IntroductionThe aim of this report is to carry outan evaluation of changes to capital structure of two organisations operatingwithin the real-estate industry; Land Securities Group Plc and Grainger Plc.
Itwill then compare and contrast the bankruptcy risk for these two firms and thencritically discuss which firm could be more susceptible to bankruptcy. Part A: Evaluation of CapitalStructure Capitalstructure refers to ‘how a firm finances its overall operations and growth byusing different sources of funds’. This includes a mixture of debt and equityused to fund an organisations growth.
Changes in the capital structure of thetwo firms will influence the financial risk and, hence, have an impact on thevalue of the company. This section will compare and contrast the capital structuresof the two firms Land Securities Group Plc and Grainger Plc using relevanttheory models and financial ratios to help form an evaluation. When referring to capital structure thereare three theories that can be applied; Modigliani-Miller I, Modigliani-MillerII and Trade Off Theory. The first theory Modigliani Miller I is notrelevant towards Land Securities PLC and Grainger PLC due to the unrealisticimplications of it. This basic proposition theory assumes a completely ‘perfectcapital market’ which would ‘assume no taxation at the firm level’ (McDonald,2011) and no financial distress costs. These two organisations have both paidtax over the five-year time frame and therefore this theory is not appropriateand can’t be used. The second theory Modigliani-Miller II wasadapted in 1963 to show how ‘corporate income taxes (tc) interact with thefirm’s financing choices’.
This theory suggests that as a company gears up, theimpact will be a lower cost of debt which would have a direct effect bydecreasing the WACC. This will subsequently increase the value of the company. Therefore for both of these real estate firmsthere will be an adverse effect for these firms as the gearing ratios havedecreased over time (appendices). Referring to appendices ? the WACC for Landand Grainger has increased over the period as gearing has decreased.
This has also been demonstrated throughappendices which shows the trend via line graphs. From looking at the gearing ratios for thetwo companies (appendices) it is clear that they have both reduced over theperiod and therefore coincides with the modigliani-miller 2 theory. Graingerhas high gearing ratios which ‘represents a high proportion of debt to equity’ https://www.accountingtools.
com/articles/2017/5/5/gearing-ratio This is common for companies in ‘industrieswith large and ongoing fixed asset requirements’ such as Grainger especially asdebt finance is cheaper than using equity. This is because ‘lenders require alower rate of return than ordinary shareholders’ BOOK and transaction costsassociated with raising and servicing debt are usually less than ordinaryshares.However, operating with high gearing can showlower financial stability as a high level of debt can be problematic if Graingerencounters financial issues or a rough patch in the long term and can’t affordits high debts. This reduces the ability to operate as a ‘going concern’ andcan increase exposure to financial distress. Financial distress can be verydangerous for companies as it is a’condition where a company cannot meet, or has difficulty paying off, itsfinancial obligations to its creditors, typically due to high fixed costs’. Investopedia. https://www.
investopedia.com/terms/f/financial_distress.asp#ixzz54OPkjjSW This could include more expensive financingor may find it harder to get any further loans as lenders may not appreciatehigh levels of gearing and there’s a risk of having to borrow at a higherinterest rate. Therefore, although Modigliani-Miller II signifies that theideal capital structure consists of higher levels of debt financing, GraingerPlc must consider the implications and possible downfalls of the risksassociated with financing. Agency costs?Although Graingers gearing ratios are highappendices show that they have decreased by a large amount over the periodwhich would indicate that they are choosing to pursue a more sensible approachto gearing.
Land Securities has much lower gearingratios than grainger appendice meaning they have relied a lot less on debtwhich shows higher financial stability than grainger and therefore more likelyto be able to operate as a going concern. This will reduce the risk of financialdistress for the company. It can be argued that although they may have morestability, Land Security will have to pay more for financing as having a higherequity to debt ratio will mean shareholders will require a higher rate ofreturn which in contrast to lenders will be higher. Referring to the market value (appendices)it is clear that there has been a decrease over the five-year period for thetwo companies. This would again coincide with the Macmillion 2 theory.