Brice BOUVIER

Student Number - 07155935

3BUS0025 - Accounting Dissertation

Ethics Approval Number -

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CHAPTER ONE - INTRODUCTION ....................................................................... 3 Abstract ...................................................................................................... 3 Background ................................................................................................. 3 Summary..................................................................................................... 3 Methodology .............................................................................................. 4

CHAPTER TWO - LITERATURE REVIEW............................................................... 5 Explanation of the basic concepts ............................................................... 5 The gearing: A trip through history.............................................................. 8

CHAPTER THREE - METHODOLOGY.................................................................. 15

CHAPTER FOUR - DATA GATHERING AND ANALYSIS .....................................17 The case of Eurotunnel ...............................................................................17 The case of British Airways .........................................................................22

CHAPTER FIVE - CONCLUSION.......................................................................... 25 Going further… ...........................................................................................26

Bibliography .................................................................................................... 28

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CHAPTER ONE Introduction Abstract In today’s business world, there are few central problems. One of them concerns the concept of stakeholders’ wealth maximization. Over the last 50 years, many questions concerning the optimization of stakeholders’ wealth arose from the different scandals such as Enron, Worldcom or Parmalat. One of the most discussed area is how to optimize the capital of companies in order to maximize the stakeholders wealth? This question is the central problem of the following dissertation.

Background The debt and equity have always been opposed in the discussions concerning the capital structure’s optimization. The concept of capital’s optimization is one of the major discussion of the modern corporate finance theory. It has been first evoked by Modigliani and Miller (MnM’s) in 1958, that is to say 50 Years ago. But nowadays, after many years of discussion, it has been stated that « Financial economics has a rich literature analyzing the capital structure decision in qualitative terms. But it has provided relatively little specific guidance. In contrast with the precision offered by the Black and Scholes option pricing model and its extensions, the theory addressing capital structure remains distressingly imprecise. This has limited its application to corporate decision making… ». Hayne E. Leland For the fiftieth anniversary of Modigliani and Miller’s theorem, I have decided to try to sum up all these discussions and apply the framework thus created to two concrete and recent examples: Eurotunnel and British Airways. These example should allow us to go deeper in the analysis of the problem and draw trends useful for companies.

Summary The following dissertation is about the concept of capitals optimizations in order to maximize stake holders wealth. Along the next chapters we will go through the problem of choosing the financing method of a company: debt, equity or a mix of both? Each one has its own strengths and weaknesses. Therefore, the difficult trick is to find the optimal balance between them, in order to minimize the cost of capital and creating more money from the investments. But the optimal ratio of debt and equity (also called level of gearing and leverage), depends of many factors which could have an infinitely different impact on the company in practice that it was forecasted in theory. Finally, in the conclusion, we will also try to explore other methods to improve the efficiency of a capital.

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Methodology This dissertation is made exclusively from secondary data for two different reasons: On one hand, the theme of the dissertation is very complex and technical. As a result, it is not possible to do a questionnaire. In order to get representative data, we would need many answers to this questionnaire. And because this questionnaire is exclusively for Finance managers, it would be too difficult to obtain reliable results. Moreover, the subject does not require the analysis of a particular social situation.

On another hand, using primary data is very time consuming and this dissertation has been started only few weeks before the submission deadline, but the quality must not be sacrificed in favor of productivity. As an Erasmus student in a double degree exchange and at the beginning of the academic year, my home institution told me that I should not be doing a dissertation. But just before Christmas, I have been informed that I should do this work. As a result, the ethical approval needed to be quickly organized. After all the administrative approach (meeting with the Erasmus Tutor, meeting with the dissertation module leader and then with my dissertation’s supervisor), we were in February, that is to say too late for primary data gathering.

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CHAPTER TWO Literature review The understanding of the problem explored by this dissertation goes through the understanding of many concepts of Finance and their interactions. This literature review aims to explain to the reader these concepts.

Explanation of the basic concepts Stakeholders’ Wealth: The very first idea to develop is the concept of stakeholder wealth. This is the one of the most important of modern corporate finance. In theory, every decision should be made in the objective of maximizing the value of the firm and therefore, the stakeholders’ wealth. It could be made by different methods: the shares’ price maximization, the dividend decisions… But these two different methods are inter-related: If the decision is made to pay a high dividend, the amount of intern finance available for an investment is lower. Thus, some good investments could be give up and the value of the firm expressed by the stock price could go down. On the contrary, an increase in the dividends paid to stakeholders could be perceived by the market as a sign of good financial health of the company. For this reason, the share demand would go up and thereby, the share’s price would do the same We could sum up this mechanism by saying that the dividend payment could influence positively but also negatively the stakeholder’s wealth.

The relation between risk and return: This is also a very basic concept of corporate Finance. The risk and the return are highly linked one to each other. The relation is due to the fact that the return generated by an investment could never be guaranteed at 100%. However, some investments have a lower risk than others. The risk could be broke up into 2 different nature of risk which form the global risk: -

The systematic risk which is the risk associated to systematic factors like economic cycles, political factors, or foreign exchange market. The unsystematic risk is the risk linked to a specific investment, that is to say the risk that a specific company goes to bankruptcy.

If someone invests a certain amount of money in a low risk activity, the required rate of return will be lower than the required rate of a risky invest. There are no rational person which would invest in a high risk deal with a low rate of return.

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However, even if the systematic risk is unavoidable, a widely used theory appeared to remove the unsystematic risk. Markowitz’s theory proves that the more we invest in shares that offset one each other, the more the unsystematic risk is reduced. In other words, to reduce the unsystematic risk, we should invest in shares which are not similar. The commonly used example is an umbrella and an ice cream. If the weather is bad, we would rather buy umbrella for the rain and the coldness would not make us buy an ice cream. One the contrary, if the weather is hot, nobody would buy an umbrella and many people would want a refreshing ice cream. Thus, the two investments (in our example umbrella and ice cream) are linked together and the loss generated by one of the investment is balanced by the gain of the other one. As a result, and if we invest in many different shares, the unsystematic risk can be diversified away. Markowitz’s theory quantifies this This relation between risk and return has to play a very important role for both investors and companies. Indeed for an investor, it could have an effect on the volatility in the returns of the investments whereas for a company, the relation risk-return could influence the projects cash flows and thus, the stakeholders’ wealth.

The cost of capital and the investments decisions: Here is another key concept to understand better the issue of this dissertation’s subject. The cost of capital is “the rate of return required by investors supplying funds to a company and so the minimum rate of return required on prospective projects” (Watson & Heads). The cost of capital is the reason why a company will lose money on an investment with a very low rate of return (i.e. a rate lower than the cost of capital). Therefore, every project should yield at least the cost of capital to consider it as a “break even” project. The Weighted Average Cost of Capital (WACC) is determined by valuation of every individual source of finance such as the equity and the debt. This WACC is really used in the investment appraisal methods. As an example, we could show the Net Present Value method expressed by this relation: ࡺࡼࢂ = Where

‫ܥ‬ଵ ‫ܥ‬ଶ ‫ܥ‬௡ + + ⋯+ − ‫ܫ‬଴ ଶ (1 + ‫( )ݎ‬1 + ‫)ݎ‬ (1 + ‫)ݎ‬௡

‫ܫ‬଴ = The initial investment ‫ܥ‬ଵ,ଶ,௡ = The project cash flows of each years r = The cost of capital

Here, we can see that the cost of capital is a basis of the calculation. Thus, the cost of equity and the cost of debt must be taken into consideration to make investment decisions.

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Strengths and weaknesses of Equity finance The equity finance is the part of the capital which incurs the risk of the business, that is to say the part of the capital the most likely to fluctuate. The equity capital is commonly referred as the ordinary shares but includes also the less frequent preference shares or the retained earnings. This source of finance is really important but some specificities make it an expensive one for the companies. In case of the liquidation of the company, the equity is paid off only after the debts were paid off. As a consequence, the equity could be considered as more risky than the debt and the required rate of return is higher. But the equity could also be dangerous. Indeed, the purchase of an ordinary share gives important rights to shareholders: attend general meetings, vote on appointment of new directors and auditors. As a consequence, ordinary share holders have a power on the company. Moreover, for a company listed on the stock exchange, anyone can buy the ordinary shares, including the competitors… To complete the weaknesses of equity, we should also explain that it could lower the Earnings per share. Indeed, if there are a lot of shares available to investors, the earnings per shares are consequently lower. Moreover, a lot of share can be translated in a important offer compared to the demand and thus, the price of the share could go down. At this point of the reflection, it is right to wonder why companies do keep using this external source of finance. The answer fit in one word: Safety. Safety because the some -

-

The equity is not contractually remunerated, that is to say that one of the two source of profit for shareholders are the dividends agreed to be paid. In other words, the companies does not have liabilities to meet. If something goes wrong in the business during the year, there are no obligation to pay the dividends to shareholders at the end of the period. The equity does not have a repayment date, that is to say that the companies will not have to pay back the money initially invested in an agreed period of time. That removes an important obligation for the companies. However, shareholders will be able to earn money in the form of an increase or a decrease in the shares’ price. The difference of the original price and the selling price would therefore be a profit or a loss.

Strengths and weaknesses of Debt finance The debt could be considered as the competitor of the Equity finance because it is the other way of raising external Finance. It has also strengths and weaknesses, significantly different than the equity finance’ ones. First of all, we must say that a debt finance implies 2 important factors: -

There are interests to pay to debt holders. All along the duration of the loan, the company will have liabilities in terms of money to spend, in order to pay the providers of debt finance. Another weakness of debt finance is that the capital must be repaid. That adds a new obligation to the company.

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As a consequence of these remarks -and it is the major difference with equity finance- the company must meet liabilities during the period. In the case of really poor results, the company might be unable to pay back the interests plus the capital. The insolvency is the reason why a firm in financial distress could be put into liquidation. Additionally, when a company is in that situation, an order concerning the repayments is provided by the law: First of all, the debt holders and at a last time the shareholders. That legal factor makes the debt less risky for the companies. And according to the expression “Higher the risk, the higher the required rate of return”, the Cost of Debt is lower than the Cost of Equity. Then, the debt could be considered as a cheap source of finance But the assets of this source of finance does not stop here. The debt is also widely used because it acts as a tax shield. Indeed, the tax will be lower for a debt financed company than for a equity financed company because the interests paid on a debt are deductible from the operating profit. This demonstration proves that mechanism: Hi Debt

Low debt

Ordinary shares 10% Debt Finance (£m)

400 100 500

490 10 500

Operating Profit Interests paid Profit Before Tax Tax (@ 30%)

80 10 70 21

80 1 79 23,7

Moreover, because borrowing money does not give any decision rights in the company, the debt does imply a loss of control. Finally we should say that the debt is really quick to raise and brings flexibility to the finance of the company.

The gearing: A trip through history. In this dissertation, we try to find a way to maximize the stakeholders’ wealth, that is to say both shareholders and debt holders’ wealth. To do so, we must make sure that the market value of the firm is as high as possible. This maximization of the value can be ensured by the maximization of the net present value of company’s future cash flows. Then, the best thing to do is to find an optimal balance between debt and equity in order to determine the lower Weighted Average Cost of Capital (WACC).

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Modigliani and Miller I (1958) The first theory arose from Modigliani and miller in 1958, a half-century ago. At that time, Modigliani an Miller argues that “in a perfect market, the market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent of the way it chooses to finance its investments”. Here, we should understand that the WACC remains the same, even if the gearing ratio (Debt/equity) goes up. As a consequence, there is no optimal capital structure:

Cost of capital (%) Cost of Equity

WACC

α

Cost of Debt 0

Level of Gearing

In this graphical representation of M and M’s theory I, the cost of equity increases in a linear way because the more the gearing ratio increases, the more the financial risk increases for equity. Indeed, if the gearing is high, there is more volatility of the distributable profits because of interest payments. However, the cost of debt remains constant because there is no bankruptcy risk in a perfect market. If α represents a 100% equity financed company, we can highlight the fact that if the firm changes his equity into debt, the WACC does not fluctuate because the savings made by the use of debt as a cheaper source of finance is canceled by the increasing cost of the equity left. This theory (referred as Miller and Modigliani I) assumed that were no taxes. That has been criticized by a lot of academics. Moreover, MM I tends to understate the cost of borrowing for small companies and individual.

Modigliani and Miller II (1963) As a result to the discussions, M and M produced a second paper in 1963 in which they review their view including the concept of tax. As demonstrated above, one of the features enjoyed by companies using debt is the tax shield. Thus, if the tax is considered by Modigliani and Miller’s theorem, their prior vision of a WACC independent from level of gearing needed to be revised. In this paper, they admit the existence of tax and incorporate it to their view:

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Cost of capital (%) Cost of Equity

WACC

Cost of Debt after tax 0

Level of Gearing

On that graph, we can see that the cost of equity stays the same because the financial risk remains the same. However, we can see that the cost of debt decreases to incorporate the tax deduction allowed by the debt finance. As a result the more we increase the gearing ratio and the more the Weighted Average Cost of Capital decreases. This relation maximises the stake holders’ wealth because if the WACC is low, the net cash flows generated by investments are higher. But this new position of Modigliani and Miller makes us wonder instantly why shouldn’t we finance companies with 100% debt finance? But even after the second paper from Miller and Modigliani, companies does not show all debt capitals. Many researches has been carried out to find which factor(s) Modigliani and Miller failed to consider. Three were found: -

Bankruptcy cost: In their newly published model, they assumed that the market was perfect and as a consequence, that there were no bankruptcy risk. Indeed, in a perfect market, the companies can always raise finance to balance the losses. But ignoring the possibility of bankrupt implied a lack of credibility and therefore, the theory did not stood up in practice. Indeed, as risk is often associated to cost, the cost of bankruptcy were spread into direct and indirect costs. The direct costs is the cost of paying more interests if the risk increases or, in case of liquidation, the administrative cost of hiring attorneys and accounting people. The indirect cost is the cost of trying to avoid bankruptcy by selling assets in order to meet the interest payments. If this bankruptcy risk is taken into consideration, a new model of Modigliani and Miller can be created. In that model and at high levels of gearing, the tax shield created by the increasing gearing ratio is countered by the increasing bankruptcy risk: Market Value

Market Value with tax shield only Y

W

X

0

B

Influence of bankruptcy risk on market value

Level of Gearing

That could be explained easily. At low levels, the more we increase the leverage, the more the company enjoys tax shield. But when the gearing becomes higher and because the

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market cannot be perfect, bankruptcy risk appears. This bankruptcy risk is faced by stakeholders and thus, the cost of capital increases and the market value decreases. From this graph, some assumptions could be made. The value between [WX] and the blue dotted line represents the value of the tax shield according to the gearing ratio. Up to a gearing ratio equals to B, the bankruptcy cost does not counter the benefits enjoyed by the tax shield of the debt. Finally, Y represents the optimal market value of the company and B represents the optimal level of gearing. -

Agency cost: At very high level of leverage, the agency problem goes to a higher extent. The agency problem, or the divergence of objective between managers and owners can be explained as follows:

Debt Holders

Equity Holders

0

Level Risk Level ofof Risk

These arrows represents the behaviour behaviour of the two kind of provider of external finance reading to the increase of the gearing ratio. On one hand we find the debt holder who have an important interest in the company. But this interest does NOT depend of the results generated by high risk projects. projects. As a result they will want to avoid risk to keep their investment safe and ensure that the company will keep paying its interests. Thus, they will tend to set up mechanisms to monitoring the managers and their decisions. This mechanism has a cost and must be taken into consideration when applying Modigliani and Miller’s theory to practice. On another hand, the share holders have a smaller investment in the company and thereby, they have less to risk. Because they earn money in function of the firm’s profitability, they will try to increase the risk of the projects undertaken by managers, in order to maximize their profits. As represented by the exhibit above, the preferences of equity holders and debt holders are antagonistic and the effort made made by each part of the company have a cost which becomes significant at very high levels of gearing.

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-

Tax exhaustion: According to Watson and Head, a highly geared company can become tax exhausted. Simplified, the benefits of tax shield and others features of high gearing become insufficient compared to the risk taken by the company (interests payments, bankruptcy etc).

Finally in 1977, Miller decided to integrate the different levels of taxes (personal and corporate) to the model provided in their second paper in order to be closer from reality. He argued that when the investments are balanced, each one suits its investors’ tax situation (corporate or personal tax). If the company needs to increase its gearing ratio, the equity holders would be motivated only by a more attractive rate of return. Yet, this rate’s increase would delete the benefits of the tax shield provided by the debt finance. That is translated in a flat line representing the WACC in function of the gearing ratio. In this new model, the bankruptcy risk were not considered. But if we incorporate it, we have the following relation:

Cost of Capital (%) WACC

0

Level of Gearing

As a result, there are no optimal capital structure. The companies just have to make sure that the gearing ratio is not too high because the bankruptcy risk would make the WACC rocketing.

The traditional approach We have just shown that Modigliani and Miller’s view had shown its limits. But a “competitor” exists. The traditional approach is based on the effects of 4 classes of risks: I II III IV

-

The Risk free rate: which is the lowest required rate of return of an investor. The Business risk: is the risk occurring from a firm’s operations. The Financial risk: represents the risk associated with the level of gearing. The Bankruptcy risk: is the required rate of return related to the risk faced by shareholders which will be the last to get their investment back in case of liquidation.

Now, we should say that the equity depends of the whole classes of risk but that the debt is only related to the risk free rate and the bankruptcy risk, but at a higher level of gearing than for shareholders.

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Required rate of return

IV III II I 0

Level of Gearing Exhibit - Structure of Equity Finance’s Risk and its relation with the required rate of return

Required rate of return

IV I 0

Level of Gearing Exhibit - Structure of Debt Finance’s Risk and its relation with the required rate of return

The traditional approach considers the balance between these 2 structures and tries to define an optimal WACC: Cost of equity Cost of Capital (%) WACC

Cost of debt

0

α

Level of Gearing

Exhibit – Reaction of the WACC to the increasing gearing ratio, the traditional view.

In this exhibit, we can see that α represents the optimal gearing ratio. At α the WACC is the smallest and thus, the cash flows generated by the projects are maximized, and as a consequence the stakeholders wealth is also improved.

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But this view is not perfect neither because like Modigliani and Miller, some assumption were made to build this approach: the taxes are not considered, there are no other choice than ordinary shares or debt. Moreover, the cost of changing equity into debt is absent. Therefore, many factors can avoid this theory to stand up in practice.

Pecking order theory Finally, there is also an alternative theory which focuses more on an hierarchy of the sources rather than a balance between debt and equity. Donaldson (1961) says that the first source of finance should be internal finance or retained earnings. Thus, the retained earnings should be the first source of finance because there is no issuing costs and the access is really easy. If the company has used all the available internal finance, additional finance can be raised by borrowing money because the firms can borrow little amounts of money and because the cost of issue is smaller than for equity finance. Ultimately, the companies can raise finance by issuing new shares.

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CHAPTER THREE Methodology The redaction of a dissertation is a long and demanding task. It requires a lot of self motivation, sacrifices and overall a perfect organization in order to meet all the deadlines. To explain which has been my approach to the research methods used, I have to explain my situation. I am a French Student in exchange at the University of Hertfordshire. The Erasmus’ program allowed me to come to this university and prepare a double degree. But the UoH has different policies than my home institution (IPAG). Indeed in Hertfordshire University, the preparation of a dissertation is not a requirement to succeed and graduate. However, in France, the dissertation is absolutely required for the students who are doing their semester in France. Moreover, it is stated in IPAG’s terms and conditions that concerning the students who prepare a double degree in a partner institution, their only objective to obtain IPAG’s diploma is to meet the requirements of the partner (i.e. the university of Hertfordshire in my case) Just before my departure for the United Kingdom, I asked for an appointment with my French tutor at IPAG. At this moment, it was decided that according to the rule I have just explained, I did not needed to register for a dissertation. As a consequence, I decided to pick up other interesting courses instead of a dissertation. But unfortunately, in just few days before Christmas’ break, my school changed side and informed me that I needed to do a dissertation to fulfill IPAG’s requirements. That was impossible for me to settle this problem before the break because all the university’s tutors were busy. Back in January, I organized meeting with Erasmus supervisor, Mike Rosier we sent me to the dissertations’ tutor: Marie Ashwin. After that, there were additional delays to find my supervisor, Emad Awadallah and meet him. As a result I started my dissertation only 8 weeks before the deadline. This short period of time implied that I should use only secondary data, as long as primary data are slow to be gathered and difficult to exploit. Indeed, primary data are really time consuming but they are also difficult to exploit because the validity of the findings can be discussed. Primary data can be influence by many factors such as the context in which you do your study, where you do your study etc. In other word, the sample questioned can be not representative of the reality. Moreover, as Delbridge and Kirkpatrik (1994) stated: “because we are part of the social world we are studying we cannot detach from it, or for that matters relying on our common sense knowledge and life experience when we try to interpret it.” Moreover, the subject of this dissertation is complex and primary data’s colleting would have been made only in companies, by asking the finance team. Hence, it is not as easy as administrate a questionnaire in the streets: access to organizations can be difficult.

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Finally, I have been forced to use exclusively secondary data. Thanks to some literature on research methods, I realized that re analyzing data that have already being collected could be useful to find answers to my core problem, how to maximize stakeholders’ wealth (Hakim, 1982). Being short in time and abroad for Easter break, I have decided to base the main part of my researches on Internet. Indeed, unlike for a library, Internet is accessible even if you are not at home. Moreover, the access to databases such as Fame or Marketline are really eased thanks to Athens, a method to confirm that you are a student of a university which has access to the resource. Moreover, the University’s intranet (studynet) has been of a great help. Indeed, thanks to this resource, I had the possibility to access the PowerPoint of courses I did not registered for. Concerning the books, some of my text book were vital to the explanation in the second chapter (literature review). Moreover, I came back few days before the due date so that I can access additional information from the LRC. The short term loan allowed me to change some details and make the dissertation illustrated better. The LRC is a true gold mine and we, students, are very lucky to have the possibility to enjoy the benefits of such an important centralization of information. Internet allowed me to look for financial data. Indeed, every company has to produce an annual report which makes all the financial data available to public. This has been useful because it allowed me to study the stories of Eurotunnel and British Airways. All the researches about Eurotunnel were carried out in French because really much more information are available in French than in English. Finally, I have also used newspapers archives on the websites. The Financial Times’ website is really complete and provides an access to a large range of sources.

To sum up, using Secondary data enabled me to save time and money in research. I have been able to access high quality data (Stewart and Kamins, 1993) and quickly. Moreover, the data I accessed were permanent in time and as a consequence, my dissertation will be useable even in ten years. If I would have used primary data, the phenomenon observed could have been changed over the years. Other considerable feature, by searching for a data, I often found other data useful for other parts of the dissertation. I even remember that if I would not have used secondary data, the widening of the area in the conclusion would not exist.

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CHAPTER FOUR Data gathering and analysis As a following to the lens described in chapter 2, I have decided to study the position of different firms, in order to test the different theories and see which one can be verified or undermined.

The case of Eurotunnel Story of a financial chaos The first one which will be explorer is EUROTUNNEL. Eurotunnel is a private group, owned by a mix of French and British entities and split into two major companies Eurotunnel SA for France and Eurotunnel PLC for the United Kingdom. This group were created in august 1986. Right away, Eurotunnel signed a contract with TransManche Link (TML) to start the engineering works to dig the channel tunnel. As you can imagine, this titanic project had a more than significant cost. However, a bank report written in 1984 calculated that the project was sustainable. For this reasons, many private companies invested in it, unlike the governments: “Not a public penny”, Margaret Thatcher, February 1986. From a financial point of view, the first problem occurred because of two parameters: -

-

The duration of the works. Indeed, the tunnel were ready to be exploited 1 year later. Moreover, the money has a time value. It is often illustrated by this question: would you prefer £100 now or £100 in one year’s time? The channel tunnel works lasted more than 6 years during which no exploitation were possible. Hence, once operating needed to be more profitable than forecasted. The cost of the works. In 1987 (before the launch of the construction), they were estimated at about €7.5 billion while they appeared to be more than twice in practice: €16 billions. To raise this amount of finance, money were borrowed from banks and the interests payments generated could make the profit decrease and even becoming negative. In addition and as if it were not enough, the forecasted traffic appeared to be over-estimated. The optimistic studies announced 30 millions of people transferred and 15 millions of tons of freight moved, per annum. In reality, the first year of exploitation the traffic were made of 6,8 millions of passengers (-77.6%) and 1,5 millions of tons of freight moved (-90%).

The financial situation of the company became very alarming and the tax on benefits were 59%. Hence, a solution needed to be found to match the liabilities. To face this event, the company started to raise debt finance:

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S/H Funds

Debt

Cap. Emp.

Debt Ratio

1988

998

177

1,175

15.06 %

1991

1,556

3,559

5,115

69.60 %

1994

1,740

8,022

9,762

82.18 %

1997

336

8,884

9,220

96.36 %

But in 1997, the company barely avoided bankruptcy and a restructuration of the capital were decided with banks. Indeed, the revenues were really lower than the expected ones and did not permitted to pay the interests. Thereby, the situation had to be regulated. In 1998, the discussions ended up with the decision of creating a restructuration plan. Bank finally took a bigger part of Eurotunnel’s capital and accepted to replace their debt by shares. The Eurotunnel’s capitalization is maintained thanks to a share issue signed by the historical individual shareholders to prevent from bankruptcy and hence, to protect their investment. The position seemed to find an equilibrium. In march 1998, Eurotunnel announces its first operating profits. One year later, in 1999, the company announces its first net profits and plans to pay back some of its debts. But the restructuring were not that easy. Remaining debts remained too important and the situation of underestimated cost and overestimated profits disabled the pay backs. In terms of numbers, we can say that their own capital stock were estimated at €1.7 billion, while the huge debt stayed at €9 billion, 10 time a year’s turnover. Moreover the interests payable in 2003 were €500 million, almost 60% of 2003’s turnover. Other scandal generated by the case Eurotunnel, the group of shareholders defended by an association (created only for this purpose) tries to remove the current directors of Eurotunnel. Obviously there is a divergence of objective between shareholders and directors. In April 2005, the fight is won by the shareholders and the director of Eurotunnel is replaced: Richard Shirrefs gives his seat to Jean-Louis Raymond, which will be replaced in June 2005 by Jacques Gounon, the current director. Finally, a last step in this chaos is notable: In august 2006, the French government accepts to put Eurotunnel under the protection of a process called “safeguard”. That allows the firm to freeze its interests’ payments for a duration of 6 months, renewable 2 times. That gives time for the company to restructure its finance. As a result, a public offer of exchange is proposed and 87% of the shareholders agreed to this offer. It is more than enough to create a new company: GetSA is born. Thanks to this mechanism, bankruptcy is avoided and the value of the debt is divided by two. Nowadays, GetSA works well despite the crisis of the subprime. The direction has even announced that they will pay back half of the ORA II in cash, that is to say paying back more bonds than expected. This will save about €35 million a year and increase the Earnings Per Share because the

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bonds will not be transformed in shares but paid back in cash. The strength of the Euro will permit GetSA to issue less shares than if the bond would have matured.

Connection with theories At this stage of the study, we can apply to this case some of the theories of Modigliani and Miller: We can see that the debt has increased a lot over the time. Eurotunnel did not seemed to face a bankruptcy risk because the debt ratio reaches a pick in 97 with 96.36%. In other words in 1997, Eurotunnel was almost completely debt financed whereas in 1988, the company was mainly equity financed. But the fluctuations in the capital employed can be divided into 2 families: -

-

Increasing both equity and debt: Between 1988 and 1991, Eurotunnel had increased its shareholders funds of 56% but in the same time, their debt increased of 1911%. From 91 to 94, the equity increases of just 12% and debt improved of 124%. We can conclude that the firm had a large preference for debt finance, despite the negative features such as interests payments. Increasing debt and reduce equity: The firm goes further in the process of raising debt finance. In the three years between 1994 and 1997, the debt increased by 11% and the equity were reduced of 80.7%.

I would be tempted to say that the purpose of this preference for debt finance is related to the level of tax carried by Eurotunnel (59% of benefits). The tax shield generated by the debt would help to keep the stakeholders happy, at least as long as the company does not face bankruptcy risk. We could say that this history proves the inefficiency of both Modigliani and Miller I and Modigliani and Miller II. Indeed, we can see that the WACC depends at least partly of the debt and equity ratio. Eurotunnel has decided to borrow money to cover the underestimated cost and overestimated traffic. Thus, they increase their gearing ratio up to 1997 where the debt represents more than 96% of the capital. Then, the payment of interests becomes impossible and the company is almost bankrupted. That invalidates the first theory because WACC became obviously too expensive at a high level of gearing and thereby, the proportion of debt against equity has an influence. Meanwhile, as the company failed to adopt an almost all-debt structure, it also proves the irrelevance of the second theory. Indeed, the savings generated by the tax shield does not balance the bankruptcy risk. The second model of Modigliani and Miller argues that the more we increase the gearing ratio, the more the tax savings are important and thus, the most the value of the company is maximized. Thanks to the case of Eurotunnel, we realize that this second theory does not stands up in practice. However, some elements can lead us closer the a relevant theory. The second study of Modigliani and Miller were investigated by many other researchers. The incorporation of the bankruptcy risk to that model seems to be closer the Eurotunnel’s situation.

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Eurotunnel might have been further than B, level where the benefits of debt finance are overover canceled by the bankruptcy risk. Moreover, the recent events of the share holders who wants to replace the current directors implies that agency cost could exist. Of course, these costs will not help Eurotunnel to make the situation straight. Nevertheless, this graph tends to describe how would react a company to an increasing gearing ratio but not to a decreasing gearing ratio. Thus I would like to propose a new model which tries to identify and incorporate hidden costs such as agency cost and cost of changing debt into equity. Market Value

I

0 100%

II

III

Gearing ratio when replacing debt by equity

IV

0%

In the first part of this graph, we can notice that the market value is rocketing, a normal reaction to the decrease of the bankruptcy risk. The bankruptcy risk is removed and thus, the shareholders will require less money because the risk is lower. lower. Moreover, the market value tends to increase at a lower extent than in the prior graph read from right to left. Indeed the cost of changing debt in equity and the monitoring cost (agency costs) are notable and balance the gains created by the reduction of the bankruptcy risk. In the second part, we can see that the market value decreases quickly. This would be due to the fact that the decreasing financial risk (and hence the resulting decrease in cost of equity) is less important than the cost of changing changi and agency costs.

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In a third time, the financial situation finds an equilibrium and there is no more need for owners to monitor the managers. As a result, the decreasing financial risk enjoys more and more weight in the market value compared to the cost of changing going lonely. For this reason, the curve of the market value is flattening. Finally, in a fourth time, the market value does not fluctuate anymore in the total absence of agency costs, the cost of changing and the financial risk are cancelling one each other. Additional remark: This graphical representation does not tends to give an accurate idea of the optimal capital structure fixed in the time as long as the cost of changing is a punctual cost which can be spread if it is amortized d on a pre-determined pre determined period of time. As a conclusion, this relation is useful to understand better the treats pending on a strategy of exchanging debt into equity.

On another hand, another theory can be verified by the experience of Eurotunnel: the traditional trad approach.

In our case Eurotunnel adopted a too high level of gearing. A risk of bankruptcy appeared in 1994 and the cost of equity rocketed. For this reason Eurotunnel had the reflex of decreasing the equity by 80% between 1994 and 1997, while hile increasing the debt by 11% in order to maintain their capital. But as described in chapter 2, there is a hierarchy of pay back in case of liquidation: debt first and last, the equity. But their reflex increased the gearing ratio and the cost of debt rocketed r also. The underestimation of traffic implied that the firm was struggling with paying the interests to debt holders. Consequently, Eurotunnel was stuck in a too high level of gearing. Finally, they tried to replace debt by equity in order to pay less less interests and obtain a lower Weighted Average Cost of Capital. This theory is thus validated by the case of Eurotunnel. Finally, this story can also being compared to the pecking order theory. This theory says that the first source of finance should be internal finance or retained earnings. The problem for Eurotunnel is that there were no money coming in during the construction and that the duration plus the huge cost of the works were translated in a very high cost of capital. So, Eurotunnel had liabilities liabili to meet and no internal source of finance available. Needing additional finance and in accordance with Pecking Order Page 21

Theory, Eurotunnel decided to borrow money from banks. When this resource has been exhausted, they issued new shares to raise finance. Hence, the debt increased of 4432% between 1988 and 1994 while the equity was raised by 74%. The catastrophic situation of Eurotunnel make tempting the reasoning that Pecking Order Theory is not relevant. However, the problem arose more because of the unexpected cost of the project rather than from the source of finance chosen. For this reason, we can conclude that this experience cannot be related to the Pecking Order Theory.

The case of British Airways The story of a spectacular recapitalization British airways is the largest airways operator of the United Kingdom and one of the biggest European players. They operate on 147 different route in 75 countries, this firm is national and international. Its activity is widely developed as they transport passengers, freight and mail. British airways is a really complicated company as they own many subsidiaries and have many different franchisees. In terms of number, The company recorded revenues of £8,492 million during the fiscal year ended March 2007, an increase of 3.4% over 2006. But the situation has not always been bright.

Year ended

Passenger Flown

Turnover (£m)

Net Profit/loss (£m)

EPS (Pence)

March 31, 2007

33,068,000

8,492

438

25,5

March 31, 2006 (Restated)

32,432,000

8,213

464

40,4

March 31, 2005

35,717,000

7,772

392

35,2

March 31, 2004

36,103,000

7,56

130

12,1

March 31, 2003

38,019,000

7,688

72

6,7

March 31, 2002

40,004,000

8,34

-142

-13,2

March 31, 2001

36,221,000

9,278

114

10,5

March 31, 2000

36,346,000

8,94

-21

-2

March 31, 1999

37,090,000

8,915

206

19,5

March 31, 1998

34,377,000

8,642

460

44,7

March 31, 1997

33,440,000

8,359

553

55,7

March 31, 1996

32,272,000

7,76

473

49,4

From these data, four graph should be made: Page 22

On these graph, we can see that the profit rofit and earnings per shares are going down from 1997 to 2002.. It would have been normal if the Passengers flown would have decreased over the same period of time but the fact that the number of passengers carried increases leads us to search for another explanation. Moreover, this theory is reinforced by the analysis of the turnover as long as it does not fit the movement observed on the Net Profits and the EPS. In reality, this drop is due to an increase in oil price, the strength of the pound and the intense i competition. Furthermore, to o go deeper in this analysis, it is interesting to have a look at the gearing ratio for each financial year: Year ended March 31, 2007 March 31, 2006 (Restated) March 31, 2005 March 31, 2004 March 31, 2003 March 31, 2002 March 31, 2001 March 31, 2000 March 31, 1999 March 31, 1998

Gearing Ratio (%) 269,79 395,49 261,66 344,09 413,41 453,82 239,25 240,93 208,28 166,61

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We see there that from 1998, the gearing ratio increases. In 2001, it is multiplied by more than two to reach a pick at 454%. The EPS became very low because the company had to pay interests to debt holders. Therefore in 2002, a plan of recapitalization is decided by the directors. The problem is that to do so, British Airways would need to raise finance by issuing new shares. Unfortunately, this solution is not conceivable because the Earnings Per Share are already negative in 2002 and hence, a share issue would not settle the problem. British airways answered with a whimsically logic. British airways announced that they will sell their stake in Australia’s Qantas Airways to reduce their debt. They expected to rise more than £400 million thanks to this operation. Indeed, their debt is considerable and needs to be reduced. As a result this sale of stake explains the decrease in passengers flown and turnovers because part of BA’s activity is given up. Moreover after this chapter of recapitalization, the increase of profits and earnings per shares resumes

Connection with theories Here, we can start by saying that the theories which fail to take into consideration the costs of bankruptcy can be pulled away. Modigliani and miller I and II are proved to be inefficient because the bankruptcy risk (or the too important part of interests payments) is a reality. But the story of British Airways has not been chosen to show the accuracy of all the theories. Indeed, the most interesting part of this case is the way they financed this recapitalization. They decided to sell some of their assets, here a stake in a healthy company, in order to raise finance. They could have tried to issue new shares, even if it meant more sacrifices on the Earnings per Share. Finally, they decided to seek for internal finance. In accordance to the explanation made by Myers in 1984, may be that British Airways, by the way of asymmetry of information, knew that the market was overestimating the Qantas’ shares and underestimated the benefits of a recapitalization. Thus, British Airways could have decided to sell its stake in Qantas to enjoy the overestimations of the capital market and invest it in the underestimated project of reducing the debt. According to Pecking order Theory, there are no optimal structure for British airways and their decision are only made from an opportunist point of view. In other terms they might have decided to their share in Qantas and not another investment because they knew that the price they would receive would be overvalued. In any ways, British Airways operated o good operation with Qantas because they bought 25% stake in march 1993 for $665 million. In 2004, they sell their 18.5% remaining for $1120 million. If we want to compare, they bought 18.5% for $492 million (665*18.5/25 = 492). Ten years later, they sell for $1120 million, that is to say with a benefit of 128% (

ଵଵଶ଴ିସଽଶ ∗ ସଽଶ

100 = 128% ) solely with the shares’

price increases. Indeed, this calculation does not take into consideration the dividends. Thus, they increased the value of their investment at an average rate of 11.6% per year, a satisfying rate.

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CHAPTER FIVE Conclusion I would like to start our conclusion with a quote from Myers (2001): ‘‘There is no universal theory of the debt-equity choice, and no reason to expect one. There are several useful conditional theories however.’’ All along this dissertation, we focused the attention on the research of an optimal capital structure. Indeed, finding the appropriate balance (if it exists) would result in a minimization of the Weighted average cost of capital. If a company enjoys a low WACC, the investments will generate more profits. These profits will allow the firm to pay the interests to the debt holders, but also remunerate the equity holders with the one hand the fluctuations of the shares’ price and on the other hand, with the dividends. In the fourth chapter, we analyzed the really representative stories of 2 companies: Eurotunnel and British Airways. In order to reduce their Weighted Average Cost of Capital, these 2 companies decided to settle a strategy of recapitalization, that is to say replacing debt by equity finance. However, Eurotunnel and British Airways achieved their objective in two diametrically opposite ways. Eurotunnel decided to transform debt into equity in two times: -

-

Firstly they asked the banks (their debt holders) to transform the debt in ordinary shares. Thanks to the backup of the French and British governments, and because the required rate of return on equity is higher than for debt, the creditors accepted. In a second time they proposed a public offer of exchange. This mechanism allowed them cut half of the debt.

British Airways played a finest game. They sold one of their stake in an Australian airways company (Qantas). The money generated where thus used to pay back an important part of their debt and avoided the firm to keep paying the interests. Thanks to that, the growth of the company resumed.

These two concrete example leaded us to confirm or infirm some theories. As a result Modigliani and Miller were badly touched as long as they always failed to consider some factors, albeit vital in practice. These factors are the agency cost, the cost of changing and the bankruptcy costs. However, through these experiences, we have proved that the all debt companies do not survive in the real world. That forms an empirical evidence that bankruptcy risk must be considered. However, no experience proved the existence of an optimal capital structure. This can be construed as follows: Unfortunately, there is no optimal capital structure which can be found by an exact science such as mathematics. The capital structure seems to depend of many factors such as the strategic and financial issues of every single company. In this case, the theory can just give a general idea, a trend to find a solution. Indeed, to find a company’s optimal structure, the researcher will need to consider the financial health, the growth stage of the products to prevent from decreases in profits in case of

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a declining product, the aversion to risk of the company holders. Moreover, monitoring the market could be an advantage. Indeed, in the current context of the subprime, it would not be relevant to raise finance by an issue of ordinary shares. This relation is well illustrated by the following representation given in Corporate Finance, Principles and Practice, by Denzil Watson and Anthony Head:

WACC (%) Theoretical WACC

WACC in practice

0 B

α

C

Level of Gearing

We can see that the theory gives an optimal structure at a level α of gearing. On the contrary, the Weighted Average Cost of Capital observed in practice show that the WACC does not depend of the gearing level as long as it stays between the point B and C. However, the practice validates the theory according which extreme solution, in others words all equity or all debt firm, are devoted to failure because the WACC is maximized. To end up this first part of the conclusion, it has to be said that obviously the best source of finance is the internal one. The features enjoyed are as precious as gold: no hidden cost such as agency cost, transaction cost. Moreover and this is the most important concept to remember, internal Finance does not imply a transfer of decision power, nor the obligation to pay interests.

Going further… As a final thought, I would like to widen the area of that dissertation. All along this line and pages, we focused on the research of an equilibrium between debt and equity finance in order to maximize the profits of the investments. But there are may be other ways to raise finance and avoid the risks and weaknesses of debt and equity. The LBO, or Leverage Buy Out is a good example. So, what is a LBO? A LBO is a financial technique consisting in rising money in order to buy another company. You may wonder at this time what is the difference with borrowing money? Well, the difference is that the borrowed money will be paid back just after the takeover. The ‘predator’ company will use the exceeding treasury of the targeted firm to write off the debt. As an additional bonus, the predator will receive the dividends payments.

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This technique is discussed because it puts at risk the targeted company. But even if these mechanisms are criticized, it must be noted that this is a short term strategy.

In addition , the goal of this dissertation ids to find a way to maximize stakeholders’ wealth. But which organization could seek to maximize the wealth without looking for its protection? No one! One method to protect the debt holders and equity holders is to follow the theorem of Markowitz which explains that in order to spread risk away, the companies should invest in different shares who offset one each other. This Concept can be translated to the currencies of the capital. Indeed, the currency of a capital in a company which as an international activity should not be in a unique currency. Having a capital divided in many currencies would prevent the firm’s against devaluations. Indeed, the relation risk return is useful here. If the company has a capital with US dollars, Pounds and Euros, the probability for a devaluation of one of the currencies is higher than the probability that the 3 currencies lose their strength in the same time. In fact, the only possibility would be a crash in the world’s economy or a World War. However, the recent crisis of the subprime in the United Stated can be considered as a threat. Indeed, the unbalanced American economy seems to infect the others economies of the world such as the European Union or the Japan.

Word Count -9250Limit = 9,000 to 11,00

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Bibliography NEWSPAPERS: Business: The Company File Tunnel vision: the Eurotunnel story, March 1999, http://news.bbc.co.uk/1/hi/business/the_company_file/297115.stm http://www.lesechos.fr/ BA to raise £435 m in sale of Qantas stake. Leora Moldofsky, Financial Times, 8 september 2004. http://search.ft.com/ftArticle?queryText=BA+to+raise+%C2%A3435+m+in+sale+of+Qantas+stake&y= 10&aje=true&x=9&id=040908001518&ct=0&nclick_check=1

WEBSITES: Quotes from http://www.boursorama.com and yahoo finance: http://uk.finance.yahoo.com/ EUROTUNNEL : succès de la première phase de l'augmentation de capital, March 2008, http://www.boursorama.com/infos/actualites/detail_actu_societes.phtml?&symbole=1rPGET&news =5220476 La chronologie d`Eurotunnel, June 2007. http://www.boursorama.com/forum/message.phtml?page=1&id_message=361698028 Eurotunnel: Goldman Sachs pourrait pointer à 20% du capital, March 2008. http://www.boursorama.com/infos/actualites/detail_actu_societes.phtml?&symbole=1rPGET&news =5225779

TEXTBOOKS : Corporate Finance and investment. Decisions & Strategies, Pike and Neale, Prentice hall, 5th Edition. Corporate Finance, Principles & Practice, Denzil Watson and Anthony Head, Prentice Hall, Fourth edition

COMPANY REPORTS : Eurotunnel’s Annual Reports, http://www.eurotunnel.fr/frcP3Main/frcCorporate/frcFinancialData/frcFinancialReports/frpAnnualR eports British Airways’ Annual reports, http://www.bashares.com/phoenix.zhtml?c=69499&p=IROL-index

DATABASES: Fame, company information in an instant, https://fame.bvdep.com/version2008317/cgi/template.dll Marketline, http://www.marketlineinfo.com/library/default.aspx

COURSES 3BUS0210 - Business Finance (Semester A 2007/8), Mme Jane Fletcher, University of Hertfordshire 3BUS0260 - Corporate Finance (Semester A 2007/8), Mr Edward Kerr, University of Hertfordshire

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