Glas Cymru Capital Structure.
Summary of the Article
Glas Cymru, a non-profit making organization, headed by the former treasury secretary, Lord
Burns is on the front line fighting for the company to be fully financed from external debt instead
of the traditional shareholders ownership. Glas Cymru is finalising its plans to acquire the
principality’s water supplier at the cost of two billion pounds sterling. For the deal to go through,
Glas Cymru needs to raise this amount of money through the sale of long-term bonds to
prospective investors. This move intends to keep the firm’s cost of capital within the two
percentage points below the recommended level. The major objective of Glas Cymru’s total
financing of investment on debt capital as opposed to equity capital is to save the cost of equity
capital. These adds to approximately 4 to 4.5% of its regular cost of capital on savings.
Since other similar investments have suffered due to diversification, Glas Cymru will keep the
funds squarely in the water sector because it is monopolistic and promises a good return. Another
motivator that has led Glas Cymru to this deal is the fact that they are buying at a price that is
significantly lower than the regulatory price that is in existence and this gives the company a
cushion of at least 150 million pounds at the start of business (Taylor and Duyn, 2002).
Evaluation of Glas Cymru’s actions and objectives in relation to capital structure theory
The capital structure theory was researched and developed by Modigliani and miller. The two
professors came up with the capital structure theories that concluded that in perfect markets, the
capital structure of a company mattered not so significantly and the choice a company makes
regarding its financial operations and financing its activities. The value of a firm is significantly
determined by its ability to generate enough income and increase its earning power and also
subject to the risk of its future prospects and the underlying assets, and that its immediate value
is entirely independent of its choice of selection in investment and the distribution of dividends .
Glas Cymru strategy is to fund the purchase of the principality’s water sector by use of debt
capital obtained from bonds floated in the public. These is in relation to cutting down the cost of
capital which according to Glas Cymru would be much higher if they opted to finance the
investment in the principalities water sector through the shareholders equity capital which are not
exempted from taxation and which have long term interest repayment period. These decisions are
made by the managers as in the case of Glas Cymru whose management decisions fall under the
capital structure theories of Modigliani and miller model trade-off theory, agency theory, and
signalling theory. The effect of the debt borrowed by Glas Cymru on its capital structure depends
on its impact on WACC feedback to FCF. With no taxes, (MM proposition 1) Glas Cymru value
will be independent of its own capital structure. The irrelevance proposition of MM Capital
structure assumes a situation of no taxes and no bankruptcy costs, the average weighted cost of
capital remains constant even with changes in the company’s capital structure. The capital
structure does not affect the company’s stocks since there are no changes or benefits from
positive increases in debts therefore irrelevant. Capital can only be viewed as irrelevant under
very tight and restrictive assumptions as MM theory concludes.
Glas Cymru Capital Structure
Where taxes are applicable in the MM Proportion 1, the total value of the unlevered
company is equal to its earnings before taxes and interest which eventually adds up as the cost of
equity. The value of unlevered company is equal to the company of unlevered firm with its
additional taxes capitalized eventually at the cost of its debt. (Burgess, 2006).
Trade-off theory points at the optimal capital structure being attained at the point where
its marginal distress costs exceed its marginal tax advantage from the additional debt in the MM
model. These costs are only applicable at high levels of debt, otherwise the WACC of many
capital structures are mostly unaffected. Glas Cymru intends to save between 4-4.5% of its cost
of capital, by replacing the shareholders equity by the debt capital.
Debts can reduce relatively the Equity Agency problem of managers using company
finances to fund non essential expenses (such as perks, irregular acquisitions or investment in
retarded projects) or invest in low risk due to the undiversified interest in company problem
which is common in large companies with diffuse owners or stock holders where management
owns very little in the company’s shareholding.
The use of financial leverage like in the case of Glas Cyrmru, in these case Bonds free
flow of cash for the firms generating more than enough cash required to fund extra NPV
opportunities , reducing their perk consumption and the value destroying positive growth. The
managers increases the free cash flow by ensuring there is utmost efficiency in the firms overall
operations. Failure means the managers will opt for outside board members, takeover bids or
substitution of the existing strategies. The debt holders also controls the diffuse free ridding
stock holders hence it reduces the Equity Agency costs.
The signalling Theory MM assumes that the investors and interested parties including the
managers have similar information. Where most of the information are mutual, stockholders also
assumes that firms will issue new stock where Bonds are overvalued and issued. Where
undervalued stocks are issued it indicates lower FCF, unwillingness to commit to increased debt
financing service. Leverage-decreasing events indicates overvalued stock and vice versa which is
supported by empirical data.
The signalling theory attributes in pecking order hypothesis companies will most likely
choose from the following arrangement of funding sources to maintain overall financial stability.
The first choice is retained earnings, extra cash debt issuance, and stock issuance. Profitable
companies use less debt because they can source funds easily internally(equity) These
contradicts off theory that suggests high debts because of low rates of defaulters and the need for
In the case of Glas Cymru, the very regulator who approved the financial decision to fund
the purchase of the principle water through debt discouraged other firms from doing the same,
citing that this was a special case scenario that needed such action. This clearly demonstrates the
fact that there is more than one school of thought concerning the act of private companies
leveraging debt to their advantage as explained in Miller’s theory that highlights the offsetting of
a company’s tax burden through borrowing (Modigliani and Miller, 1954; Myers, 1984).For
those opposed to the use of debt to fund institutional investments, their main argument against
this approach is that debts only serve to increase the risk level of an investment and hence place
Glas Cymru Capital Structure
the invested funds in jeopardy given the bullish market conditions that have been seen in recent
times. An increase in the amount of debt taken up by a firm also serves to make its credit rating
tumble down and at times signal panic on the side of shareholders (Graham and Harvey, 2001).
The trade-off theory of capital structure favours the issue of bonds as done by Glas Cymru since
it has more of a tax benefit than the issue of dividends to equity holders (Modigliani and Miller,
1958).This enables the firm to meet its objective of maximizing returns by replacing equity with
debt. On the other side of the divide, bankers as well as other financial analysts seem to be in
favour of the employment of debt as a tool to ensure increased profitability and hence increasing
the value of institutions that are running on debt. The first advantage of debts that makes them so
attractive as opposed to equity funding of companies is the fact that the burden of debt is
significantly reduced when the business has been operating on debts.
Those who will buy the bonds that Glas Cymru is putting up for sale are therefore promised great
returns on their investments. This is because the creditors who are owed money have a claim to
the money before the government and these results in minimal and sometimes almost nil taxes
being imposed on the returns that the business gains (Dewatripont and Tirole, 1994).
It is clear that the objective of Glas Cymru is not to get the highest credit rating and this makes
financial sense according to Roberts, 2003. An increasing number of companies in Europe and
America seem to have heeded this and are continuing to downgrade their credit ratings. This
seems to contradict conventional wisdom regarding the ratio of capital to debts that a business
can have. This position may explain the cautious stance that was taken by the regulator who
authorized the purchase of Dwr Cymru by Glas Cymru. The idea is to shift the benefit from the
business to the shareholders and the chances of this being achieved are increased by lowering the
cost of capital and increasing the money available to carry out business with greater profits
The major objective of any successful organization is to maximize its earnings while targeting its
sales and minimizing costs. Any measure that can extend and guarantee the achievement of any
of these objectives will definitely draw the attention of these strategic managers. If a high level
of leverage will guarantee profitable returns for the business then its implementation should be
considered having in mind the unpredictable nature of the interest rates that fluctuate with the
slightest disturbance of the market. These interest rates can reach unaffordable levels unlike
Equity funded financing whose interest rates or dividend payable can be controlled. Debts
however are not subject to taxation and this makes the idea of running on credit as opposed to
shareholder’s equity an increasingly popular venture. The financial management of Glas Cymru
should critically weigh all its options before making a decision whether to adopt the measures to
increase its leverage or retain its current Equity status. Finally to sum up all the theories, Capital
structures require sound judgement both from the management and the shareholders. The
willingness to add debt allows increased growth rate.
Glas Cymru Capital Structure
Burgess, K. 2006. Pressure building for public companies to adopt private equity tactics Some
institutional investors are questioning whether companies should put up more resistance
to approaches from buy-out firms and use some of their typical methods to create value.
Financial Times-London Edition.
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Taylor, A and Duyn V 2002.Companies & Finance Uk: Glas Cymru Launches Bond Campaign
Water Marketing Drive In Plan To Raise Pounds 2bn For Purchase Of Dwr Cymru-
Financial Times-London Edition