Capital structure and assessing financing options Flashcards
2 types of gearing
- Operational (operational gearing)
- FInancnal (financial gearing)
What does operating gearing measure?
Ho much costs are fixed v variable
Operating gearing calc
fixed costs/variable costs
OR
fixed costs/total costs
What does a higher operating gearing mean?
More volatility & risk in sales
What does financial gearing measure?
The amount debt is used
Financial gearing calc
Debt/Equity
OR
Debt/(Debt+Equity)
Calculating financial gearing: How are preference shares & dividends treated usuallly?
Treated as debt (and debt interest)
What does higher financial gearing mean?
More fixed (interest) cost = more variability
Traditional view of gearing
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
Is there an optimal level of gearing?
Yes
(The amount that produces lowest WACC)
But impossible to find without trial and error
3 views of gearing
- Tradiitonal
- M&M pre-tax
- M&M post-tax
M&M pre-tax view of gearing: Assumptions
Perfect capital market
No transaction costs
No individual dominates the market
Full information efficiency
All investors are rational and risk averse
No taxes
M&M pre-tax view of gearing
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
M&M post-tax view of gearing: Further assumptions
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
M&M post-tax view of gearing: Further Conclusion
Gearing up reduces the WACC
The optimal capital structure is 99.9% gearing.
Practical problems with high gearing
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.
Practical influences on gearing policy
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).
Is gearing a risk that operates systematically?
Yes
I.e. will make every company riskier
How does gearing affect beta in a CAPM calc?
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
Asset beta
A beta measuring systematic business risk only – i.e. the smaller beta
that isn’t increased to reflect gearing
Equity beta
A beta reflecting systematic business risk and the firm’s level of gearing
– i.e. the larger beta that has gearing in it.
Equity and asset betas formula.
Equity beta =
AssetBeta ( 1 + (MVd(1-T))/MVe)
T = CT rate
MVd = MV Debt
MVe = MV equity
To select a suitable beta for appraising a project, a firm must
1 find an appropriate asset beta
2 adjust it to reflect its own gearing levels – gear the beta to convert to an equity
beta
Selecting a beta: If the best beta available is from a geared company, i.e. it is an equity beta, the stages become:
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
What are you effecitvly fdoing when you degear?
Finding the Asset Beta from the Equity Beta
Degearing formula (i think)
AssetBeta = EquityBeta / (1 + (D(1-T))/E )
How can we discount a project when the gearing level changes (so can’t use WACC)?
Adjusted present value
APV (adjusted present value) process
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’).
APV: Should you use theoretical debt capacity or actual?
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.)
