Topic 10: Capital structure and gearing Flashcards
What is higher, cost of equity or cost of debt and why?
Cost of equity is usually higher as the risk is higher so investors want more compensation
What is the creditor heirarchy? and examples?
Secured creditors
Unsecured Creditors
Preference shareholder
Equity shareholders.
How to calculate value of a company?
PV of expected future cashflows discounted at WACC
What happens to company value if WACC increases?
It lowers the company’s value because its increasing the discount rate.
How does a change in gearing impact on WACC?
higher gearing increases risk so increases WACC and it works the other way.
What is the traditional theory of gearing on WACC?
Modigliani and Miller’s theory of gearing without tax.
Modigliani and Miller’s theory of gearing with tax
Traditional Theory.
What is Modigliani and Millers Theory of gearing without tax?
A company’s value is the present value of the future cashflows regardless of how the earnings are returned either dividends or capital gain. A value of a company should not be affected if the capital structure changes, they say WACC doesn’t change as the positives and negatives cancel each other out. so there is no optimal capital structure.
What is Modigliani and Millers Thoery of gearing with tax?
It does matter how investors are paid as there is tax relief on interest payments but no tax relief on dividends. They say WACC will decrease as gearing increases because the benefit of increased debt outweighs the drawbacks ALWAYS, because of that tax relief.
Using Modigliani and Millers of gearing with tax what is the optimum level of gearing?
99.9%
What are the assumptions needed for Modigliani and Miller’s theory of gearing?
Taxation is ignored at least initially.
Perfect markets
All debt is risk free and investors can borrow or invest at a risk free rate of return.
All investors act rationally
What is the pecking order thoery?
It is the way that companies order their finances of what to use first to last e.g retained earnings first, new issue last.
What are some practical issues with high levels of gearing?
Risk of bankruptcy - a lot of interest needs to be paid as it is a commitment.
Tax Exhaustion - The company needs to be profitable as the tax relief is only useful to profitable companies.
Restrictions - Restrictions can be placed on a business for instance if they have a poor credit score.
Covenants - This is external restrictions compared to restrictions internally, example people can request a certain maximum amount of gearing.
Increase Kd = Due to increasing interest commitments companies can see the high level of gearing and may request higher interest rates as the risk of default is higher.
What are the factors to consider when deciding what source of finance to use?
Cost - Cost of debt is lower than cost of equity, but gearing increases which increases ke because of financial risk.
Duration - Equity is permanent, debt is repaid.
Restrictions - on the level of debt internally or externally.
Availability - Bank may not lend due to company having high level of debt. If the company has had an issue of shares, they cant do it again soon.
Issue costs - New issue of shares of equity incurs a lot of fees.
Impact of financial statements, its where everyone can see how a business is doing and high finance isn’t a good look
What are the following ratios:
EPS
P/E Ratio
DPS
Dividends Yield
TSR
Dividends cover
1.) Earnings per Share = Earnings available to equity shareholders/Number of equity shares in issue.
2.) Price/Earning Ratio = Share price/EPS
3.) Dividends per share = Dividends payable to equity shareholders/ Number of equity shares in issue.
4.) Dividends Yield = DPS / Share price
5.) Total Shareholder return = (DPS + change in share price) / Share price at the start of period.
6.) EPS/DPS
What are the following ratios:
Gearing (Both)
Interest cover
ROCE
ROE
Operating gearing (All 4 ways)
Gearing 1 = Non-current Liabilities/ Equity and non current liabilities.
Gearing 2 = Non-current Liabilities/ Equity.
3.) Interest Cover = Operating profit/ Finance charges(Interest payments)
4.) Return on capital employed = Operating profit/ Capital Employed.
5.) Return on Equity = Earnings available to equity (shareholders)/ Equity.
6a) Operating gearing 1= Fixed Costs/Variable costs
6b.) Operating gearing 2 = Fixed assets /Total Costs
6c.) Operating gearing 3 = Contributions / Operating profit.
6d.) Operating gearing 4 = % Change in operating profit / % Change in Return.
