Blog 9: Capital Structure affect firm's decision

The main task for the managers is generating the shareholder value. There are many methods to maximize shareholders' wealth, one of the method is mixing debt and equity. Firms may increase gearing level to decrease the weighted average cost of capital (WACC). However, as we know, gearing is a relationship between debt and equity. Therefore, increasing gearing level that means increase the debt level, firms have to pay a large amount of dividends interest for those debt. As the result, financial crisis may occur. Thus, firms have to control the gearing level to “just in level” which not too high that generate risk to shareholder or too low that break the opportunity of generate shareholder value. Therefore, a better method is optimal capital structure by mixing debt to equity.

However, a description of gearing level in 1958 by Modigliani & Millar (Arnold, 2008, p.793) argues that there is no impact on the WACC to shareholder wealth and no optimal structure exists. But his theory is assuming that there is no taxation and no costs of financial distress and liquidation. Even the theory is correct, can it apply to this real world business? In my opinion, it can’t.

The share price of Bank of Ireland increased 41% to prevent the government take the majority stake of the bank. However, a test which was found by Irish banking system stated that those banks need £21.2bn to survive the financial crisis. Bank of Ireland tries their best to meet the capital requirements from Irish banking system. (BBC, 2011)

They may do it by debt management which increases the debt to reduce government Intervention. However, as mentioned above, these would cause financial crisis.

Some analysts suggest another method that Bank of Ireland might solve this problem by restructuring. It is because the cost of restructure is paid by taxpayer. (BBC, 2011) However, if relate to the theory of Modigliani & Millar, assuming there is no taxation. Who are going to pay for these? Ultimately, Bank of Ireland has to pay for it.

If Bank of Ireland raises funds by other countries banks, it may cause credit crunch. Thus, it means that Bank of Ireland is difficult to raise funds by those methods to finance business.

In this situation, Bank of Ireland has to make decision how to raise money that least harm to the firms. As mentioned above, Modigliani & Millar theory can’t apply to the real world, I think the most suitable method is to restructure the business to prevent government take the majority stake of Bank of Ireland that reduce the shareholder’s wealth.

Reference:

Arnold, G. (2008) Corporate Financial Management. 4^th edn. Harlow: Financial Times Prentice Hall

http://www.bbc.co.uk/news/business-12932334