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

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 successfully exploit such conditions, being worth on average 11% more than conventional closed-end funds. Cross-section and time-series analyses reveal that the extra value comes mainly from two sources. The first (worth 4.7%) arises simply from limiting the life of the company, which automatically reduces the agency problem and makes any discount converge towards zero. The second (worth 5.6% ) comes from being fifty-percent levered, which is shown to be predominantly a clientele effect rather than a tax effect. Using an option-pricing approach, it is found that two thirds of the extra value becomes lodged in the market prices of the ordinary (capital) shares, rather than in the prices of debt or dividend shares. The main conclusion is that small investors are willing to pay for leverage, in order to increase dividend yields. The investors could do the borrowing themselves, but problems of scale and information would make that more expensive.