13. Capital Structure (5%) (P6)

Front 1

Why have financial gearing

Back 1

LIRE

Lower annual return req’d by fixed return securities compared to equity bc lower risk
Interest payments are expense item – confers tax shield benefit
Retain control of co
Equity cause dilution of earnings in ST

Front 2

Dangers of gearing

Back 2

WARE

WC mngt may become diff bc of sig cash drain of interest payments
Ability to repay principle by due date needs to be ensured
Riskier for co – EPS more variable & increasing danger that interest may be unpaid if to higher relative to PBIT
External/env changes may have more effect on co (more sensitive) (in supply, labour disputes, increases in interest rates)

Front 3

Factors influencing level of financial gearing

Back 3

BADAP

- Business risk – variability of PBIT & factors causes it (boom, strikes etc). Imp factor is % of fixed costs in firm’s cost structure = ‘operating gearing’ = (revenues – variable operating costs)/EBIT. If high, less capacity for added financial risk of fixed rate debt.
- Attitudes of capital suppliers – concerned w rate of return but also security offered & ability of bus to meet payments. Also s/hs entitled to div only after fixed charge paid so will affect their decision. Increasing returns by increasing gearing may generate add profits, but market will demand higher return to compensate for increased risk, resulting in lower share prices & reducing s/hs capital gains.
- Patterns of assets & trading patterns – secured debts capital requires tangible assets. Also affect of nature of firm’s bus – i.e. well-established/tried & tested is less risky.
- Demand patterns – industry & ind demand (LT growth prospects of industry as a whole); sales stability; competition (high level req special skills or heavy capital investment may discourage new competitors & established bus will find it easier to raise debt capital. If few barrier to entry into a market, prospect of increased completion might make investors more cautious).
- Attitudes of management & proprietors – instinctively averse (secured borrowing restricts freedom – Ke is opp cost of unencumbered use of As). Max borrowing ltd by financing ability, availability of security & risk (issues if variable interest rates rise & other costs rise/sales fall but allows full use of its resourcse, maxs tax shield & when prices rises, ‘real’ cost of fixed-rate debt will fall).

Front 4

Measuring financial gearing – the statement of financial position

Back 4

Book value approach – figures audited & reliable; reveal managerial gearing strategy BUT historic as well as current values reduces usefulness.

= NCL / total equity plus NCL

Market value approach – up-to-date valuations so realistic bc SM decides co’s worth BUT only for quoted co’s & may not reflect LT position since ST factors have temp adverse impact on sh prices.

= market value of NCL / market value of equity plus market value of NCL

Front 5

Measuring financial gearing – the earnings basis

Back 5

Interest cover ratio – (ie how many time greater PBIT is than annual interest payments)

= PBIT / annual interest payments

Effect on EPS

= % change in EPS / % change in EBIT

Front 6

Capital structure debate – traditional view of rel of cost of capital to gearing

Back 6

Risk-averse investors require RFF plus add return for specific business risk. An add return related to gearing of co is return for financial risk.

Debt causes cost of cap to fall as debt is cheaper than equity, poss increased by debt tax shield. But as gearing increases, lender reqs higher rates of interest to compensate for increased risk.

Ke higher than Kd (b/c of bus risk). As Kd increases, Ke increases to reflect the added financial risk which increases overall risk borne by s/hs. WACC initially falls when Kd increases but only to a certain point. Aim is to manipulate capital structure to minimise overall cost of cap, thereby using lower DR to max the potential no. of +ve NPV projects.

Front 7

Capital structure debate – net operating income approach (re rel of cost of capital to gearing)

(Modigliani & Miller)

Back 7

Basic propostions:
Market value of firm depends only on capitalised future earnings (PBIT).
Capitalisation rate (cost of cap) is given only by risk class w/in which firm placed (ind of way investment is financed).
Ke = Ke (for an ungeared co based on its risk class) + a premium for financial risk.
Behaviourial foundation for the theory lies in arbitrage (2 idential goods cannot continue being sold in same market at diff prices – dealers will buy low/sell high for profit & this brings prices into equality).

As gearing increases, Ke increases just enough to offset ben from cheaper debt, ensurng WACC doesn’t move as gearing increases. Occurs bc of arbitrage. (p223)

Front 8

Capital structure debate – gearing in a taxed world (re rel of cost of capital to gearing)

(Modigliani & Miller)

Back 8

Debt tax shield: IRA
Increase value of firm as PV of tax shield is owned by firm
Reduces rate of increase in Ke as debt-equity ratio increases – bc shield reduces financial risks associated w/ rising interest payments as corp gearing increases bc interest cost reduced by shield.
As co increases gearing, continuous/cumulative ben from tax shield & lowers tax liability – results in declining overall cost of cap.

Front 9

Capital structure debate – gearing in the real world (re rel of cost of capital to gearing)

Back 9

In the real world – gearing confers tax shield benefit but other factors mitigate level in practice:

Agency – principal wants to ensure loan used for intended purpose & may place restrictions/impose agency costs – e.g secure loans on FAs; restrictive covenants (ratios, div growth, interest cover, restrict other borrowing); covenants restricting freedom of action (disposal of A, anti-merger, obligations to repair). Costs on suppliers of these steps may increase rate of interest on loans.

Financial distress (liquidation) – poss of co liq increases as gearing increases so may restrain gearing. Costs of liq sig – measured by reduced NAV on liq (bc delays in liq As & losses incurred; prof fees; ST attitudes; customers going elsewhere; probs in WC mngt – p225.

Tax exhaustion – tax shield reduced bc PBIT is low & is less than interest payment; interest payment are v high; and other tax shields are available (capital allowances). If unable to obtain full shield, result is net increases in cost of loans.

Lack of debt capacity – insuff collateral assets to secure debt expansion. Quality of As as collateral depends on nature of asset (real estate preffered); existence of 2nd-hand market; rate of depreciation. If collateral unavailable, rates of interest increase quickly.

Overall effect – tax shield results in cost of capital falling as gearing increases but the 4 factors cut in to reduce rate of decline until eventually they reverse the decline & leads to increase in cost of capital.