and vice versa which is supported by empirical data.

The signalling theory attributes in pecking order hypothesis companies will most likely choose from the following arrangement of funding sources to maintain overall financial stability. The first choice is retained earnings, extra cash debt issuance, and stock issuance. Profitable companies use less debt because they can source funds easily internally(equity) These contradicts off theory that suggests high debts because of low rates of defaulters and the need for tax incentives.

In the case of Glas Cymru, the very regulator who approved the financial decision to fund the purchase of the principle water through debt discouraged other firms from doing the same, citing that this was a special case scenario that needed such action. This clearly demonstrates the fact that there is more than one school of thought concerning the act of private companies leveraging debt to their advantage as explained in Miller’s theory that highlights the offsetting of a company’s tax burden through borrowing (Modigliani and Miller, 1954; Myers, 1984).For those opposed to the use of debt to fund institutional investments, their main argument against this approach is that debts only serve to increase the risk level of an investment and hence place the invested funds in jeopardy given the bullish market conditions that have been seen in recent times. An increase in the amount of debt taken up by a firm also serves to make its credit rating tumble down and at times signal panic on the side of shareholders (Graham and Harvey, 2001).

The trade-off theory of capital structure favours the issue of bonds as done by Glas Cymru since it has more of a tax benefit than the issue of dividends to equity holders (Modigliani and Miller, 1958).This enables the firm to meet its objective of maximizing returns by replacing equity with debt. On the other side of the divide, bankers as well as other financial analysts seem to be in favour of the employment of debt as a tool to ensure increased profitability and hence increasing the value of institutions that are running on debt. The first advantage of debts that makes them so attractive as opposed to equity funding of companies is the fact that the burden of debt is significantly reduced when the business has been operating on debts.

Those who will buy the bonds that Glas Cymru is putting up for sale are therefore promised great returns on their investments. This is because the creditors who are owed money have a claim to the money before the government and these results in minimal and sometimes almost nil taxes being imposed on the returns that the business gains (Dewatripont and Tirole, 1994).

It is clear that the objective of Glas Cymru is not to get the highest credit rating and this makes financial sense according to Roberts, 2003. An increasing number of companies in Europe and America seem to have heeded this and are continuing to downgrade their credit ratings. This seems to contradict conventional wisdom regarding the ratio of capital to debts that a business can have. This position may explain the cautious stance that was taken by the regulator who authorized the purchase of Dwr Cymru by Glas Cymru. The idea is to shift the benefit from the business to the shareholders and the chances of this being achieved are increased by lowering the cost of capital and increasing the money available to carry out business with greater profits (Marsh, 1982).

Conclusion

The major objective of any successful organization is to maximize its earnings while targeting its sales and minimizing costs. Any measure that can extend and guarantee the achievement of any of these objectives will definitely draw the attention of these strategic managers. If a high level of leverage will guarantee profitable returns for the business then its implementation should be considered having in mind the unpredictable nature of the interest rates that fluctuate with the slightest disturbance of the market. These interest rates can reach unaffordable levels unlike Equity funded financing whose interest rates or dividend payable can be controlled. Debts however are not subject to taxation and this makes the idea of running on credit as opposed to shareholder’s equity an increasingly popular venture. The financial management of Glas Cymru should critically weigh all its options before making a decision whether to adopt the measures to increase its leverage or retain its current Equity status. Finally to sum up all the theories, Capital structures require sound judgement both from the management and the shareholders. The willingness to add debt allows increased growth rate.

References

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Marsh, P. 1982. The choice between equity and debt: An empirical study. The Journal of finance, 37(1), 121-144.

Modigliani, F., and Miller, M. 1958.The cost of capital, corporation finance and the theory of investment.The American economic review, 48(3), 261-297.

Myers, C. 1984 The Capital Structure Puzzle, The Journal of Finance. 39 (3)

Roberts, A. 2003.Highest scores may not be most efficient ratings. Financial Times- London Edition.

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Taylor, A and Duyn V 2002.Companies & Finance Uk: Glas Cymru Launches Bond Campaign Water Marketing Drive In Plan To Raise Pounds 2bn For Purchase Of Dwr Cymru-Financial Times-London Edition