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Chapter 7
3.7 Capital structure in the real world
In practice, entities should be advised to use some debt finance in the capital
structure in order to reduce the WACC.
However, at high levels of gearing, the M & M assumptions break down, so
companies in the real world should not aim for extremely high gearing levels.
This then leaves the problem of how companies should determine
their capital structures in the real world.
The main practical considerations are:
Debt capacity – a function of the company’s creditworthiness and credit
scoring.
Existing debt covenants – management must keep plenty of ‘leeway’ or
‘headroom’ to ensure that the flexibility of the company is maximised.
Increasing costs of debt finance as gearing rises
Tax exhaustion – at some point the interest payable will be so high that
taxable profit will be reduced to zero. Beyond this point, there will be no
further benefit of raising debt finance.
Views of other stakeholders – for example, customers may be concerned
about buying goods from companies that have poor credit worthiness (due
to concerns about warranties and guarantees being honoured), suppliers
might not want to supply, or advance credit (due to the risk of default), and
employees might choose to leave if they fear for their job security.
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