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22 Cards in this Set

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  • Back

Capital gearing is concerned with the level of debt in an entity's capital structure. The gearing ratio expresses the relationship between fixed debt capital and shareholders' funds.

how is it calculated?

(D) / (E+D)

D = Total long-term debt

E= Shareholder's fund

what is High Gearing?

High Debt

The importance of the gearing ratio as a measure of ?

The risk of the entity means that the classification of financial instruments as debt or equity is of great importance.

The advantage to equity holders of using debt arises from ?

The tax shield on debt, that is, the benefit to shareholders deriving from the treatment of debt for tax purposes as being deductible in arriving at an entity's taxable profits

The main disadvantage of increasing debt is that ?

The additional interest payable reduces the earnings available to shareholders, thereby increasing the risk of their investment and consequently increasing the cost of capital, as new investors will require a higher return on equity to compensate for the increased financial risk.

The effect on the income statement and related ratios may have a bearing on whether an entity seeks to classify financial instruments as debt or equity.

should book value or market value be used?

Wherever possible, market values should be used in preference to book values for the capital gearing ratio.

Perpetual debt is within the definition of gearing?

The payments are regular and fixed in nature, and therefore the capital element is more akin to debt than equity.

Redeemable preference shares is within the definition of gearing?

Where the issuer is obliged to redeem the shares at a fixed or determinable future date, at a fixed or determinable amount, the instrument has the characteristics of a liability

Non-redeemable preference shares is within the definition of gearing?

These should be normally classified as debt.

Zero-coupon bonds is within the definition of gearing?

These involve the delivery of a financial asset at a fixed or determinable point in the future, and it is therefore classified as debt.

Short-term borrowings is within the definition of gearing?

These are not usually included in the calculation of gearing.

An important ratio linking gearing with profitability is the interest cover, a measure of safety whereby the higher the rate, the greater the protection for shareholders and lenders, as the company is then less vulnerable in the event of a significant drop in profits.

Interest Cover = Profit before Intrest and Tax/ Interest payable

The use of borrowings introduces financial risk to the statement of financial position. This financial risk means that the earnings available to the ordinary shareholders become more volatile if the interest charges on borrowings are fixed.

Financial leverage = profit before Interest / payable and taxprofit before tax

This effect on earnings is similar to the effect of leverage, which considers the relationship between fixed and variable charges and their effect on profits.

Operating leverage = contribution (sales less variable costs) / profit before Interest payable and tax

The cost of capital is

The cut-off rate which separates viable from non-viable opportunities. Only those entities able to offer the prospect of a return in excess of the cost of capital will be able to attract the funds required to grow.

he cost of equity must

Relate to the return that equity investors expect to reward them for the risk taken by investing in the company.

There are a number of approaches to estimating the cost of equity:

Dividend valuation model

Dividend growth model

Estimating the growth rate

Capital asset pricing model (CAPM)

For irredeemable debt, the cost of debt is given by an interest yield calculation

kdnet = i(1-t)/p0

where:kdnet = cost of debt (after tax)

i = annual interest

t = rate of corporation tax

p0 = market value of debt

The cost of redeemable debt is calculated using an internal rate of return approach. The calculation takes ?

The internal rate of return of the annual net of tax interest payments from year 1 to year n plus the redemption payment in year n minus the original market value of the debt in year zero.

Convertible debt is calculated ?

Pn = P0 × (1 + g)n

The cost of preference share capital is related to the amount of dividend payable on the share. It is represented as follows:

kpref = d / p0


kpref = cost of preference shares

d = annual dividend

P0 = current ex-div market price

The WACC can be found ?.

The WACC can be found by calculating the cost of each long-term source of finance weighted by the proportions of finance used.