6. FM - Capital Structure and assessing financing options Flashcards
What is operating gearing?
A measure of the extent to which a firm’s operating costs are fixed rather than variable
How is operating gearing measured?
Measured as either
Fixed costs/variable costs
Fixed costs/total costs
What does it mean if a firm has a ‘high operating gearing’
They have a high proportion of fixed costs in their cost structures
i.e. Fixed cost/ variable costs or total costs = large number
What impact does higher operating gear have on a company?
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
What is financial gearing?
A measure of the extent to which debt is used in the capital structure.
Measured as either
Debt/equity
Debt / Debt+Equity
What are the 2 measures for financial gearing?
Debt/equity
Debt / Debt+Equity
How are preference shares usually treated? (As debt or equity?)
Usually treated as debt finance and preference dividends are treated as debt interest
How does fixed interest costs affect the operating profits of a company?
The presence of fixed interest cost leads to greater variability of profits available for SH
Therefore has greater risk
How is the value of a company measured?
By the value of its future cash flows discounted at the WACC
How can gearing affect shareholder wealth?
If we can decrease the WACC, we will increase the MV of the company which creates SH wealth (works vice versa too)
What happens to the WACC as we increase the level fo financial gearing within a company?
- 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
What are the 3 theories of gearing?
Traditional view (pre M&M)
No tax M&M
Tax M&M
Describe what happens as you change the level of gearing in the traditional view of gearing
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
Describe how traditional view of gearing acts on a chart and what conclusion is formed from this
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
Describe the no-tax theory of Modigliani and Miller’s assumptions
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
What does M&M no tax argue?
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
Describe the diagram for M&M
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
What is the conclusion of M&M no tax?
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
What adjustments are made to M&M theory for tax?
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
Describe the graph of M&M after tax
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
How does the value of the company change according to M&M with tax?
Value of the company increases as the level of gearing increases
What is the conclusion for M&M with tax?
Gearing up reduces the WACC
Optimal capital structure is 99.9% gearing
What are the practical problems with high levels of gearing?
- Increased bankruptcy risk
- Tax exhaustion
- Agency costs
Why does an increased bankruptcy risk mean people often don’t use high levels of gearing?
As gearing increases, the risk of going bankrupt increases
Causes Kd to rise and Ke to rise faster
