Capital Structure and Firm Value: A Study of Split-Capital Closed-End Funds in the UK

25 Pages Posted: 4 May 2001

Date Written: April 23, 2001

Abstract

Ever since Modigliani and Miller made their irrelevance proposition, a key theme in corporate finance has been to explain the conditions under which capital structure does affect firm value. Split-capital closed-end funds (which are listed companies) exist to exploit such conditions. This study examines how financial engineering of the liabilities enhances company value. We find that splitting a fund into some mix of shares relating to debt, dividends and capital adds about 10% to company value, because split-capital funds trade at much smaller discounts than conventional funds. Analyses of cross-section and time-series data reveal that there are two approximately equal sources of the extra value. The first (worth 4.7%) arises simply from having a wind-up date, which forces the discount to converge to zero over time. The second (worth 4.6% ) comes from being levered with zero-dividend preference shares. Of this leverage effect, about one third is attributable to a tax shield and two thirds to a clientele effect. An option-evaluation of the ordinary (capital) shares indicates that they contribute more than half of the extra value of split funds relative to conventional funds, although they are frequently mispriced. Hence the split-capital structure enhances company value because: (i) there is a clientele effect for debt (indicating that the debt market is imperfect); (ii) there is a tax shield to be exploited; and (iii) limiting company life constrains managers to make an eventual sale at net asset value.

Keywords: capital structure, closed-end fund, discount, option, leverage, prime, score

JEL Classification: G32, G23, G13

Suggested Citation

Gemmill, Gordon, Capital Structure and Firm Value: A Study of Split-Capital Closed-End Funds in the UK (April 23, 2001). Available at SSRN: https://ssrn.com/abstract=268921 or http://dx.doi.org/10.2139/ssrn.268921

Gordon Gemmill (Contact Author)

Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

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