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