Chapter 6 Capital structure and assessing financing options Flashcards
1.1 Operating and financial risk (gearing)
A distinction must be made between operating and financial gearing.
Operating gearing is a measure of the extent to which a firm’s operating costs are fixed rather than variable, measured as fixed costs / variable costs, or fixed costs / total costs.
Firms with a high proportion of fixed costs as known as having a high operating gearing, as sales vary the fixed costs cause profit to vary more. Therefore, high operating gearing leads to greater variability in operating profit (greater risk).
Financial gearing is a measure to the extent to which debt is used in the capital structure, measured as either Debt / equity or debt / debt + equity.
The presence of fixed interest costs leads to more variability of profits available for shareholders and therefore greater risk.
2.1 Gearing and shareholder wealth
The value of a company is the value of future cash flows discounted at the WACC. If we decrease WACC, we will increase MV of the company, creating shareholder wealth.
If we increase the level of financial gearing two things happen to the WACC. Debt is cheaper than equity as it is less risky and interest is tax deductible, therefore increasing the proportion of the lower Kd in the WACC calculation. And increasing levels of debt makes the return to shareholders more variable. This will cause Ke to rise and therefore pushes WACC up.
3.1 Theories of gearing
There are three theories:
Traditional view of gearing
- At low levels of gearing: equity holders see risk as being unchanged. As cheaper debt is incorporated, WACC falls
- High levels of gearing: equity holders see increased volatility of returns as debt interest is paid first. Increased equity risk increases Ke and WACC starts to rise.
- Very high levels of gearing: bankruptcy worries equity and debt holders. Both Ke and Kd rise, and WACC increases further
The no-tax theory of Modigliani and Miller 1958
Theory based on premise of a perfect capital market with no transaction’s costs, no individual dominates the market, full information efficiency, all investors are rational and risk adverse and no taxes.
They argued:
- Investors are rational, Ke is directly linked to increase in gearing
- As gearing increases, Ke increases in direct proportion
- The increase in Ke exactly offsets the benefit of the cheaper debt finance
- And therefore, the WACC remains unchanged
The with-tax theory of Modigliani and Miller
They updated the model to reflect that the corporate tax system gives tax relief on interest payments. This is the same starting point of the last theory, but is adjusted to reflect that:
- Debt interest is tax deductible, so Kd is lower than before
- The increase in Ke does not offset the benefit of the cheaper debt finance
- Therefore, the WACC falls as gearing increases
- The conclusion is gearing up reduces the WACC and the optimal capital structure is 99.9% gearing
3.2 Practical problems with high gearing
Firms rarely have high gearing due to:
- Increased bankruptcy risk: gearing increase, increases risk of bankruptcy as it will cause Kd to rise and Ke to rise faster
- Tax exhaustion: tax shield on debt may not be achieved if the company profits are not high enough to cover interest costs
- Agency costs: directors may be more risk averse than the shareholders as their livelihood depends on the company remaining solvent
As a result, gearing levels tend to be based on more practical concerns such as the costs of raising finance, asset quality, loan covenants, availability of other sources of finance and levels of other risks.
4.1 Impact of gearing on beta factors
Gearing is a risk that operates systematically. Therefore, when we apply CAPM to calculate the required return to equity, it is necessary to increase the beta we use when the company in question is geared. When we use the CAPM we therefore ensure the beta used reflects the risk of the industry that the project is in, and also the level of gearing in the investing company.
Asset beta: measures systematic business risk only
Equity beta: reflects systematic business risk and the firm’s level of gearing
The equity and asset betas are related as follows:
B(equity) = B(asset) (1 + D(1 – T)/E), where E is the market value of equity, D is the market value of debt and T is the corporation tax rate.
To select a suitable beta, a firm must:
- Find an appropriate asset beta
- Adjust it to reflect its own gearing levels – gear the beta to convert to an equity beta.
If the best beta available is from a geared company (it is an equity beta), the stages become:
- Find the appropriate equity beta
- Adjust the available equity beta to convert it to an asset beta – degear it
- Readjust the asset beta to reflect its own gearing levels – gear the beta
5.1 Adjusted present value
Using WACC to discount a project assumes that the level of gearing will not change. If the gearing level changes, then we need to use the APV:
- Find the base case NPV by discounting using Keu (is the Ke calculated as if the company had no gearing at all)
- Add the PV of the tax shield brought about by using debt finance by discounting at the pre-tax cost of debt
If the resulting APV is positive, project should go ahead. When calculating the present value of the tax shield (tax relief on interest) it should be based on the project’s theoretical debt capacity and not on the actual amount of the debt used.
6.1 Business plans
A business plan will cover strategic direction, chosen strategies, reasoning and expected outcomes.
A standard layout would be front sheet, contents page, executive summary, history and background, mission and objectives, products or services, market information, resources employed, management and operations, financial information, summary action plan – containing milestones and appendices (past accounts, CVs, market research and technical data).
7.1 Forecasts
If a business is considering raising finance for expansion or making other significant charges, it will need to put together forecast financial statements. This is often combined with a requirement to calculate the impact on various different ratios such as: earnings per share, dividend cover, interest cover, gearing and dividend pay-out ratio.
