Capital structure and assessing financing options

Question 1

Define business risk

Answer 1

The variability of earnings before interest and tax associated with the industrial sector in which a firm operates.

Question 2

Define financial risk

Answer 2

The additional variability in returns as a result of having fixed interest debt in the capital structure. Equity holders take this risk in particular but debt holders also suffer financial risk at high gearing levels.

Question 3

Define operating gearing

Answer 3

The extent to which a firm’s operating costs are fixed, as opposed to variable. It is linked to business risk.

Question 4

Define financial gearing

Answer 4

The extent to which debt is used in the capital structure.

Question 5

2 ways that financial gearing can be measured

Answer 5

1. Capital terms by market values

2. Income terms using interest cover

Question 6

2 formulas for financial gearing by capital terms

Answer 6

1. debt / equity

2. debt / (debt + equity)

Question 7

1 formula for financial gearing by income terms

Answer 7

EBIT / interest

Question 8

For gearing calculations, should preference shares be treated as debt or quity?

Answer 8

Debt

Question 9

2 impacts of gearing up

Answer 9

1. Ke increases due to increased financial risk, which, all else equal, pushes up the value of WACC.
2. The proportion of debt relative to equity in the capital structure increases and since Kd < Ke, this pushes down the value of WACC, all else equal.

Question 10

Traditional view of financial gearing

Answer 10

1. As an organisation introduces debt into its capital structure, WACC falls because initially, the benefit of cheap debt finance more than outweighs any increases in the cost of equity required to compensate equity holders for the higher financial risk.
2. At low levels of gearing, there is little change in the shareholders’ required returns.
3. As gearing increases, the equity holders will ask for progressively higher returns and eventually this increase will start to outweigh the benefit of cheap debt finance, and the WACC will rise.
4. At extreme levels of gearing the cost of debt will also start to rise as debt holders become worried about the security of their loans and this will also contribute to an increasing WACC.

Question 11

What conclusions can be drawn from the traditional view of gearing?

Answer 11

1. There is an optimal level of gearing at which the value of the firm’s equity plus debt is maximised. This occurs at the point where the WACC is minimised.
2. There is no precise method of calculating Ke or WACC, or indeed the optimal capital structure. The latter needs to be found by trial and error by changing the gearing and seeing how the market responds.
3. The above conclusion applies equally to situations either with or without corporation tax.
4. If both interest and dividends are constant perpetuities and debt is irredeemable, then MVe + MVd = (earnings x (1 - T)) / WACC.

Question 12

Modigliani and Miller’s no-tax view of financial gearing

Answer 12

1. value of equity in an equivalent ungeared firm = value of debt + value of equity in a geared firm
2. The cost of equity rises in direct proportion to increased gearing.

Question 13

What conclusions can be drawn from Modigliani and Miller’s no-tax view of gearing?

Answer 13

1. With no corporation tax, there is no advantage for firms to gear up.
2. WACC is constant no matter the gearing level.
3. There is no optimal level of gearing as the benefits of cheap finance are exactly offset by the increased returns required by shareholders for the extra financial risk.

Question 14

Modigliani and Miller’s post-tax view of financial gearing

Answer 14

1. value of debt + value of equity in a geared firm = value of equity in an equivalent ungeared firm + (market value of the geared firm’s debt x corporation tax)
2. Benefits of tax relief mean increasing debt reduces WACC and this is less than offset by the increasing returns required by shareholders which push up the WACC. As a result, the WACC falls as the level of gearing increases.

Question 15

What conclusions can be drawn from Modigliani and Miller’s post-tax view of gearing?

Answer 15

1. The effect of interest being allowable against tax means that geared companies pay less tax.
2. Geared companies will have more cash to pay out to investors, and therefore are worth more.
3. The optimal capital structure is a geared one.
4. WACC falls as the gearing level rises.
5. Optimal level of gearing is almost 100% debt.

Question 16

3 problems associated with high levels of gearing

Answer 16

1. Bankruptcy costs
2. Agency costs
3. Tax exhaustion

Question 17

Impact of bankruptcy costs

Answer 17

1. As firms take on higher levels of gearing, the chances of default on debt repayments, and hence the risk of bankruptcy, increases.
2. Investors will be concerned about this and will sell their holdings, causing a fall in the value of the company’s securities, with a corresponding increase in the firm’s cost of funds.
3. To optimise capital structure, financial managers must therefore keep gearing below the point where the cost of investor concerns over bankruptcy outweigh the benefits gained from the increased tax shield on debt.

Question 18

3 direct costs of bankruptcy

Answer 18

1. If a firm is liquidated, its assets are usually sold at less than their going-concern value. Liquidation costs, redundancy costs and distress prices for assets can all lead to assets realising less than their economic value.
2. These costs mean that the company’s going concern value will be greater than its winding-up value. This loss in value will often be borne by the debt holders in the event of bankruptcy.
3. To compensate for this, investors in both debt and equity will ask for higher rates of return from highly-geared companies and thus drive down the prices for their securities.

Question 19

1 indirect cost of bankruptcy

Answer 19

These costs can be suffered by companies that eventually go bankrupt or by those that hover close to bankruptcy for many years.

Question 20

4 actions that are beneficial to shareholders but detrimental to debt holders

Answer 20

1. Paying large cash dividends will realise part of the company’s value for the shareholders at the expense of the debt holders.
2. Managers may try to hide the extent of a firm’s poor financial state by cutting back on research, maintenance, etc, and thus improve the results of ‘this year’ at the expense of those of ‘next year’. This ‘playing for time’ tactic can worsen a debt holder’s position.
3. Management may negotiate a loan for a relatively safe investment project offering good security, and therefore carrying only modest interest charges, and then use the funds to finance a far riskier investment.
4. Management may arrange further loans which increase the risks of the initial lenders by undercutting their asset backing.

Question 21

4 types of loan covenant

Answer 21

1. Restrictions on issuing new debt
2. Restrictions on dividends
3. Restrictions on merger activity
4. Restrictions on investment policy