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FM > 6. FM - Capital Structure and assessing financing options > Flashcards

6. FM - Capital Structure and assessing financing options Flashcards

1
Q

What is operating gearing?

A

A measure of the extent to which a firm’s operating costs are fixed rather than variable

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2
Q

How is operating gearing measured?

A

Measured as either
Fixed costs/variable costs

Fixed costs/total costs

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3
Q

What does it mean if a firm has a ‘high operating gearing’

A

They have a high proportion of fixed costs in their cost structures
i.e. Fixed cost/ variable costs or total costs = large number

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4
Q

What impact does higher operating gear have on a company?

A

It leads to greater variability in operating profits
Therefore greater risk

As when the sales of a company varies, the fixed costs will cause the profit to vary even more

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5
Q

What is financial gearing?

A

A measure of the extent to which debt is used in the capital structure.
Measured as either
Debt/equity
Debt / Debt+Equity

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6
Q

What are the 2 measures for financial gearing?

A

Debt/equity

Debt / Debt+Equity

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7
Q

How are preference shares usually treated? (As debt or equity?)

A

Usually treated as debt finance and preference dividends are treated as debt interest

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8
Q

How does fixed interest costs affect the operating profits of a company?

A

The presence of fixed interest cost leads to greater variability of profits available for SH
Therefore has greater risk

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9
Q

How is the value of a company measured?

A

By the value of its future cash flows discounted at the WACC

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10
Q

How can gearing affect shareholder wealth?

A

If we can decrease the WACC, we will increase the MV of the company which creates SH wealth (works vice versa too)

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11
Q

What happens to the WACC as we increase the level fo financial gearing within a company?

A
  • Debt is cheaper than equity as
    – it is less risky
    – interest is tax deductible
    Therefore increasing the proportion of the lower Kd in the WACC calc pushes the WACC down

But also increasing levels of debt makes the return to SH more variable (i.e. equity becomes more risky)
This causes Ke to rise and therefore pushes WACC up

This happens simultaneously so works against each other

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12
Q

What are the 3 theories of gearing?

A

Traditional view (pre M&M)
No tax M&M
Tax M&M

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13
Q

Describe what happens as you change the level of gearing in the traditional view of gearing

A

At low levels of gearing

  • Equity holders see their risk as being relatively unchanged
  • As cheaper debt is incorporated, WACC fails

At higher levels of gearing

  • Equity holders see increased volatility of returns as debt interest is paid first
  • The increased equity risk increases Ke and WACC starts to rise

At very high levels of gearing
- Bankruptcy risk worries equity and debt holders alike
Both Ke and Kd rise, and WACC rises further

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14
Q

Describe how traditional view of gearing acts on a chart and what conclusion is formed from this

A

Ke is gradual slope upwards between cost of capital (Y) and gearing (X)
Kd is parallel to gearing (i.e. cost of capital % doesn’t increase, only gearing) - but then curls up at the end
WACC starts at Ke but drops down to X (optimal level of gearing) before it then goes up again

Only trial and error can find where X is

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15
Q

Describe the no-tax theory of Modigliani and Miller’s assumptions

A

theory of gearing
Based on the premise of a perfect capital market where there are:
- Not transaction costs
- No indiv dominates the market
- Full info efficiency
- All investors are rational and risk averse
- NO TAXES

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16
Q

What does M&M no tax argue?

A

As investors are rational, Ke is directly linked to the increase in gearing
As gearing increases Ke , increases in direct proportion
- Increase in Ke exactly offsets benefit of cheaper debt finance
So WACC remains unchanged no matter the level fo gearing
i.e. always same cost of capital

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17
Q

Describe the diagram for M&M

A

Cost % on y
Level of gearing on X

Kd is parallel to level of gearing, as always same cost of cap
Keg increasing straight line diagonally
WACC = also parallel to X axis as impact of gearing is netted off by cheaper debt finance

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18
Q

What is the conclusion of M&M no tax?

A

The WACC and therefore the value f the firm is unaffected by changes in gearing levels and gearing is irrelevant

WACC = also parallel to X axis as impact of gearing is netted off by cheaper debt finance

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19
Q

What adjustments are made to M&M theory for tax?

A

Same starting point but adjusted to reflect that
- Debt interest is tax deductible so that Kd is lower than before
- Increase in Ke doesn’t offset the benefit of the cheaper debt finance
Therefore WACC falls as gearing increases

20
Q

Describe the graph of M&M after tax

A

Y axis = cost %
x axis = level of gearing
Ke = diagonal increasing as each increases
Kd = parallel with x axis as cost % doesn’t change
Acc starts at Keg but slowly decreases

21
Q

How does the value of the company change according to M&M with tax?

A

Value of the company increases as the level of gearing increases

22
Q

What is the conclusion for M&M with tax?

A

Gearing up reduces the WACC

Optimal capital structure is 99.9% gearing

23
Q

What are the practical problems with high levels of gearing?

A
  • Increased bankruptcy risk
  • Tax exhaustion
  • Agency costs
24
Q

Why does an increased bankruptcy risk mean people often don’t use high levels of gearing?

A

As gearing increases, the risk of going bankrupt increases

Causes Kd to rise and Ke to rise faster

25
Q

Why is tax exhaustion a risk with high levels of gearing?

A

Tax shield on the debt may not be achieved if company profits aren’t high enough to cover the interest costs

26
Q

Why are agency costs a problem with high levels of gearing?

A

Directors may be more risk averse than the SH as their livelihood depends on the company remaining solvent

27
Q

What are the practical influences on the gearing policy?

A
  • Costs of raising finance
  • Asset quality (for use as security)
  • Loan covenants (restrictions on further lending imposed by existing lenders)
  • Availability of other sources of finance
  • Levels of other risks (operational and industry risk)
28
Q

Is gearing a systematic risk?

A

Yes, i.e. every company is made more risky

29
Q

How does gearing affect the CAPM?

A

When we apply the CAPM to calc the required return to equity, it is necessary to increase the beta when the company is geared

30
Q

What must beta reflect for CAPM?

A
  • Risk of the industry that the project is in

- Level of gearing in the investing company

31
Q

Define ‘asset beta’

A

Beta measuring systematic business risk only

i.e. the smaller beta that isn’t increased to reflect gearing

32
Q

Define ‘equity beta’

A

A beta reflecting systematic business risk and the firm’s level of gearing
i.e. the larger beta that has gearing in it

33
Q

What is the formula for calculating B equity

A 
B(equity) = B(asset) x ( 1 + [D(1-t)/E])
Where 
E = market value of equity 
D = market value of debt 
T = corporate tax rate
34
Q

How is a suitable beta for appraising a project?

A
  • Find an appropriate asset beta

- Adjust it to reflect its own gearing levels, gear the beta to convert to an equity beta

35
Q

What adjustments must be made when the best beta available is from a geared company?

A

i.e. it is an equity beta
stages:
1) Find the appropriate equity beta
2) Adjust the available equity beta to convert it to an asset beta (degear it)
3) Readjust the asset beta to reflect its own gearing levels (gear the beta)

36
Q

What process is used if the level of gearing can change?

A

If gearing level changes, need to use the APV

37
Q

What does APV stand for?

A

Adjusted present value

38
Q

What are the steps for APV?

A

1) Find the base case NPV by discounting using Key (this is the Ke calc as if the comp had no gearing at all)
2) Add the PV of the tax shield brought about by using debt finance by discounting at the pre-tax cost of debt

i.e. APV - base case NPV + PV of the tax shield

39
Q

What result for an APV test suggests that a project should be carried out?

A

If the APV is +ve

40
Q

What should present value of tax shield be based on?

A

Projects theoretical debt capacity and not the actual amount of debt used
E.g. if a question said actual debt raised is £800k but inv is believed to add £1m to debt capacity, the PV is the £1m (theoretical amount

41
Q

What does a business plan cover?

A
  • Strategic direction
  • Chosen strategies
  • Reasoning
  • Expected outcomes
42
Q

What is the standard layout of a business plan?

A
  • Front sheet
  • Contents page
  • Executive summary
  • History and background
  • Mission and objectives
  • Products or services
  • Market information
  • Key business information
  • Financial information
  • Summary action plan
  • Appendices
43
Q

When is a forecast financial statement put together?

A

If a business is considering raising finance for expansion or making other significant charges

44
Q

What questions can be given about forecasts?

A

May be asked to forecast an income statement, balance sheet or even cash flow statement from simple info given

Often combined with a requirement to calc the impact of various diff ratios: 
Such as 
Earnings per share
Dividend cover
Interest cover
Gearing 
Dividend pay-out ratio
45
Q

What are some of the ratios you may be required to calc?

A 
Earnings per share
Dividend cover
Interest cover
Gearing
Dividend payout ratio

FM (12 decks)

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