Capital Structure Flashcards
Operating Gearing
refers to the extent to which a firm’s total non-financing costs are rather than variable (impact on PBIT)
Financial Gearing
concerns the proportion of debt in the capital structure.
Ways to measure financial gearing
- balance sheet figures or market values
- capital gearing focuses on the extent to which a firms total capital is in the form of debt (B/S)
- income gearing is concerned with the proportion of the annual income stream which is devoted to the prior claims of debt holders (pre-interest profits)(I/S)
Capital gearing using market value formula
long - term debt / total market capitalisation
- Vd/ Ve+Vd
income gearing using interest cover formula
profit before interest and tax / interest charges
- lower interest cover means the higher the income gearing
positives when a company borrows more
- debt is cheaper than equity
- more debt should push the WACC down, all else equal
- lower WACC = higher NPVs = more shareholder wealth
negatives when a company borrows more
- more interest means shareholders have to wait longer for dividends
- shareholders’ risk increases - financial risk
- so cost of equity rises pushing up WACC, all else equal
- Higher WACC lower NPVs
Value formular
V= total cash flows to debt and equity (C) / WACC
M&M 58
- total market value of any company is independent of its capital structure
- the WACC is constant because the cost of equity capital rises exactly offset the effect of cheaper debt
M&M 58 Assumptions
- no taxation
- perfect capital markets, perfect information available to all and no transaction costs
- no costs of financial distress and liquidation
- firms can be classified into distinct risk and classes
- individuals can borrow as cheaply as companies
M&M 63
- the more you give to debt holders the bigger the value becomes.
- introduces corporation tax to bring an additional advantage of using debt capital
M&M 63 Optimal capital structure
- 100% debt finance.
- WACC would be at its lowest
Cost of financial distress - Indirect examples
- uncertainties in customers minds
- uncertainties in suppliers mids
- assets sold quickly, price may be very low
- delays, legal imposition and the tangles of financial reorganisation may place restrictions on management action, interfering with the efficient running of the business
- management may give excessive emphasis to short-term liquidity
- temptation to sell healthy businesses
- loss of staff morale, difficulty in recruiting talented people
costs of financial distress- direct examples
- lawyers fees
- accountants fees
- court fees
- management time
financial distress
where obligations to creditors are not met or are met with difficulty
trade off model
- amends M&M 63 to include costs of financial distress
- optimal solution depends on outside factors
factors influencing the risk of financial distress costs
- sensitivity of the company’s revenue to general level of economic activity.
- proportion of fixed to variable costs
- liquidity and marketability of the firms assets
- cash generative ability of the business
agency costs
direct and indirect costs of attempting to ensure that agents act in the best interest of principles
information asymmetry
managers know more than lenders so restrictions (covenants) are built into a lending agreements
- lenders will require a premium on the debt interest to compensate the cost of monitoring
Pecking order
- firms prefer to finance with internally generated funds
- if the firm needs more they seek debt.
- as a last resort the companies raise external equity finance
