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Glas Cymru Capital Structure.

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.
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
financing. 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 their are no changes or benefits from positive increases in debts therefore irrelevant.
The move to manipulate the cost of capital by taking on debts is increasingly becoming a trend in
the corporate world whereby companies are opting to purchase other firms that are ailing as a
result of debt, ‘fixing’ or remedying the situation then reselling the revamped organization at a
profit. Private equity firms have made a killing through this process for some time now. The
feasibility of such moves is however being questioned by a section of financial analysts who
disagree with the value creation tactics that are being employed by these institutional investors.
At present, Glas Cymru is clearly on the same path whereby, they already plan to pump two
million pounds of debt money into the water company (Burgess, 2006).

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

Glas Cymru Capital Structure
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 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 this 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
(Marsh, 1982).


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.

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.
Dewatripont, M., and Tirole, J. 1994. A theory of debt and equity: Diversity of securities and
manager-shareholder congruence. The Quarterly Journal of Economics, 109(4), 1027-
Graham, J.R.and Harvey, C.R 2001.The theory and practice of corporate governance:evidence
from the field. Journal of Financial Economics 60 (2001) 187- 243
Marsh, P. 1982. The choice between equity and debt: An empirical study. The Journal of
finance, 37(1), 121-144.
Modigliani, F., and Miller, M. 1958.The cost of capital, corporation finance and the theory of
investment.The American economic review, 48(3), 261-297.
Myers, C. 1984 The Capital Structure Puzzle, The Journal of Finance. 39 (3)
Roberts, A. 2003.Highest scores may not be most efficient ratings. Financial Times- London
Scott Jr, H. 1976. A theory of optimal capital structure.The Bell Journal of Economics, 33-54.
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

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