The aim of this report is to carry out
an evaluation of changes to capital structure of two organisations operating
within the real-estate industry; Land Securities Group Plc and Grainger Plc. It
will then compare and contrast the bankruptcy risk for these two firms and then
critically discuss which firm could be more susceptible to bankruptcy.
Part A: Evaluation of Capital
structure refers to ‘how a firm finances its overall operations and growth by
using different sources of funds’. This includes a mixture of debt and equity
used to fund an organisations growth. Changes in the capital structure of the
two firms will influence the financial risk and, hence, have an impact on the
value of the company. This section will compare and contrast the capital structures
of the two firms Land Securities Group Plc and Grainger Plc using relevant
theory models and financial ratios to help form an evaluation.
When referring to capital structure there
are three theories that can be applied; Modigliani-Miller I, Modigliani-Miller
II and Trade Off Theory.
The first theory Modigliani Miller I is not
relevant towards Land Securities PLC and Grainger PLC due to the unrealistic
implications of it. This basic proposition theory assumes a completely ‘perfect
capital market’ which would ‘assume no taxation at the firm level’ (McDonald,
2011) and no financial distress costs. These two organisations have both paid
tax over the five-year time frame and therefore this theory is not appropriate
and can’t be used.
The second theory Modigliani-Miller II was
adapted in 1963 to show how ‘corporate income taxes (tc) interact with the
firm’s financing choices’. This theory suggests that as a company gears up, the
impact will be a lower cost of debt which would have a direct effect by
decreasing the WACC. This will subsequently increase the value of the company. Therefore for both of these real estate firms
there will be an adverse effect for these firms as the gearing ratios have
decreased over time (appendices).
Referring to appendices ? the WACC for Land
and Grainger has increased over the period as gearing has decreased. This has also been demonstrated through
appendices which shows the trend via line graphs.
From looking at the gearing ratios for the
two companies (appendices) it is clear that they have both reduced over the
period and therefore coincides with the modigliani-miller 2 theory. Grainger
has 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 ‘industries
with large and ongoing fixed asset requirements’ such as Grainger especially as
debt finance is cheaper than using equity. This is because ‘lenders require a
lower rate of return than ordinary shareholders’ BOOK and transaction costs
associated with raising and servicing debt are usually less than ordinary
However, operating with high gearing can show
lower financial stability as a high level of debt can be problematic if Grainger
encounters financial issues or a rough patch in the long term and can’t afford
its high debts. This reduces the ability to operate as a ‘going concern’ and
can increase exposure to financial distress. Financial distress can be very
dangerous for companies as it is a
‘condition where a company cannot meet, or has difficulty paying off, its
financial 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 financing
or may find it harder to get any further loans as lenders may not appreciate
high levels of gearing and there’s a risk of having to borrow at a higher
interest rate. Therefore, although Modigliani-Miller II signifies that the
ideal capital structure consists of higher levels of debt financing, Grainger
Plc must consider the implications and possible downfalls of the risks
associated with financing. Agency costs?
Although Graingers gearing ratios are high
appendices show that they have decreased by a large amount over the period
which would indicate that they are choosing to pursue a more sensible approach
Land Securities has much lower gearing
ratios than grainger appendice meaning they have relied a lot less on debt
which shows higher financial stability than grainger and therefore more likely
to be able to operate as a going concern. This will reduce the risk of financial
distress for the company. It can be argued that although they may have more
stability, Land Security will have to pay more for financing as having a higher
equity to debt ratio will mean shareholders will require a higher rate of
return 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 the
two companies. This would again coincide with the Macmillion 2 theory.