Debt is cheaper than Equity....not full stop.

This week's lecture was based on the idea that debt is cheaper than equity and a hypothetical optimal mix between them can finance a company. An optimal capital structure maximises shareholder wealth.


Debt is cheaper than equity but DO NOT finance your entire business venture on debt. If debt was cheaper than equity entirely there would be no problem with Portugal borrowing money from the International Monetary Fund or the European Central Bank as it's cheaper than using any equity the Government has left over (which is very little). Borrowing from these institutions lowers a country's economic rating thus making future borrowing for the country more expensive. Debt is not a viable or sustainable financing option.


Modigliani and Miller argue that a firm's value as a business enterprise is independent of how it is financed.
They make assumptions in this theory that no tax is paid and that all knowledge is perfect.
This theory was produced in a business immature environment and these assumptions cannot now be taken in our corporate world. They are simply too big an assumption.


Modigliani and Miller state that the perfect equity/debt mix is within a range of investments. This perfect mix is very changeable with new investments or divestments and would not be worth the company spending time trying to find the optimal mix. This optimal mix was found for a time with the banks prior to the crisis. Each bank was investing in risky ventures that brought bumper results. The debt was never repaid to the retail part of the banks each time. As the lending continued the banks held little capital and when loans were defaulted on the problems started, the capital structure of the bank didn't msw.
The interim report by the Independent Commission on Banking (ICB) has recommended that the banks must have a minimal capital structure of 10%. For every £100 lent out £10 must be held in equity, increasing the Basel 3 standard of 6%. This would prevent another bailout the scale of which we have just seen as it protects savers money. The banks will now have to find an optimal debt/equity mix as their over inflated bonuses will now depend on it.


Ian Gordon from Exane BNP Paribas comments that the ICB's report is nothing more than obvious regulatory 'noise' that they will have to listen to until the final report is published. The comment made in the Guardian (http://www.guardian.co.uk/ 13/04/2011) illustrates them as arrogant, unwilling and misinformed as to the part they played in the crisis. It shows no willingness to evaluate their optimal debt/equity mix because it worked so well before 2008 and the only changes they'll make is if the Government come in with a heavy hand and force them.....which is probably not going to happen due to the political fear that if the banks go overseas it could leave them with no financial future.

Risky Business

2008 saw a global recession resulting in the Irish banks being bailed out by their Government (and later by the IMF and ECB). The Irish banks had lent money to property developers who used it to build housing estates with the idea that the houses would be sold at a huge profit and the loans would be paid back with interest. The banks had done these types of loans since the housing market boom, it had a great interest payback and was considered 'as safe as houses'.
Risk assessment for property development must have been calculated during the housing market boom. The risk has been calculated on the assumption that this boom would be a perpetual moving market, or at least not ready to fail so soon.
Merrilll Lynch conducted research months prior to the crash and commented;
"(the) lending practices of several big Irish banks are the riskiest and most reckless in Europe".
Had this research been commissioned by the Government the whole scenario could have been avoided, as it was the research had to be removed due to complaints by their clients (the banks they had analysed).
The paradox of this statement is that it prewarns of a cataclysmic financial event but it also creates anxiety in the markets and can create no confidence in the banks which is equally damaging.
Christensen, Kaufman and Shih argue that the chance of innovation is reduced if the main driver for shareholder wealth is the earnings per share. This is true in the case of the Irish banks. Less risky investment projects could have been chosen but this would not MSW and were not used. The loans given to the developers were relatively short term for high yield. The NPV would have been the highest on these projects and these are the ones that have been approved. Calculating risk in this way does not allow for fluctuations in the economic environment as David Grundy stated in Lecture 9 that expected NPV 'assumes constant states'.

The Credit Crunch

The credit crunch all started in the USA in the subprime market. Subprime is the riskier end of mortgages. These loans started to be defaulted on and a whisper of recession was heard and panic spread all over the globe.


Northern Rock, a UK bank asked the Bank of Englad for a loan, soon after this was reported they had a run on the bank, people were queueing to get their money out. In February 2008 the bank was nationalised after two failed takeover bids refused to guarantee people's money. House prices began to fall in the UK in response to over inflated prices previously, the housing market bubble had well and truly burst.


Two US banks went bust, Bear Stearns and Lehman Brothers. This was declared the start of the financial crisis. I would debate this as I think the start of the financial crisis happened when Gordon Brown gave banks the licence to print money and let them regulate themselves. Think Lord of the Flies with Saville Row suits.


It wasn't all doom and gloom during this period China and India were thriving in this low competition environment, this did further compound our problems though as their high demand for oil was driving costs up resulting in higher food, energy and living costs.


The British Government went about trying to salvage the situation by spending taxpayers money on nationalising banks. I questioned at the time why shouldn't banks be allowed to fail?
Peoples money, savings, investments, houses, jobs......oh right, that's why. Then Gordon Brown should never have let the banks off their leads, he created a monster. *he didn't actually create the monster he just turned a blind eye (no pun intended) to the havoc they were causing.
Well in that case why aren't the bankers being sacked? Why are they still received bile inducing bonuses? Now they know they are too big to fail, they've got a confirmation sticker. Who regulates for greed?
And no Gordon Gekko, this amount of greed is not good, nor sustainable.


In summary the credit crunch was caused by an idea that we could have it all, the banks supported this idea and encouraged us to take on more and more debt. The credit bubble didn't just burst for the banks, it burst for the consumer as well. The financial hardships that we suffer now are a direct result of us paying back for what we shouldn't have had in the first place. It wasn't just the banks that are to blame, just because a loan is offered we don't have to take it, our responsible selves should have spoken up and said no, you just cannot afford it.

Mergers and Acquisitions; impossible dream?

This week’s lecture was about mergers and acquisitions. Having previously read that 70% of mergers go badly (Forbes.com) leading to a potential destruction of shareholder wealth; why would any CEO decide a merger or acquisition was better than an alternative investment?

The Guardian (British M+A dealmaking at four-year high) shows that during the first period in 2011 the demand for mergers and acquisitions was there, especially in the energy markets with BP’s investment in the oil fields owned by India’s Reliance Industries and Ensco’s takeover of Pride International.

BP’s interest in an investment in India is prudent due to the current economic growth rate of India (www.bbc.co.uk India growth rate rises to 8.8%) which increases demand for oil production. This merger will maximise shareholder wealth by moving into a high demand market increasing market share.

This merger decreases BP’s reliance on the oil fields in the uncertain Arab nations due to the recent uprisings and the possibility of the contagion spreading to other oil rich dictatorships. BP’s merger hasn’t yet been finalised but it would be an example of a horizontal merger as it deals in oil refinery.

The tutor gave us a challenge to find a successful vertical merger. My example would be the merger between Alliance and Boots Plc in 2006. Alliance produces pharmaceuticals and through merging with Boots Plc it reduced its reliance on outlets for it’s products therefore reducing costs and maximised shareholder wealth to both Boots and Alliance now known Alliance Boots Plc and trading at 1986p per share an increase of nearly 1300p per share.

This example shows that when a merger goes well it maximises shareholder wealth by double and this is what all CEO’s should be trying to attain.