Chapter 18 - Capital Structure Flashcards
what is operating gearing?
a measure of the extent to which a firm’s operating costs are fixed rather than variable as this affects the level of business risk in the firm
What are the operating gearing calculations?
Fixed costs / Variable costs
Fixed costs / total costs
% change in EBIT/ % change in rev
At higher levels of gearing what happens to fixed costs?
the higher the proportion of fixed costs and the riskier the EBIT
What is financial gearing?
a measure of the extent to which debt is used in capital structure
Are preference shares usually debt or equity?
debt
What is the calculation for the equity gearing ratio?
Debt / Equity
What is the calculation for the capital gearing ratio?
Debt / Total capital
What is the calculation for the interest gearing ratio?
Debt interest / operating profit before debt interest and tax
What values can be used when calculating financial gearing?
the nominal (book) values or market values
If nominal values are used what must be remember to include?
include reserves in the value of equity
A company with a higher level of financial gearing will have increased what?
variability of returns to shareholders
Increase in gearings represents what?
An increase in risk for the equity investor
For ordinary (equity) shares or for preference shares, the total market value is calculated as what?
number of shares in issue x ex-dividend share price
what is the calculation for equity nominal value on ordinary (equity) shares?
add up the value of any share capital, share premium and equity reserves on the SFP
what is the calculation for equity nominal value on preference shares?
add up the value of any share capital and share premium on the SFP
what is the calculation for debt market value for tradeable debt such as companies issued with loan notes?
number of loan notes in issue (divide by 100) x ex-interest price per loan note
what is the calculation for debt market value for non- tradeable debt such as companies issued with loan notes?
there will be no market value, use the nominal value instead
what is the calculation for debt nominal value for trade-able and non-tradeable debt?
take figure from the SFP
What is the MV of a company equal to?
PV of its future cash flows discounted at the WACC
If WACC falls what happens to the business value?
business value will rise
As proportion of debt increases what will happen to the WACC?
debt is cheaper source of finance (lower risk and tax relief on interest) so the WACC falls
As proportion of equity increases what will happen to the WACC?
the equity holders perceive more risk caused by the increase in debt, so the cost of equity rises and WACC rises
What is the traditional view based on?
a real world observation
What are the traditional view conclusions?
- shareholder wealth is affected by changing the levels of gearing
- there is an optimal gearing ratio at which WACC is minimised and the total value of the company is maximised
- financial managers have a duty to achieve and maintain
- we accept that the WACC is probably U shaped for entities generally, we cannot precisely calculate a best gearing level
- optimum level will differ from one entity to another and can only be found with trial and error
What are M&M’s key assumptions?
- a perfect capital market in which there are no information or transaction costs
- debt is risk free and kd remains constant at all levels of gearing
- no taxation
What is M&M’s no tax theory?
in the absence of tax, the two opposing factors cancel out exactly, so the WACC (and business value) is constant at all levels of gearing
What is M&M’s no tax theory but with tax?
the tax relief on debt interest caused the WACC to fall (and business value to rise) as gearing increases
What is the implication of the M&M theory with taxation?
the optimum gearing level is 99.9% debt
In practice, firms are rarely found with very high levels of gearing. Why is this?
- bankruptcy risk
- agency costs
- tax exhaustion
- the impact on borrowing/debt capacity
- difference between risk tolerance levels between directors and shareholders
- restrictions in the articles of association
- increase in the cost of borrowing as gearing increases
What is the pecking-order theory?
there is no search for an optimal capital structure through a theorised process
In the pecking-order theory it is argued that firms will raise new funds in what ways?
- internally generated funds
- debt
- new issue of equity
What is the calculation for the dividend valuation model and current WACC?
re = (Do(1+g) / Po) +g
When would we use the dividend valuation model?
to estimate a cost of equity if:
- there is no change in trade
- there is no change in gearing
- funding is not project specific
What is the CAPM calculation?
E(ri) = Rf + Bi [E(rm) - Rf]
Use the CAPM to estimate what?
a cost of equity if there is a change in the trade of the business, such as new project in a different business area
The beta of the new trade will indicate what?
the level of systematic risk exposure, and drive the required return
The CAPM uses a beta factor to represent what?
the systematic risk levels of the investment
What are the 3 types of beta factors?
Asset Beta (Ba)
Equity Beta (Be)
Debt Beta (Bd)
What is Asset Beta?
the beta for an un-geared company. represents the systematic risk of the business type only
What is debt beta?
Usually 0 unless told otherwise
What is equity beta?
the beta for a geared company
represents both the business risk and the financial risk (related to gearing levels) of the company
