Chapter 11 - The Cost Of Capital And Capital Structure

Question 1

What is the cost of capital / equity?

Answer 1

The rate of return required by the providers of capital for making an investment in the company.

Question 2

What is the risk-adjusted discount rate?

Answer 2

RADR is the rate used to discount a risk asset or investment such as real estate.

It represents the required periodical returns by investors to compensate for the higher risk involved. Higher the risk = higher the discount rate. Discount rate is essentially the rate of return.

RADR is based on the risk-free rate (RFR) (such as short-term interest rate from government securities) and a risk premium for the riskier assets.

RADR = RFR + risk premium

Question 3

What is the difference between systematic and unsystematic risk?

Answer 3

Systematic:

• relates to a market or economy
• e.g. political factors
• affects all shares in market
• cannot diversify risk

Unsystematic:

• specific to a company/industry
• e.g. competitors, location risk
• affects specific business/industry
• can diversify with a portfolio of 15-20 different shares

Question 4

Measuring systematic risk

Answer 4

• The greater the β, the greater the systematic risk and the expected return
• β of 1 = systematic risk of the share is equal to the systematic risk of the market
• β of greater than 1 = systematic risk of the share exceeds the systematic risk of the stock market and therefore the excess return on the share is greater than the excess return on the stock market
• β of less than 1 = systematic risk of the share is lower than the systematic risk of the stock market and therefore the excess return on the share is less than the excess return on the stock market
• The intercept point of the gradient is termed alpha (α). In a perfect world, the alpha coefficient should be 0. Where it is greater than 0, it implies the return on the share is generating an abnormal return due to an element on unsystematic risk. Over time, abnormal returns will cancel out.
• Cost of capital is represented as the RADR. Any share which has a β of more than 0 will have a risk premium attached to it which is the incentive or the extra return to be earned by the shareholder
• When β is less than 1, the RADR will be lower than the return on the market
• When β is more than 1, the RADR will be higher than the return on the market

The calculation for systematic risk and cost of equity, where β exists can therefore be calculated as:

RFR + β x (RM – RFR) x 100 = RADR

Where, RM = return on stock market portfolio

Question 5

What are the assumptions of CAPM?

Answer 5

• Investors are rational and possess full knowledge about the market
• Investors expect greater returns for taking greater risks
• It is possible for an investor to diversify the unsystematic risk by actively managing the portfolio
• Borrowing and lending rates are equal and there are no transaction costs
• Markets are run perfectly and market imperfections tend to correct themselves in the long run
• RFR is the same as the returns on the government bonds
• There is no taxation/inflation

Question 6

What are the criticisms of CAPM?

Answer 6

• Apart from changes in β, there are other reasons (such as company size/market value) for the shares to give excess returns. These are not considered by CAPM
• There are practical difficulties in deriving the systematic risk and the β of a company as trading on the stock market is subject to numerous factors
• Companies with more than one division and business channel may have different systematic risks for each division but β is derived on the basis of a single share price
• CAPM is a one-year model and is only relevant for one year

Question 7

Cost of capital using the dividend valuation model

Answer 7

Used where there is no β.

States the value of the company/share is the present value of the expected future dividends discounted at the shareholders’ required rate of return.

P = Do x (1 + g) ÷ ( Ke – g)

Where:
Do = current level of dividend
P = current share price
g = estimated growth rate in returns

to calculate Ke the formula is rearranged to:

Ke = (Do (1 + g) ÷ P) + g

Question 8

What is the cost of debt?

Answer 8

Cost of debt relates to the effective interest rate a company pays on its debt.

Cost of debt is usually expressed as an after-tax rate = (1 – t) because interest is a tax-deductible expense.

Irredeemable debt:
Perpetual debt which is never repaid. Cost of debt after-tax is calculated as:

Kd = (i x (1 – t)) ÷ Sd

Where:
Kd = cost of debt capital
i = annual interest
t = corporation tax rate
Sd = market price of debt

The cost of debt with no tax relief and the cost of preference shares is calculated using the following:

Kd = i ÷ Sd

Question 9

What is redeemable debt?

Answer 9

Usually repaid at nominal but may be issued as repayable at a premium on nominal value.

Cost of a redeemable debt can be calculated by the internal rate of return (IRR). IRR calculates the rate of return at which the net present value of all the cash flows from a project or investment is equal to zero. Evaluates the profitability and the attractiveness of potential investments. Companies with higher risk = higher cost of debt.

Question 10

What is the weighted average cost of capital (WACC)?

Answer 10

Represents the minimum return that a company must earn on its existing assets. Reflects the weighted average rate of return a company is expected to pay to the providers of long-term finance. WACC = influenced by the external market.

WACC is derived by averaging a firms cost of equity and cost of debt according to the market value of each source of finance.

WACC = Ke x (E ÷ (E +D)) + Kd x (D ÷ (E +D))

Where:
E = total market value of equity
D = total market value of debt

Remember: Kd will need to be calculated using one of the two formulas depending on whether tax is deductible.

Question 11

Capital structure

Answer 11

After determining the finance required, the business must consider the use of various sources of finance. Capital structure = mix of debt and equity finance. It is concerned with the balance between equity and non-current liabilities.

Value of the company can be measured using the following two formulas:

EBIT ÷ overall cost of capital
Market value (MV) = Future cash flows ÷ WACC

E.g. if a project generates future cash flows of £100 at 10% WACC: MV = £100 ÷ 10% = £1,000

Question 12

What are the 8 factors affecting capital structure?

Answer 12

1) Financial leverage or gearing
Debt is normally cheaper than equity. EPS will increase with use of long-term debt and preference share capital if the business yields a return higher than cost of debt. Use of high level long-term debt or gearing increases risks for shareholders as fixed interest has to be paid before dividends.

2) Growth
Equity financing is popular in start-ups and high growth industries, such as technology sector. High cost of servicing debt restricts growth

3) Cost principle
Debt is cheaper than equity as debt is less risky. Interest on debt is deductible for corporation tax purposes which is not allowed for dividends. Based on the cost principle, debt financing should minimise the cost of capital and maximise EPS.

4) Risk principle
(A) Business risk – risk of variability of earnings resulting in an inadequate profit, or even a loss, due to uncertainties in the business. Internal risk = poor product mix, inadequate resources, absence of strategic management etc. external risk = competition, economic climate, government regulations etc. There is little a financial manager can do to alter the business risk due to external factors
(B) Operating risk – risk of disruption to the core operations of a business resulting from breakdowns in internal procedures, people and systems. Measures the risk from operating costs that are fixed. Operating gearing is the proportion of fixed costs a company has relative to its variable costs. There may only be limited opportunities for altering operating gearing
(C) Financial risk – risk of default due to not being able to cover fixed financial costs. Depends on extent of gearing. Risk can easily be controlled by changing the level of financial gearing.

5) Control principle
Where funds are raised through equity capital, shareholder interests are diluted. Where funds are raised through debt capital, there is no effect on control. Debt may be preferred over equity to minimise risk of loss of control

6) Market conditions

7) Tax exposure
Tax deductibility of the debt interest payments can make debt financing attractive

8) Other factors
Government regulations such as tax rates, trends in capital markets, capital structure of other companies and flotation costs

Question 13

What is financial gearing?

Answer 13

Measures proportion of debt relative to equity and shows the extent to which operations are funded by interest bearing lenders vs shareholders. Can be calculated using one of the following two formulas:

Equity gearing = (debt borrowing + preference share capital) ÷ (ordinary share capital + reserves)

Total or capital gearing = (debt borrowing + preference share capital) ÷ (total long-term capital)

Debt is the book or market value of interest-bearing financial liabilities. If available, market values should be used for debt and for equity to get the best measure. Higher the gearing = higher the debt

Question 14

What is interest gearing?

Answer 14

Shows the percentage of profit absorbed by interest payments on borrowings. Measures the impact of gearing on profits.

Interest gearing = (debt interest+ preference dividends) ÷ operating profits before debt interest and tax

Question 15

What is interest cover ratio?

Answer 15

How many times greater PBIT is than annual interest payments. Higher = less risk.

Interest cover ratio = PBIT ÷ annual interest payments

Question 16

Issues with high levels of gearing

Answer 16

• Interest is payable regardless of the operating profit and as such bankruptcy risk is increased
• Agency cost and restrictive conditions imposed in loan agreements constrain management’s freedom of action such as restrictions on dividend levels or the company’s ability to borrow
• After a certain level of gearing, companies will have no tax liability left against which to offset interest charges (tax exhaustion)
• Companies may run out of suitable assets to offer as security against loans with high gearing
• Gearing increases the cost of borrowing

Question 17

What does operating gearing measure and what are the ways in which it is calculated?

Answer 17

Measures the proportion of fixed costs a company has relative to its variable costs.

In times of growth, a high proportion of fixed costs and a low proportion of variable costs can be advantageous.

Common method of measuring operating gearing is to consider the level of contribution earned in relation to sales, known as the contribution-to-sales ratio (C/S ratio). Contribution margin is the excess of total sales over total variable costs. Margin will be positive if sales exceed variable costs and vice versa.

Operating gearing can be calculated using any one of the following three ratios:

1) Contribution-to-sales ratio = (Sales revenue – cost of sales) ÷ sales revenue x 100
The higher the operational gearing, the higher the sensitivity of profit to a change in sales.

2) % change in EBIT ÷ % change in sales
The higher the operational gearing, the higher the sensitivity of EBIT to a change in sales.

3) Fixed costs ÷ variable costs
The higher the fixed costs, the higher the operating gearing.

Question 18

What do capital structure theories attempt to discover?

Answer 18

a) whether an optimal capital structure exists,
b) the optimal mix between debt and equity finance
c) the relationship between WACC, the market value of the firm and the level of gearing in the capital structure.

Question 19

What is the traditional approach to capital structure?

Answer 19

Suggests an optimal capital structure is obtained by a blend of equity and debt financing that minimises
WACC while maximising its market value.

The only way of finding the optimal mix under the traditional view is by trial and error as WACC will change with the level of gearing. Optimal level of gearing is achieved when the WACC is at a minimum.

Under the traditional approach, financial managers should raise debt finance until it achieves the optimal level of gearing that gives the cheapest overall cost of capital. Once achieved, the optimum level of gearing must be maintained.

Question 20

What are the limitations of the traditional approach to capital structure?

Answer 20

• Does not quantify the effect of changes in gearing. It locates the optimal point by trial and error
• Ignores other real-world factors such as corporate tax rates and investment habits of investors
• It was based on the following assumptions:
o The firm pays all of its earnings as a dividend
o The firm’s total assets and revenues are fixed
o Only debt and equity financing is available
o Investment habits remain rational
o There are no taxes

Question 21

Modigliani and Miller (1958) approach: without taxes

Answer 21

• Argued the relationship between the cost of capital, capital structure and the valuation of the firm should be explained by the net operating income approach also known as the capital structure irrelevancy theory
• Suggested the valuation of a firm and the weighted average cost of capital are irrelevant to the capital structure of a company
• Basic concept = value is independent of its capital structure. Market value is determined solely by investment decisions.
• Argued that when gearing increases, the increase in the cost of equity (associated with the higher financial risk) exactly offsets the benefit of the cheaper debt finance. As WACC remains unchanged, the value of a leveraged firm is the same as the value of an unleveraged firm if they operate in the same type of business and have similar operating risks. Value of a company depends upon the future operating income generated by its assets

Assumptions:
• No transaction costs relating to buying and selling securities, as well as bankruptcy costs
• Perfect capital markets with a symmetry of information. Investors will have access to the same information that a corporation would and they react rationally
• Cost of borrowing is the same for investors and companies and debt is risk free

Question 22

What are the 2 propositions of the MM hypothesis?

Answer 22

MM proposition I:
With the assumption of no taxes, capital structure or leveraging does not influence the market value of the company. It assumes that debt holders and equity shareholders have the same priority in the earnings of a company and that the earnings are split equally,

Value of the geared firm = Value of the ungeared firm (NOI ÷ WACC).

MM proposition II
Cost of equity is a linear function of the firm’s debt equity ratio. With an increase in gearing, the equity investors perceive a higher risk and expect a higher return, increasing the cost of equity.

Rate of return required by shareholders (Ke) increases in direct proportion to the debt/equity ratio.

The cost of equity in a geared company Kg = the cost of ungeared company Kg + a premium for financial risk

As gearing increases, the cost of equity rises just enough to offset any benefits conferred by the use of apparently cheap debt (Kd). This means WACC remains constant at all levels of gearing. The company value depends upon the future operating income.

Question 23

Modigliani and Miller theory of capital structure with taxes: the trade-off theory

Answer 23

• MM theory was revised to recognise tax relief on interest payments.
• Actual cost of debt is less than nominal cost of debt because of the tax benefits.
• The trade-off theory advocates that a company can use debt as long as the cost of distress or bankruptcy does not exceed the value of tax benefits.
• As gearing increases, the cost of equity increases in direct proportion to gearing, however, as the overall cost of debt after tax is lower than the nominal cost of debt, the investors’ returns are less volatile. Results in increases of cost of equity causing WACC to fall as gearing increases.
• Gearing up reduces the WACC and increases market value of the company. The optimal capital structure is 99.9% gearing, meaning the higher the debt, the lower the WACC and the higher the market value. The company should use as much debt as possible.

Question 24

What are the criticisms of the MM trade-off theory?

Answer 24

• Ignores bankruptcy risk. Companies do not gear up to 99.9% gearing. if a business is considered risky due to high levels of bankruptcy, the share price will go down and WACC will be increased
• Restrictive conditions in loan agreements can constrain flexibility to make decisions (e.g. paying dividends)
• After a certain level of gearing, companies may no longer have any tax liability left against which to offset interest charges.
• High levels of gearing may not be possible with companies exhausting assets to offer as security against loans
• Different risk tolerance levels between shareholders and directors may impact gearing levels
• Directors have a tendency to be cautious about borrowing

Question 25

What is the pecking order theory?

Answer 25

Alternative theory on capital structure. States companies have the following order of preference for financing decisions:

1) Retained earnings
2) Straight debt
3) Convertible debt
4) Preference shares
5) Equity shares