Flashcards in 10) Capital structure Deck (31)
What is operational gearing?
Operating gearing is a measure of the extent to which a firm’s operating costs are fixed rather than variable as this affects the level of business risk in the firm.
what are the formulas that can be used to measure operational gearing
% change in EBIT / % change in revenue
What is high operating gearing and what does it mean when analyzing
The greater the operating gearing, the greater the ___ variability
Firms with a high proportion of fixed costs in their cost structures are known as having ‘high operating gearing’.
Thus if the sales of a company vary: The greater the operating gearing the greater the EBIT variability.
The level of operating gearing will be largely a result of the industry in which the firm operates.
What is financial gearing?
Financial gearing is a measure of the extent to which debt is used in the capital structure.
Note that preference shares are usually treated as debt
How can the financial gearing be measure through?
financial risk can be measured by statement of financial position or profit and loss.
Balance sheet; Equity gearing AND Capital/Total Gearing
Profit and Loss: Interest gearing and Interest cover
whats equity gearing
(LT debt + Preference share capital) / (Ordinary share capital + reserves)
share capital includes the premium
What is total/Capital gearing
Capital gearing can mean Debt to Equity OR total capital
1) non-current liabilities ÷ Total Long term capital
2) non-current liabilities ÷ ordinary shareholders funds
Long Term capital= Preference shares, debts, ordinary share capital, premium, reserve
non-current liabilities- LT debt + Preference share capital
What is interest gearing and interest cover
interest gearing is a statement of profit or loss measure rather than a financial position statement one.
It considers the percentage of the operating profit absorbed by interest payments on borrowings and as a result measures the impact of gearing on profits.
Operating profits before debt interest and tax
It is more normally seen in its inverse form as the interest cover ratio ;
when calculating the ratios, should you use market or book values?
explain the pro and con of each and in reality which is used for each
Advantages of market and book?
are more relevant to the level of investment made
represent the opportunity cost of the investment made
are consistent with the way investors measure debt and equity.
are how imposed gearing restrictions are often expressed
are not subject to sudden change due to market factors
are readily available.
what does high financial gearing cause
the company with the higher level of financial gearing will have increased variability of returns to shareholders.
What are the theories of gearing?
Miller and Modlagni with no tax
Miller and Modlagni with tax
What is traditional theory
explain at low levels of gearing as well as high
Initially the WACC will fall. This is because the benefits of the cheaper debt finance will outweigh the drawback of a rise in the cost of equity.
Beyond a certain point, however, the drawback of more debt finance will begin to outweigh the benefits of debt finance. If further debt finance is raised beyond this point then the WACC will begin to rise.
At low levels of gearing: Equity holders perceive risk as relatively unchanged and ke may rise but not by very much, so the increase in the proportion of cheaper debt will have the greater effect and the WACC will fall as gearing is increased. Here, Ke is increasing at a slower rate hence ITS NOT A STRAIGHT LINE as other graphs
At higher levels of gearing: Equity holders see increased volatility of returns (riskier returns) as more debt interest must be paid out of shareholder profits.
This leads to:
increased financial risk
increase in Ke (faster than at low levels of gearing) outweighs the benefit of the extra (cheap) debt being introduced
WACC starts to rise.
At very high levels of gearing: Serious bankruptcy risk worries equity and debt holders alike. Ke AND Kd rise. WACC rises further.
where is the optimal level of gearing for traditional
There is an optimal level of gearing – point X. At point X, the overall return required by investors (debt and equity) is minimised. It follows that at this point the combined market value of the firm’s debt and equity securities will also be maximised as WACC is the lowest too
what is M&M with no tax?
and explain WHY and HOW the WACC remains constant
Modigliani and Miller (no tax) conclusion:
Under MM’s theory, there is no one optimal capital structure; rather the capital structure (the level of debt) does not affect the WACC and thus does not affect the value of the firm. All structures are optimal.
M and M argued that, in the absence of tax, a company is worth the present value of its future cash flows generated by its assets, irrespective how the earnings are returned to fund lenders i.e. dividend or interest.
Therefore, the value of the firm should not be affected by a change in its capital structure. This also means that the WACC should not be affected by a change in capital structure.
The WACC of a geared company should always therefore be equal to the WACC of an equivalent but ungeared company.
as investors are rational, the required return of equity is directly proportional to the increase in gearing. There is thus a linear relationship between Ke and gearing (measured as D/E)
the increase in Ke exactly offsets the benefit of the cheaper debt finance and therefore the WACC remains unchanged.
What are the assumptions for M&M
1. Taxation is ignored
2. Markets are perfect. Investors have perfect information and there are no transaction costs
3. All debt is risk free and investors can borrow or invest at the risk free rate of return
4. All investors act rationally
what is M&M with tax?
Interest on debt is tax deductible, whereas dividend payments are not. Therefore these is a tax advantage to having debt instead of equity finance.
As a result of this, M&M argued that WACC therefore should fall until a gearing level of 99.9% is achieved.
Modigliani and Miller (with tax) conclusion:
The WACC falls as the debt level increases, and thus the value of the firm increases. The optimal capital structure is to have as much debt as possible i.e. a gearing level of 99.9%.
What are the issues with high levels of gearing?
▪ Increased risk of bankruptcy
▪ Agency cost
▪ Tax exhaustion – interest payments may exceed the profits
▪ Restrictions on borrowings in the articles of association
▪ Covenants restricting the amount of borrowing
▪ Increases in the cost of borrowing as the amount of debt rises
▪ Differences in risk tolerance levels between shareholders and directors
As a result of these market imperfections, despite the theories, gearing levels tend to be based on more practical concerns and companies will often follow the industry average gearing.
what are agency cost?
lenders/debentures holders often impose restrictive conditions in the loan agreements that constrain management’s freedom of action, e.g. restrictions:
(i) on the level of dividends
(ii) on the level of additional debt that can be raised
(iii) on management from disposing of any major fixed assets without the debenture holders’ agreement.
what is tax exhaustion
However, as a company gears up, interest payments rise, and reach a point that they are equal to the profits from which they are to be deducted; therefore, any additional interest payments beyond this point will not receive any tax relief.
This is the point where companies become tax - exhausted, ie interest payments are no longer tax deductible, as additional interest payments exceed profits and the cost of debt rises significantly from Kd(1-t) to Kd. Once this point is reached, debt loses its tax advantage and a company may restrict its level of gearing.
Debt is no longer so cheap as to outweigh the effect of the rising ke and the WACC no longer falls with increasing debt (effectively a return to the ‘no-tax’ model).
what is pecking order theory
This states that a company will prefer retained earnings to any other source of finance. If it is not possible to raise sufficient new finance by means of retained earnings then the company will raise finance by debt.
Only if it is not possible to raise finance by debt will a company issue new shares.
The order of preference will be:
• Retained earnings
• Debt issue
• Equity issue
Under the pecking order theory the level of gearing of a company emerges from the choice as to how finance is raised as opposed to their being a conscious decision to raise finance in a particular way
.When can we use WACC for investment appraisal?
the historic proportions of debt and equity are not to be changed (otherwise the weightings in the WACC will change and the WACC would need to be recalculated)
the operating risk (business risk) of the firm will not be changed (otherwise ke will change and so will the WACC)
the finance is not project-specific, i.e. projects are financed from a pool of funds (otherwise the project may best be evaluated using the specific cost of finance).
the project is small in relation to the company so any changes are insignificant.
When can we use CAPM in investment appraisal?
CAPM can be used to help find a discount rate when the project risk is different from that of the company’s normal business risk.
The logic behind the CAPM is as follows:
Objective is to maximise shareholder wealth
Rational shareholders will hold well diversified portfolios
Any new project is just another investment in a shareholder’s portfolio
CAPM can set the shareholders’ required return on the project
What is the formula for Project IRR?
=(Project expected value- Current outlay) / current outlay
What are the two types of beta?
Asset Beta- Business Risk (a beta which only reflects systematic risk)
Equity Beta- Business & Financial risk (a beta which reflects systematic and gearing risk)
What are the steps to find a project specific discount rate?
1) De gear the beta of a quoted company that has similar level of risk to the new project. AKA find equivalent Ba
2) re-gear the beta to reflect the gearing of the company undertaking the investment. AKA find Be from the Ba from above. This will reflect the right level of systematic risk
3) Use the CAPM equation to find a project specific discount rate
what is business risk
Business risk in financial management relates to the variability of shareholder returns which arises from business operations.
It can be measured from a statement of profit or loss perspective by operational gearing, which considers the relative importance of fixed and variable operating costs in relation to operating profit (PBIT). One definition of operational gearing is contribution/profit before interest and tax or PBIT.
Business risk is not influenced by the way in which a company is financed, that is, it is not influenced by the capital
structure of a company.
what is finance risk
Financial risk relates to the variability of shareholder returns which arises from the way in which a company finances itself, that is, from its capital structure. It can be measured from a balance sheet perspective by gearing (financial gearing, debt/equity ratio, debt ratio) and from a statement of profit or loss perspective by interest cover and income gearing.
The combination of business risk and financial risk is referred to as total risk.
Under which circumstances would the DVM and CAPm model produce similar values for WACC?
Cirumstances to produce similar results:
1) we need perfect markest- no transaction costs, perfect informaion and everyone has access- in which case the beta will a true flection of company risk.
2) Accurate estimates-> dividend growth.
What are the problems estimating appropriate data inputs for using the CAPM in investment appraisal?
Rm, RF and Beta
Rf- what is the RF rate- are treasury bills completely risk free. Do Rf actually exist
Rm- issues include how many securities to include. If we want to include every single security in the market- that's difficult to estimate. you can select 20/25 and then work it out. other factors also include how far back do we go historically to include. do we want to look at 5/2/ year average, exclude certain big events to avoid that anomaly
B- we might not be the average, we might be premium or the discount so the proxy may not apply.