Blog 9: HMV is trying to reduce its debt

The traditional view of financial gearing is that a certain level of gearing can increase shareholder wealth (or the value of the company) and beyond this level, the company starts to face high risks and shareholders may consider the company as a risky one so that start to sell the shares. And eventually, the share price falls. However, in Modigliani–Miller theorem, companies’ market values are not impacted by the WACC (weight average cost of capital). The theorem (Modigliani–Miller:1985) states ‘in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, a company’s value is unaffected by how it is financed, regardless of whether the company’s capital consists of equities or debt, or a combination of these, or what the dividend policy is.’ Then the companies’ values are determined by only their businesses. But in the real world, there is no perfect market, and the taxes, bankruptcy costs, asymmetric information are indeed exist. Then what should we do in regards to the financial gearing to increase the value of the company? Companies’ debts are tax deductible. Then is it good for companies to maximum their debts?

Recently, HMV plans to shut 60 stores over 12 months in order to cut its ballooning debt. According to Financial Times, it expected to breach covenants on ￡130m of borrowings after its April year-end. And it is consider a company voluntary arrangement.

We can see from HMV’s 2010 balance sheet, there is a high gearing of company’s overall capital structure. It is about 49% (96.3￡m/ 96.3￡m + 100.4￡m). Its share price is continuing decreased despite a little rise up recently. The main reason that HMV heavily rely on debt is because of its bad products selling. More people like to buy music and video that are made online and this has affected the performance of HMV.

Why not HMV maintain this high gearing? It is just because this high gearing may let HMV face Bankruptcy risk so it is trying its best to reduce the debt. This seems to link with the traditional view – high gearing may face high risks. However, HMV’s high gearing situation is linked with its business. If HMV have a good performance, it will not rely heavily on debt. On one side, all equity will let company lose the benefit of low cost debt, on the other side, high debt will let them face the bankruptcy risk. At the same time, investors always think low debt is better than high debt. Also companies would minimum their dependence on debt (except the bank industry, etc, who rely on debt to make money) and to declare on the annual report as a good performance. Like in Ashtead Group’s 2010 annual report, it states in its performance: ‘Net debt reduced to £829m (2009: £1,036m); net debt to EBITDA leverage of 3.1 times’.

In my opinion, companies should not mainly focus on the capital structure (of course, a suitable use of financial gearing can benefit the companies a lot); instead, they should focus on how to manage their businesses well so that they can earn more profits.