Raising Finance (debt)

Question 1

What is the gearing ratio?

Answer 1

The gearing ratio is a financial ratio which compares owner equity to funds borrowed by the company.

Question 2

How is the gearing ratio calculated?

Answer 2

(Interest bearing loans/Total shareholders equity) x 100

Question 3

In a non-current liabilities table, what is represented by:
1. The percentage
2. The date in the middle column

Answer 3

1. The percentage denotes the annual rate of interest or ‘yield’
2. The date in the middle column is the repayment date.

Question 4

What is meant by short, medium and long term borrowing?

Answer 4

1. Short-term, repayable within one year e.g. overdrafts
2. Medium-term, repayable within 1-7 years
3. Long term, repayable over 7 years

Question 5

Who buys bonds and debentures?

Answer 5

1. Pension funds
2. Mutual funds
3. Insurance companies
4. Banks
5. Wealthy individuals

Question 6

What are bonds?

Answer 6

1. When a company borrows money in return for a formal ‘IOU’ plus interest
2. Bonds are generally fixed interest securities
3. Are generally long-term contracts (7 -30 yrs)

Question 7

What are debentures?

Answer 7

1. Debentures are a more secure type of bond as the company’s assets will be put up as ‘collateral’.
2. Due to this lowered risk returns are smaller

Question 8

What are convertible bonds?

Answer 8

1. Money originally invested as bonds but with the option to convert them into equity at a later date.
2. The future conversion rate is specified at the issue date

Question 9

What are ‘deep discount’ bonds?

Answer 9

1. Deep discount bonds earn no interest, they earn capital gains instead
   E.g. £100 bond sold for 20% discount, investor pays £80 now and collects £100 when bond matures

Question 10

Why is debt good?

Answer 10

1. Debt is cheaper than equity for the company because:
   a. Equity must offer a higher return to compensate for increased risk, payable through dividends or capital gains
   b. Debt attracts tax relief, corporate tax on issued shares can exceed interest rates on issued bonds
2. Issuing debt brings no dilution of equity

Question 11

Why can excessive debt lead to financial distress?

Answer 11

1. More debt leads to higher interests and repayments which are unavoidable
2. Equity carries no such responsibilities, dividends are not necessary or even expected in early stage companies
3. Default carries high costs e.g. penalty clauses

Question 12

What is WACC and what are its implications?

Answer 12

WACC is the weighted average cost of capital
1. At 0% debt: the WACC equals the cost of equity (shareholders desired minimum return)
2. As the company takes on debt, the WACC falls because debt is cheaper than equity
3. As the company takes on very high levels of debt, WACC rises again as risk of financial distress increases, so there is an optimal level of gearing.

Question 13

Is it better to be low or high geared when profits are low or high?

Answer 13

1. Better for company to be low-geared when profits are low, as interest charges won’t eat away all the profits
2. Better for company to be high-geared when profits are high as despite higher interest charges, profit left-over gets shared between fewer shares.

Question 14

What is interest cover and how is it calculated?

Answer 14

1. Interest cover is a debt and profitability ratio which determines how easily a company can pay interest on outstanding debt
2. Calculated by dividing earnings before interest and taxes by interest expense on company’s outstanding debts