Cost of Capital and capital structure Flashcards

Question

Financial gearing?

Answer 1

Financial gearing measures the proportion of debt a company has relative to its equity. It is a measure of a company’s financial leverage (also called ‘trading on equity’) and shows the extent to which its operations are funded by interest bearing lenders versus shareholders. Financial gearing can be calculated using one of the following two formulae: 1. Equity gearing = Debt borrowing + preference share capital / Ordinary share capital + equity or Debt / Equity x 100 2. Total or capital gearing = Debt borrowing + preference share capital / Total long-term capital 3. Interest gearing 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

Problems around high levels of gearing: 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: 1. bankruptcy risk increases with increased gearing; 2. 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; 3. after a certain level of gearing, companies will have no tax liability left against which to offset interest charges (tax exhaustion); 4. companies may run out of suitable assets to offer as security against loans with high gearing; 5. gearing increases the cost of borrowing; and 6. directors have a natural tendency to be cautious about borrowing and the related solvency issues.

Answer 3

Gearing and the cost of debt (Kd) and WACC 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 4

Limitations of the traditional view 1. 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. 2. The traditional theory of capital structure ignores other real-world factors such as corporate tax rates and the investment habits of investors. 3. It is based on the following assumptions: a. the company distributes all of its earnings as a dividend b. the company’s total assets and revenue are fixed c. only debt and equity financing is available d. investment habits remain rational l e. there are no taxes

Answer 5

The Modigliani and Miller (1958) approach: without taxes 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.

Answer 6

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. 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. 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. This is illustrated in Figure 12.7. 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 7

Assumptions of the MM approach without taxes: 1. No corporate taxation. 2. No transaction costs relating to buying and selling securities or bankruptcy costs. 3. Perfect capital markets with a symmetry of information. An investor will have access to same information that a company would and they react rationally. 4. The cost of borrowing is the same for investors and companies. 5. Debt is risk free

Answer 8

The Modigliani and Miller (1963) approach with taxes: the trade-off theory: 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. 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 9

Criticisms of the MM trade-off theory 1. 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. 2. 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). 3. 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. 4. High levels of gearing may not be possible with companies exhausting assets to offer as security against loans. 5. Different risk tolerance levels between shareholders and directors may impact the gearing level. 6. It can be argued that directors have a tendency to be cautious about borrowing.

Answer 10

Real world approaches: Pecking order theory 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 11

Real world factors 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.