Ch4 - The Financing/gearing Decision Flashcards
Considerations of Financing
Ongoing servicing costs - debt is usually cheaper due to tax relief, and risk faced by providers of finance
Issue costs - raising debt usually cheaper and easier than issuing new shares
Gearing - Debt and preference shares require fixed payments before ordinary shares, this increases shareholder risk and finance risk
Optimal Capital Structure - Must balance the trade-off between cheap debt finance and high gearing (bankruptcy) to achieve the best balance
Availability - Not all firms can select capital structure. Need sufficient assets as collateral, or convince shareholders to invest
Tax position - Only in a tax paying position can tax on debt finance be offset
Flexibility - high risk industries mainly use equity finance to not have to pay dividends if returns fall
Cashflow profile - ensure they don’t mature at the same time
Risk appetite
Covenants - May have restrictions on level of gearing from AoA or previous loan agreements
Traditional view on WACC
Trial and Error:
At low levels of gearing: equity holders see risk as marginal as gearing increases, this results in a lower WACC
At higher levels of gearing: Equity holders become concerned with volatility of their returns and so WACC rises as gearing increases
At very high levels: Serious bankruptcy risk affects both Ke and Kd, they both rise and WACC rises.
Modigliani and Miller’s theory (with tax)
Optimal gearing is 99.9% as debt equity is cheaper as it’s tax deductible
HOWEVER Ignores:
Bankruptcy risk, agency costs, tax exhaustion, covenants and restrictions, increases in cost of borrowing as gearing increase, impact on borrowing capacity
Factors to consider dividend decision: Shortened
GOATFICCS
G Gearing - debt = fixed payments must be made before ordinary shareholders - increases SH risk
O Optimal capital structure - trade-off between cheapt debt and risk of high gearing
A Availability - assets to cover debt, persuading shareholders, quoted or unquoted?
T Tax position
F Flexibility - high risk industry = equity finance to stop paying dividends
I Issue costs - costs for debt are cheaper and easier. Debt cheaper at level gearing
C Cashflow profile - ensure not maturing same time, tax paying for debt, can they afford?
C Covenants and restrictions - AoAs, covenants from prior lendors
S Service costs - debt cheaper interest relief if in tax paying position
Theories; Static Trade Off Theory - Gearing
M&M Theory with bankruptcy risk incorporated - Adjust debt target to stay under the ratio
Answers the trade off between the tax shield which increases the firms value through cheap debt vs the reduction in value through agency costs, bankruptcy risk and Fin distress
Pecking Order Theory
Addresses the issue of empirical evidence not supporting the static trade off theory
High cashflow = low gearing
Low cashflow = high gearing
Value of a project can alter the choice of finance, which can cause higher geared, low cashflow companies to under invest
Gearing Drift
Over time the gearing level gradually reduces
Compromise Approach
Select a long-run target gearing ratio
If far away = use static-trade off
If close to target = use pecking order theory
Factors to consider: Assymetric information - Myers and Majluf
Managers have access to inside information, therefore forecast more realistic view, shares get issued at as lower price to new shareholders transferring wealth. Therefore, internally generated is often preferred
Asquith and Mullins - New Equity Issue
New equity issues are met by sharp declines in stock prices
Agency Effects to consider
If a firm has high gearing:
Managers may gamble on high-risk projectrs to solve problems
Shareholders reluctant to put money in, but happy to take money out
Change risk when receiving a loan to a more risky project
Agency Effects - How to Solve
Debt Covenants - Restrict issuance of new debt, issuing more dividends, ensuring asset backing of loans remain the same post merger, disposal of assets
Encourages use of retained earnings, and makes new issues less attractive to investors
Financing Types: Equity
Rights issue - easiest, doesn’t dilute control, but must convince shareholders
Public Issue - IPO, expensive, larger pool of investment, time consuming, dilutes control
Private Equity - expensive and high risk, and often can lead to loss of control e.g. LBO, mezzanine finance, venture capital
Financing Types: Debt
Small:
Bank loans, family/friends, leasing assets
Large:
Bond Issue - large debt, low interest, high issue cost. Risk of not fully subscribed unless underwritten
Debentures against securities
Convertible bond - more attractive to investor
Mezzanine debt - convertible in case of default - backed by cashflow
Syndicated debt - High interest low issue
Islamic Finance
Murabaha - bank buys asset off a company for more than it’s worth, company pays it back. No early payment discounts.
Ijara - lease finance. Bank still owns it. Use is specified. Lessee must keep in good shape.
Sukuk - debt finance over assets, no voting rights, has interest elements. The Sukuk-holder participates in owning the asset and gets benefits from owning seas asset.
Equity:
Mudaraba - equity finance SHORT TERM ONLY, one person provides money, other provides expertise. Split in pre agreed ratio.
Musharaka - venture capital. Musharaka holders can contribute to management if they so wish.
Financing Foreign Projects:
Using Free Cashflow: Avoids risk of international financing, unlikely to meet capital required
Financing Foreign Projects:
Finance raised in parents’ entity country
Parent has good access to credit, better funds, and rates
Centralised function which can access more complex products
Has risk of exchange controls if done in denominated sub currency. However matching can be done to offset impact of FX movements.
Lower interest payable offset by income of subsidiary
If done in parent’s domestic currency - no way of matching
Financing Foreign Projects:
Finance raised in Subsidiary Country
Advantages:
Denominated in subsidiary’s currency so FX risk reduced. Foreign governments encourage investment into their country through grants, subsidies and cheaper finance as it’s seen that the investment will benefit their country economically.
Disadvantages:
Capitalization rules may be thin in foreign country and not allow capitalization of debt portion.
Higher interest payable on foreign debt could outweigh the decreased FX exposure.
Foreign Financing Types: Short/Medium Term
Eurocurrency loans – Straight loans, lines of credit, revolving loans. Company’s must be large and have first class credit loan. Loans may be cheaper if interest rates are lower and outweigh FX exposure, quicker to arrange, large companies can rely on their credit ratings rather than security.
Syndicated loans – same as above, can be cheaper, and diversification of source of finance can reduce fx exchange risk. Also available for smaller firms e.g. USD 10m
Short-term syndicated credit – Borrow up a set amount but not all of it. Often expensive. Used to fund takeovers and refinance debts during takeover.
Multiple option facilities – Panel of banks provide credit standby at a rate of interest linked to a reference rate e.g. SOFR, SONIA, and banks bid to provide loans when borrower needs cash. Variety of currencies
Euronotes – Firms issue promissory notes promising to pay the holder in the future. Can be single or multiple currencies. Medium term notes issue gap between bridge between Euronotes and Eurobonds.
Foreign Financing Types: Long Term
Long-term:
Syndicated loans
Eurobonds – 3-20 years, single currency, fixed or floating interest rates. Large capital sums for long periods, borrowing not subject to domestic regulation.
Disadvantages – can suffer losses if the currency in the denomination strengthens against the currency in which revenues are made. OR GAIN if it weakens
