Chapter 12 - The Cost of Capital & Capital Structure Flashcards

Question

What is interest gearing and how can it be calculated

Answer 1

Interest gearing shows the percentage of profit absorbed by interest payments on borrowings. It measures the impact of gearing on profits. It is calculated as: **Interest gearing = (Debt interest + preference dividends) / Operating Profit**

Answer 2

% change in EPS / % changes in EBIT

Answer 3

A high level of gearing implies a higher obligation for a company to pay interest when using debt financing. It has a higher risk of insolvency than equity financing. While dividends on equity shares need only be paid when there are sufficient distributable profits, the interest on debt is payable regardless of the operating profit of a company. Other problems associated with high gearing include:
* **bankruptcy risk** increases with increased gearing; * **agency cost and restrictive conditions imposed** in the loan agreements constrain management’s freedom of action, * such as restrictions on dividend levels or on 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**; and * **directors have a natural tendency to be cautious** about borrowing and the related solvency issues.

Answer 4

A highly geared company has a high ratio of long-term debt to shareholders’ funds. A high level of gearing implies a higher obligation for the business in paying interest when using debt financing. It has a higher risk of insolvency than equity financing. While dividends on ordinary share capital need only be paid when there are sufficient distributable profits, the interest on debt is payable regardless of the operating profit of a company. A review of the gearing ratio is key in the funding decisions made by financial managers and investors. It affects risk, returns and controls associated with equity capital. Investors may require a higher return to compensate for the higher risk associated with the higher gearing. According to the control principle, debt may also be preferred over equity to minimise possible risk of loss of control.

Answer 5

Other stakeholders who have an interest in the profitability and stability of the company, including employees, customers and particularly creditors, will also be interested in the level of gearing. Since debt capital is cheaper than equity capital, debt financing should minimise the cost of capital and maximise the earnings per share. The interest on debt is deductible for income tax purposes, making debt capital cheaper, whereas no such deductions are allowed for dividends. Debt should be used to the extent that it does not threaten the solvency of the firm.

Answer 6

Operating gearing measures the proportion of fixed costs a company has relative to its variable costs. As with financial gearing, fixed operating costs increase the risk for the shareholders in the same way as fixed interest payments. For example, the costs of staff employed on annual contracts are fixed, whereas those employed on a day-to-day basis are variable. In times of growth, a high proportion of fixed costs and a low proportion of variable costs can be advantageous. There is a cost advantage for producing a higher level of output, also referred to as economies of scale. Higher fixed costs mean greater operational gearing that makes a company’s profits sensitive to a change in sales revenue – a small percentage change in sales will lead to a large percentage in operating profit. With each pound in sales revenue earned beyond the break-even point, the company makes a profit. The opposite is true in times of recession.

Answer 7

The 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). The contribution margin is the excess of total sales over total variable costs. The margin will be positive if sales exceed variable costs and vice versa. Operating gearing can be calculated using any one of the three ratios below: **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. **% change in earnings before interest and tax / % change in sales** The higher the operational gearing, the higher the sensitivity of EBIT to a change in sales. **fixed costs / variable costs** The higher the fixed costs, the higher the operating gearing.

Answer 8

* whether an optimal capital structure exists; * the optimal mix between debt and equity finance; and * the relationship between WACC, the market value of the company and the level of gearing in the capital structure.

Answer 9

The traditional approach suggests an optimal capital structure is obtained by a blend of equity and debt financing that minimises WACC while maximising its market value. The WACC changes with the level of gearing because equity is more expensive than debt. Higher levels of gearing, however, increase the risk to shareholders and therefore result in higher equity costs. A company’s value initially increases alongside debt financing, as debt is cheaper than equity. After a certain point, it begins to plateau and eventually decreases as levels of gearing increase. This decrease in value is caused by excessive borrowings, also referred to as over-leveraging. Lenders will require higher rates of interest in order to compensate for increased risk. Under the traditional view, the only way of finding the optimal mix is by trial and error, as WACC will change with the level of gearing. The optimal level of gearing is achieved when the WACC is at a minimum. This is illustrated in Figure 12.6.

Answer 10

An investor return (Ke) equals the risk-free rate (RFR) plus an additional return for financial risk (related to the gearing of the company). At higher levels of gearing, the risk of investors increases with increased gearing due to the added financial risk of borrowing.

Answer 11

The cost of debt remains constant until a point at which the increasing gearing increases the risk of lenders. The lender will also require higher rates of interest in order to compensate for increased risk to interest payments and principal.

Answer 12

The overall cost of capital initially falls due to the introduction of debt, which is cheaper than equity. The low cost of debt immediately reduces WACC until a point at which the increase in gearing causes both the cost of equity (Ke) and the cost of debt (Kd) to increase. This causes WACC to increase. Point X is the optimal level of gearing, after which the cost of capital carries on increasing as debt and gearing increase. In the traditional approach, the financial manager should raise debt finance until it achieves the optimal level of gearing – that which gives the cheapest overall cost of capital. Once achieved, the optimum level of gearing must be maintained by keeping the same ratio of gearing (part equity/part debt) in future financing.

Answer 13

* The traditional theory illustrates the importance of gearing and the optimal balance between equity and debt, but does not quantify the effect of changes in gearing. It locates the optimal point by trial and error. * The traditional theory of capital structure ignores other real-world factors such as corporate tax rates and the investment habits of investors. * It is based on the following assumptions: – the company distributes all of its earnings as a dividend – the company’s total assets and revenue are fixed – only debt and equity financing is available – investment habits remain rational – there are no taxes

Answer 14

Modigliani and Miller (1958) argued that the relationship between the cost of capital, capital structure and the valuation of the company should be explained by the net operating income approach. Under this approach, the levels of operating income influence market value. This is known as the capital structure irrelevancy theory. It suggests that the valuation of a company and the weighted average cost of capital are irrelevant to the capital structure of a company. The basic concept of Modigliani and Miller’s (MM) approach is that the value of a company is independent of its capital structure. Market value is determined solely by investment decisions. When the 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 company is the same as the value of an unleveraged company if they operate in the same type of company and have similar operating risks. The value of a company depends upon the future operating income generated by its assets. The MM hypothesis can be explained through two propositions. 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 company = Value of the ungeared company (net operating income (NOI) ÷ WACC).** MM proposition II The cost of equity is a linear function of the company’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. The rate of return required by shareholders (Ke) increases in direct proportion to the debt/equity ratio. **The cost of equity in geared company Kg = the cost of ungeared company Ku + a premium for financial risk**
As the gearing increases, the cost of equity rises just enough to offset any benefits conferred by the use of apparently cheap debt (Kd). This means that WACC remains constant at all levels of gearing.
Under the MM theory, the company value depends upon future operating profits. The essential point made by M&M is that the company’s cost of capital is independent of the way in which investment is financed. Arbitrage (market pressures) will ensure that two identical companies, with same company risk and identical provisions before interest and tax (PBIT), will have the same overall market value and cost of capital irrespective of their gearing level.

Answer 15

* No corporate taxation. * No transaction costs relating to buying and selling securities or bankruptcy costs. * Perfect capital markets with a symmetry of information. An investor will have access to same information that a company would and they react rationally. * The cost of borrowing is the same for investors and companies. * Debt is risk free.

Answer 16

The impact of tax cannot be ignored in the real world, since debt interest is tax deductible. Modigliani and Miller revised their theory in 1963 to recognise tax relief on interest payments. The actual cost of debt is less than the nominal cost of debt because of tax benefits. However, the same is not the case with dividends paid on equity. 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. This is illustrated in Figure 12.8. Cost of capital K e WACC (K o ) Gearing Gearing Value of company K d (1 – t) Figure 12.8 The Modigliani and Miller theory with taxes As gearing increases, the cost of equity (Ke) increases in direct proportion with gearing. However, as the overall cost of debt after tax relief (Kd(1-t)) is lower than the nominal cost of debt (Kd), investor returns are less volatile. This leads to lower increases in Ke, causing the WACC to fall as gearing increases. Therefore, gearing up reduces the WACC and increases the market value of the company. The optimal capital structure is 99.9% gearing. This means the higher the debt, the lower the WACC and the higher the market value. The company should use as much debt as possible.

Answer 17

* It ignores bankruptcy risk. In practice, companies never gear up to 99.9%. As gearing increases, so does the possibility of bankruptcy. If the company is considered to be risky, the share price will go down, increasing the company’s WACC. * Restrictive conditions in the loan agreements associated with debt finance can constrain a company’s flexibility to make decisions (such as paying dividends, raising additional debt or disposing of any major fixed assets). * After a certain level of gearing, companies may no longer have any tax liability left against which to offset interest charges. Kd(1–t) simply becomes Kd due to tax exhaustion. * 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 the gearing level. * It can be argued that directors have a tendency to be cautious about borrowing.

Answer 18

The Modigliani–Miller theory states that capital structure is irrelevant and efforts to reduce the cost of capital using gearing will not succeed.
* 1st proposition - the value of the geared firm equals the value of the ungeared firm (earnings before interest ÷ WACC). The value of WACC is constant at all levels of gearing. * 2nd proposition - that savings from debt being cheaper than equity are equal to the increase in the cost of equity due to increased risk arising from gearing. The cost of equity in geared company Kg equals the cost of ungeared company Ku plus a premium for financial risk.
Later developments in the theory with the introduction of tax state that debt interest is tax-deductible, whereas ordinary share dividends are not. The conclusions are that debt is, in fact, cheaper than equity. Tax relief on debt interest reduces the WACC. Therefore, gearing up reduces the WACC and increases the market value of the company. The optimal capital structure is 99.9% gearing. This means the higher the debt, the lower the WACC and the higher the market value. The company should use as much debt as possible.

Answer 19

The ‘pecking order’ theory popularised by Myers and Majluf (1984) was developed as an alternative theory on capital structure. It states that companies have the following order of preference for financing decisions: * retained earnings * straight debt * convertible debt * preference shares * equity shares The reasoning is that as companies are risk averse and will prefer retained earnings to any other source of finance, they will choose debt and equity last of all. They invariably prefer internal finance over external finance. The costs of borrowing also follow the same order, equity shares being the most expensive. The value of a project depends on how it is financed. If a company follows the pecking order approach, only projects funded with internal funds or with relatively safe debt will be accepted. Risky projects funded by risky debts or equity will be rejected.

Answer 20

Companies take a balanced approach in the real world, whereby the different theories can be reconciled to make the correct financing decisions. Capital structures can also be affected by other factors such as growth, market conditions and tax exposure. Companies consider the signalling effect of raising new finance by assessing the impact of the new finance on a company’s statement of profit or loss and OCI and statement of financial position. Profitable companies will tend to drift away from their optimal gearing position over time – known as ‘gearing drift’, whereby the level of the debt-equity ratio gradually decreases as accumulated retained earnings help to increase the value of equity. Companies tend to increase their gearing positions by occasionally issuing debt, paying a large dividend or buying back shares.