Ch 19 - Capital structure and dividend policy Flashcards
What are the components of capital of a limited company?
-Equity capital
-ST debt
-Medium-term debt
-LT debt
Aims of the financial manager
main aim to maximise the return to the owners of equity, within the parameters that they have set out which involve:
-VARIABILITY of anticipated RETURNS (w.r.t the nature of the business)
-the owners DESIRE for IMMEDIATE profit rather than future high growth
- the willingness of the owners to put ADDITIONAL CAPITAL into the business
-their willingness to see a reduction in the proportion of the business which they own THE DEGREE TO WHICH RISK should be carried by the owners.
How can the management of a company control the variability of the profits of a company?
-increase/decrease gearing
-negotiate clauses in the contracts with suppliers which remove certain risks
-taking out insurance against certain risks & use of export guarantees
-other risk management measures including financial risk control & financial hedging using derivatives
What is the need for changing the capital structure of a company?
-normally from the desire to expand the business or start new or additional capital projects
-where the business finds itself with excess cash that it cannot profitably use, and so it returns this to SH’s by a way of share ‘buyback’
How may retention of profits be limited?
-SH’s may demand immediate release of profits as dividends
-there may not be sufficient accumulated funds to finance projects when required.
What are the constraints of using alternative forms of finance?
-nature of the business & its assets
-degree of gearing considered acceptable
-effects of taxation
(these are reflected in the credit-worthiness rating of the business)
What factors affect the gearing decision in practice?
-the nature of the business & its assets
-financial risk
-the cost of debt & equity
-availability of finance
-control of the business
-the market view
-taxation
How can the ‘nature of the business and its assets’ affecting the gearing decision?
> some businesses - for e.g banks & property companies - will use a high proportion of debt financing due to the nature of their assets (loans to customers, leased properties)
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others -for e.g mineral prospectors or IT developers - will have very limited tangible assets & will need to rely on equity finance. Most businesses will lie between these 2 extremes
How can ‘financial risk’ affect the gearing decision?
As a business expands it gearing - the ratio of debt:equity -the costs of financial failure rise. In the end, losses can wipe out not merely the assets financed by the loans, but also those financed by equity, at which point the business is bankrupt
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The greater the debt, the less likely it is that the available assets will be able to pay off all the creditors in full.
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In addition, the holders of equity will become concerned that, should the business hit a bad patch, the interest burden will leave nothing for them.
How can the ‘cost of debt & equity’ affect the gearing decision?
As gearing increases, the cost of both debt & equity increases as the risk increases to both the lenders and SH’s.
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Lenders will wish to consider the burden of existing debt before providing further funds. Credit rating agencies monitor the financial status of major companies (and others, on request). The down-rating of a company can have a major impact on the cost of its existing debt & its ability to borrow more.
How can the ‘availability of finance’ affect the gearing decision?
the company may wish to raise a particular form of finance but the providers of debt & equity might be unwilling to provide it.
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if a particular project is large in comparison to the business as a whole, the lender may not be prepared to lend the amount of capital required, and may wish to add covenants to the loan agreement restricting the amount of further debt the company can raise
Why might a bank be unwilling to finance the whole of a project, despite the fact that it considers the project to be profitable and secure?
A bank will control its credit exposure in a number of ways. It will consider:
-amount of each loan as a proportion of its own share capital
-amount of each loan as a proportion of the borrowing company’s share capital
-the total amount of all similar loans (i.e in the same sector or industry) on the bank’s books as a proportion of both of the above
-company doesn’t have sufficient assets to secure loan from bank
How can the ‘control of the business’ affect the gearing decision?
Raising funds through the issue of equity causes a reduction of the existing
shareholders’ proportional holding in the company if shareholders are not able or
willing to buy the new shares.
How can the ‘market view’ affect the gearing decision?
The stock market will consider every aspect of a company in a share price. If the capital structure doesn’t appear consistent with other features of that assessment, the price will change to take into account that info.
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(the more a company’s capital structure will fit the market perception of the company’s prospects, the higher the shares will be rated)
How can ‘taxation’ affect the gearing decision?
i) interest payments are tax deductible (so the tax payable is consequently reduced)
ii) capital allowances on PPE are deductible
iii) lease of PPE receives tax relief
iv) property rental payments are tax deductible
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there’s tax incentive for companies to increase gearing and take on more debt
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Debt finance is advantageous in a world with tax. Debt finance costs are deducted
from pre-tax profits, thereby reducing the amount of tax payable. In addition, the
assets purchased generate capital allowances, which can serve to reduce the tax
liability yet further.
