Capital structure and assessing financing options

Question 1

2 types of gearing

Answer 1

1. Operational (operational gearing)
2. FInancnal (financial gearing)

Question 2

What does operating gearing measure?

Answer 2

Ho much costs are fixed v variable

Question 3

Operating gearing calc

Answer 3

fixed costs/variable costs

OR

fixed costs/total costs

Question 4

What does a higher operating gearing mean?

Answer 4

More volatility & risk in sales

Question 5

What does financial gearing measure?

Answer 5

The amount debt is used

Question 6

Financial gearing calc

Answer 6

Debt/Equity

OR

Debt/(Debt+Equity)

Question 7

Calculating financial gearing: How are preference shares & dividends treated usuallly?

Answer 7

Treated as debt (and debt interest)

Question 8

What does higher financial gearing mean?

Answer 8

More fixed (interest) cost = more variability

Question 9

Traditional view of gearing

Answer 9

Low:
Risk seen as still low
So cheaper debt
So WACC falls

Med:
Risk seen as higher
Increased equity risk so Ke rises
So WACC rises

High:
Risk of bankruptcy worries debt and equity holders
Both Kd and Ke rise
So WACC rises

Question 10

Is there an optimal level of gearing?

Answer 10

Yes

(The amount that produces lowest WACC)

But impossible to find without trial and error

Question 11

3 views of gearing

Answer 11

1. Tradiitonal
2. M&M pre-tax
3. M&M post-tax

Question 12

M&M pre-tax view of gearing: Assumptions

Answer 12

Perfect capital market

No transaction costs
No individual dominates the market
Full information efficiency
All investors are rational and risk averse
No taxes

Question 13

M&M pre-tax view of gearing

Answer 13

As investors are rational, ke is directly linked to the increase in gearing

As gearing increases, ke increases in direct proportion

The increase in ke exactly offsets the benefit of the cheaper debt finance

And therefore the WACC remains unchanged

Therefore company value remains unchanged

Question 14

M&M post-tax view of gearing: Further assumptions

Answer 14

Debt interest is tax deductible so the kd is lower than before

The increase in ke does not offset the benefit of the cheaper debt finance

Therefore, the WACC falls as gearing increases

Question 15

M&M post-tax view of gearing: Further Conclusion

Answer 15

Gearing up reduces the WACC

The optimal capital structure is 99.9% gearing.

Question 16

Practical problems with high gearing

Answer 16

Gear too high? You’ll hit a bat!

Increased bankruptcy risk
As gearing increase, the risk of going bankrupt increases, which will cause kd to
rise and ke to rise faster.

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

Tax exhaustion
The tax shield on debt may not be achieved if the company profits are not high
enough to cover the interest costs.

Question 17

Practical influences on gearing policy

Answer 17

Gearing levels tend to be based on more practical concerns such as:

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).

Question 18

Is gearing a risk that operates systematically?

Answer 18

Yes

I.e. will make every company riskier

Question 19

How does gearing affect beta in a CAPM calc?

Answer 19

It is necessary to increase the beta we use when the company in question is geared.

When we use the CAPM we must therefore ensure that the beta used reflects:
1 the risk of the industry that the project is in, and also
2 the level of gearing in the investing company

Question 20

Asset beta

Answer 20

A beta measuring systematic business risk only – i.e. the smaller beta
that isn’t increased to reflect gearing

Question 21

Equity beta

Answer 21

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

Question 22

Equity and asset betas formula.

Equity beta =

Answer 22

AssetBeta ( 1 + (MVd(1-T))/MVe)

T = CT rate
MVd = MV Debt
MVe = MV equity

Question 23

To select a suitable beta for appraising a project, a firm must

Answer 23

1 find an appropriate asset beta
2 adjust it to reflect its own gearing levels – gear the beta to convert to an equity
beta

Question 24

Selecting a beta: If the best beta available is from a geared company, i.e. it is an equity beta, the stages become:

Answer 24

1 Euioty beta Find the appropriate equity beta.
2 Degear Adjust the available equity beta to convert it to an asset beta – degear it.
3 Regear Readjust the asset beta to reflect its own gearing levels – gear the beta

Question 25

What are you effecitvly fdoing when you degear?

Answer 25

Finding the **Asset Beta** from the **Equity Beta**

Question 26

Degearing formula (i think)

Answer 26

AssetBeta = EquityBeta / (1 + (D(1-T))/E )

Question 27

How can we discount a project when the gearing level changes (so can't use WACC)?

Answer 27

Adjusted present value

Question 28

**APV (adjusted present value) process**

Answer 28

1 Find the base case NPV by discounting using Keu At *cost of equity* (this is the Ke calculated as if the company 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. at **interest rate** (of debt) *i.e. APV = base case NPV + PV of the tax benefit ('shield').*

Question 29

APV: Should you use theoretical debt capacity or actual?

Answer 29

**Theoretical** *For example, if a question stated that actual debt raised is £800,000 but you are told in the question “The investment is believed to add £1 million to the company’s debt capacity”, the present value of the tax shield is based on the £1 million – the theoretical amount.)*