10) Capital structure Flashcards
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
FC/VC
FC/TC
Contribution/EBIT
% 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.
finance costs
÷
Operating profits before debt interest and tax
It is more normally seen in its inverse form as the interest cover ratio ;
operating profit
÷
finance costs
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?
Market values:
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.
Book values:
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?
Traditional
Miller and Modlagni with no tax
Miller and Modlagni with tax
Pecking order
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
- Taxation is ignored
- Markets are perfect. Investors have perfect information and there are no transaction costs
- All debt is risk free and investors can borrow or invest at the risk free rate of return
- All investors act rationally
