Capital Structure Flashcards
What is operating 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.
The higher the proportion of fixed costs the higher the operating gearing and the riskier (more volatile) the EBIT.
How do you calculate operating gearing?
Cause - cost of structure
fixed costs / total costs
How do you calculate operating gearing? (Effect-Impact on income statement)
%change in EBIT / %change in turnover
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.
Where two companies have the same level of variability in earnings, the company with the higher level of financial gearing will have increased variability of returns to shareholders.
Hence an increase in gearing represents an increase in risk for the equity investor
How do you calculate equity gearing?
(preference share capital + long-term debt) / (ordinary share capital and reserves) x 100
How do you calculate Total gearing?
(preference share capital + long-term debt) / total long-term capital x100
How do you calculate interest gearing?
(debt interest + preference dividends) / operating profits before debt interest and tax
What are the traditional views on gearing affecting shareholder wealth?
Shareholder wealth is affected by changing the level of gearing.
There is an optimal gearing ratio at which WACC is minimised and the total value of the company is maximised.
Financial managers have a duty to achieve and maintain this ratio.
While we accept that the WACC is probably U shaped for entities generally, we cannot precisely calculate a best gearing level.
The optimum level will differ from one entity to another and can only be found by trial and error
What is Modigliani and Miller (M&M) – 1958 theory with no taxation?
There exists a perfect capital market in which there are no information costs or transaction costs.
Debt is risk free and kd remains constant at all levels of gearing.
No taxation.
Under M & M’s theoretical assumptions, and in the absence of tax, the two opposing factors cancel out exactly, so the WACC (and business value) is constant at all levels of gearing.
What is Modigliani and Miller (M&M) – 1963 theory with taxation?
When the effect of tax is taken into account, the tax relief on debt interest causes the WACC to fall (and the business value to rise) as gearing increases.
Implication: The optimum gearing level is 99.9% debt
What are the problems with high gearing?
In practice firms are rarely found with very high levels of gearing. This is because of:
bankruptcy risk (increased cash commitments on interest and redemption payments can reduce cash balances)
agency costs (restrictions by existing lenders on management actions)
tax exhaustion (no tax liability left against which to offset interest charges)
the impact on borrowing/debt capacity (no further assets on which to secure debt reduces lenders’ willingness to lend)
difference between risk tolerance levels between directors and shareholders (management’s unwillingness to take risks that well diversified investors would accept)
restrictions in the articles of association (can specify borrowing limits)
increase in the cost of borrowing as gearing increases (due to bankruptcy risk and lack of assets for security)
What is the pecking order theory?
In this theory there is no search for an optimal capital structure through a theorised process. Instead it is argued that firms will raise new funds as follows:
internally generated funds (already available, cheap)
debt (less contentious than share issues, moderate issue costs)
new issue of equity (could be perceived as a sign of problems, expensive)
If an investment significantly changes the proportions of debt and equity or the risk levels of the firm, or the finance is project-specific then the existing WACC will no longer be an appropriate rate at which to discount the investment cash flows what should be done?
When it is the risk that has changed (either by altering the gearing levels or by moving into a different business area) the CAPM may be used to find an up to date cost of equity to be used in a new calculation of the WACC.
What is the risk of CAPM and gearing?
The CAPM uses a beta factor to represent the systematic risk levels of the investment.
There are two types of beta factor:
Asset beta (βa) the beta for an ungeared company
Represents the systematic risk of the business type only (business risk)
Equity beta (βe) the beta for a geared company
Represents both the business risk and the financial risk (related to gearing levels) of the company
To use the CAPM to find a cost of equity for use in investment appraisal, a beta with both the correct business risk (for the investment type) and the correct financial risk (for the company undertaking the investment) must be determined.
