Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

GEARING LEVELS REBOUND

[W]e are seeing a return to more typical

gearing levels, with a small but important

percentage of local firms moving into the

25-49% bracket, as companies go through

an orderly debt restructure. In contrast, in

October 2011, 81% of local respondents had

gearing at less than 25%. Looking ahead, 32%

of companies expect their debt-to-capital

ratios to increase over the next 12 months.

Source: Ernst & Young Australasia Capital Confidence Barometer, April

2014, p. 6. http://www.ey.com/AU/en/Services/Transactions/Australasian-

Capital-Confidence-Barometer-April-2014. Accessed 17 April 2015.

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

explain how financial leverage increases

both a company’s risk and its returns

understand how the Modigliani-Miller

model indicates that capital structure is

irrelevant in a world without taxes and

other market frictions

discuss how the presence of corporate and

personal taxes affect capital structure

explain how the costs of insolvency and

financial distress affect capital structure

decisions and explore the questions raised

by the agency cost/tax shield trade-off

model of corporate leverage

describe the most important capital

structure patterns observed around the

world and explain what factors may be

driving leverage choices.

LO 13.1

LO 13.2

LO 13.3

LO 13.4

LO 13.5

The chapter-opening ‘What companies do’

demonstrates that a company’s financing decisions

are influenced by the state of the economy; but

what other factors affect these decisions? Another

way to phrase this is: why do some companies

choose to finance their operations largely with debt,

while other companies issue little or no debt?

For an international comparison of corporate

capital structures, Table 13.1 compares

debt-equity ratios for several countries, allowing

for company size. It is notable how the large

companies tend to carry a higher ratio of debt

to equity. For Australia, Canada and South

Korea, the debt tends to be more bank lending

than corporate bond issues. As we explore

models of capital structure in this chapter, we

shall discover reasons why these outcomes can

be anticipated.

TABLE 13.1 AVERAGE DEBT–EQUITY RATIOS FOR INTERNATIONAL COMPANIES, 2013

Large Medium Small

Australia 1.147 0.927 0.459

Canada 1.181 0.963 0.152

UK 1.246 0.796 0.220

South Korea 3.746 0.710 0.676

Source: Lepone, Andrew, and Wright, Danika, Report for the Financial Services Council (FSC) Capital Market Structure Comparisons,

Capital Markets Consulting Services Pty Ltd, web: ews.cmcrc.com, 19 March 2014.