KCB WEEK 9 - Capital Structure Flashcards
KEY TERMINOLOGY
- Enterprise value/firm value = value of debt + value of equity (market value)
- Equity Gearing = (Debt borrowing + preference share capital) / (Ord share cap + reserves)
- Total/Capital Gearing = (Debt borrowing + pref share cap) / total long-term capital
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Interest gearing = ((debt interest + preference dividends) / operating profit) x 100
oPBIT/Interest = Interest cover % - % changes in EPS / % change in PBIT = if ratio is high means if EBIT has major changes it will also massively change the EPS
TRADITIONAL VIEW OF CAPITAL STRUCTURE KEY POINTS
Views of the practitioners of finance – no mathematical proof
Enterprise value/firm value = value of debt + value of equity (market value)
Blend of equity and debt financing – minimise WACC while maximising market value
Capital structure be changed to lower WACC – certain point for low WACC/high market value (optimal capital gearing)
Increase in gearing = growth in long-term borrowing
So proportion of debt capital is increasing
Cost of equity is also increasing to compensate for inc. financial risk – demand more
Cost of equity is increasing at an increasing rather than steady rate (ex. MM theory)
Cost of Debt capital – protected by law, interest payments are guaranteed
Usually will have a form of security for if company defaults – lower financial risk even at a high gearing level.
Overall average costs come down at first (where replacing more expensive equity with cheaper debt finance) – then up at very high levels of gearing
Only demand higher interest where extremely highly geared – overall costs significantly increase
Together = WACC (Ko) Ex. 9% average gearing / E was 91% / D was roughly 9% Debenture Value / Equity + Debt = 9% WACC was roughly 14%
Limitations of the traditional view of capital structure
- Does not quantify effects of changes in gearing
- Ignores real world factors
- Questionable assumptions: all earnings after tax are distributed as dividends, none kept as retained earnings
- Assets and revenue are assumed to be fixed
- Only equity and debt finance are considered not others (ex. lease finance)
- Rational behaviour of investors
Overview of MM v.1
IRRELEVANCY THEORY OF CAPITAL STRUCTURE
Process of arbitrage PROVES the WACC percentage level
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Assumptions
Perfect market
No bankruptcy
No transaction costs
Full free information available to everyone dealing with the market
Cost of borrowing / cost of earning on lending are equal (whether individual or corp)
No tax
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Cost of equity will go up at a constant rate (straight line basis)
Cost of debt capital - Kd (1 – t ) – remains constant even at v. high levels of gearing
Ko Figure will not change
By changing capital structure you cannot change WACC/market value – no point spending time whether to structure capital at X or Y% level gearing – whatever level will have the same result. If you cannot change the market value the capital gearing decision is irrelevant.
Comparing the traditional method and MM v.1
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Equity – Agree equity cost will go up as gearing does due to increased financial risk
But traditional – on an increasing rate / M&M – at a constant rate (straight line basis) - Debt - Traditional – will go down at first then increase at high gearing levels – MM – stays same
- WACC - Traditional – goes down due to replacement effect then up at high levels of gearing (optimum gearing level is X )- market value goes up until X – MM market value will not change – remains constant line with gearing
MM v.2 overview (with tax consideration)
- WACC will be falling – even at highest gearing levels
- Market value will be increasing
- If company’s can (with tax) go for 99.99% gearing
- If you cannot - maximum level possible of gearing
- Equity - as gearing increases, Ke will increase in direct proportion
- Debt overall after tax (Kd (1-t)) – lower than nominal cost of debt means investor returns are less volatile – leading to lower increases in Ke, causing WACC to fall as gearing increases.
- Contradicts common sense – those with high borrowing will be companies that fail
Criticisms of MM theory of capital structure
- Ignores bankruptcy risk
- Restrictive covenants in loans associated with debt finance can constrain company flexibility to make decisions (ex. paying dividends/raising additional debt/disposing of any major fixed asserts)
- After certain level of gearing companies may no longer have tax liability left to offset interest charges against – Kd (1 – t) simply becomes Kd due to tax exhaustion.
- High gearing levels may not be possible with companies exhausting assets to offer as security against loans
- Different risk tolerance levels between directors and shareholders may impact gearing levels
- Can be argued directors have a tendency to be cautious about borrow
What are the (main)
‘company’ risks’?
- Risk of variability in earnings – inadequate profit or even loss
- Internal and external
- Integral – poor product mix/resources/strategic management etc
- External - competition/overall economic climate/government regulations
- Little a manger can do to alter risk posed by external factors
What are the (main) ‘operating’ risks?
- Risk of disruption of core operations resulting from breakdown in internal procedures, people and systems
- Inadequate policies/system failures/criminal activity/loss faced by litigations against company
- Measures risk from operating costs that are fixed - more fixed costs more operating risk
- Operating gearing = proportion of fixed costs a company has relative to variable costs
What are the (main) ‘financial risks’?
- Risks from financing
- Risk of default where company may not be able to cover fixed financial costs
- Extent depends on leverage of company’s capital structure
- Debt financing has higher financial risk (should be in position to pay loan /interest as and when fall due)
- Most easily controlled by changing the level of financial gearing
Overview of ‘pecking order’ theory - how companies decide on their capital structure in the ‘real world’
1) Retained earnings - earnings are inside company – do not need to ask shareholders to use
2) Straight debt - debenture on which interest will be paid
3) Convertible debt - sell a debenture with option to convert into shares after certain level of time, if the debenture holders want
4) Preference shares - dividend on these are fixed, no voting rights often / limited at best, no dilution of control
5) Equity - last resort, issue of ordinary shares to raise capital
