chapter 6 Flashcards
Business risk
the variability in earnings before interest and tax associated with the industrial sector in which a firm operates
Financial Risk
Additional variability in returns as a result of having fixed interest debt in the capital structure
Operating gearing
Extent to which operating costs are fixed, high operating gearing firms have high fixed costa low variable costs and high contribution, so sensitive to change in sales volume
Financial gearing
extent to which debt is used in the capital structure - measured in capital terms (debt/equity or debt/debt+equity) or income terms (EBIT/Interest
Gearing - measured in capital terms
debt/equity or debt/debt+equity
Gearing - income terms
EBIT/Interest
Two impacts of gearing increasing
Ke increases as financial risk increases
Debt proportion increases relative to equity, as Kd<ke WACC down
What is the traditional view of gearing
When debt introduced, WACC will fall as cheaper debt outweighs increased KE
as debt increases, KE increases and this will outweigh cheap debt, WACC will rise
extreme levels, kd will also start to rise, WACC increases further
MVE + MVD =
Earnings (1-T)//WACC
MM 1958
No corporation tax, no advantage to issue debt
Value of an un-geared firm = value of geared firm
Implications of MM 1958
- WACC is constraint regardless of gearing
- no optimal level of gearing (benefit cheap debt offset by ke)
MM 1963
In the presence of corporation tax, advantageous to issue debt
MM 1963 Value of geared firm
= value of unguarded firm + D*T
where D is mv of debt, T is tax
Implications of MM1963
WACC falls as gearing increases
optimal gearing 100% debt
Problems associated with high levels of gearing
Bankruptcy costs
Agency Costs
Tax exhaustion
Bankruptcy costs
As take on more debt, risk of insolvency increases, investors concerned and sell holdings, so value of securities fall.
M&M with bankruptcy costs
MV = Value if all equity + value of tax shield - bankruptcy costs
Direct costs of bankruptcy
- Assets realise less than economy value as sold at less than GC value when liquidated
- GC value > winding up value, loss borne by debt holders
- As compensation, investors want higher rate of return
Indirect costs of bankruptcy
Relate to problems of operating company under severe financial distress
Agency problems - managers act in interest of shareholder and increase indirect cost of bankruptcy through
- paying large cash dividends (at expense of debt holders)
- hide financial state by cutting back on research, maintenance - improve this year at expense of next year
- May negotiate a loan for safe investment project and use funds for more risky investment
- Arrange further loans increasing risk
Loan covenants - restrictions on issuing new debt
prevent issuing new debt with superior claim on assets unless existing debt is upgraded to same priority, or minimum asset backing maintained
Loan covenants - restrictions on dividends
Dividend growth usually required to be linked to earnings growth, repurchase of shares often also restricted
Loan covenants - restrictions on merger activity
May be prohibited unless post-merger asset backing maintained at minimum prescribed level
Loan covenants - restrictions on investment policy
restrict investments in other companies, restrict disposal of assets, requirements for maintaining assets - hard to monitor
Tax exhaustion
at certain level of gearing, may have no taxable income left to offset interest charges against.
Capital structure and business risk
Gearing adds financial risk on top of business risk, therefore higher business risk lower gearing
Capital structure and bankruptcy
Bankruptcy costs have higher change of being incurred at higher levels of gearing
Capital structure and quality of assets
lenders want security, firms with more tangible assets can often borrow more
Capital structure and availability of other sources of finance
Small firms may be limited in terms of external finance so are forced to use equity
Capital structure and cost of raising finance
Retained earnings - zero
Loan finance - Cheap compared to equity
Equity - expensive
Capital structure and tax rate
Higher tax rate higher tax relief on interest
Gearing tends to be a lower factor if business risk is
Higher
Gearing tends to be a lower factor if bankruptcy risk is
Higher
Gearing tends to be lower if tax exhaustion on
low taxable profits
Gearing tends to be lower If assets are mainly
intangibles
Gearing tends to be lower if access to debt finance is
Litte
Gearing tends to be lower if tax rates are
low
Signalling effect
Raising debt could signal confidence to investors, as the directors are signalling they are confident about the future to commit to interest paymments
Clientele effect
Particular shareholders may be satisfied with existing level of gearing, if this changes, they may sell shares.
new investors may be happier with new gearing and buy if gearing changes.
APV Steps
- Give base case value using ke (unguarded)
- Establish PV tax shield - appropriate discount is pre tax cost of debt
- Adjust for the costs of issuing
Issues with APV
Based upon M&M with tax, agency costs, financial distress not reflected
Geared companies will have … 𝝱
Higher
as financial risk applies systematically and cannot be diversified
Cash forecasts provide early warning of liquidity problems by estimating
How much cash is required
when it is required
how long it is required for
whether it will be available
