Cima - P3 - Capital Structure

Front 1

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?

Back 1

(D) / (E+D)

D = Total long-term debt

E= Shareholder's fund

Front 2

what is High Gearing?

Back 2

High Debt

Front 3

The importance of the gearing ratio as a measure of ?

Back 3

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

Front 4

The advantage to equity holders of using debt arises from ?

Back 4

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

Front 5

The main disadvantage of increasing debt is that ?

Back 5

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.

Front 6

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?

Back 6

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

Front 7

Perpetual debt is within the definition of gearing?

Back 7

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

Front 8

Redeemable preference shares is within the definition of gearing?

Back 8

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

Front 9

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

Back 9

These should be normally classified as debt.

Front 10

Zero-coupon bonds is within the definition of gearing?

Back 10

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

Front 11

Short-term borrowings is within the definition of gearing?

Back 11

These are not usually included in the calculation of gearing.

Front 12

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.

Back 12

Interest Cover = Profit before Intrest and Tax/ Interest payable

Front 13

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.

Back 13

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

Front 14

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.

Back 14

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

Front 15

The cost of capital is

Back 15

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.

Front 16

he cost of equity must

Back 16

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

Front 17

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

Back 17

Dividend valuation model

Dividend growth model

Estimating the growth rate

Capital asset pricing model (CAPM)

Front 18

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

Back 18

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

Front 19

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

Back 19

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.

Front 20

Convertible debt is calculated ?

Back 20

Pn = P0 × (1 + g)n

Front 21

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

Back 21

kpref = d / p0

Where:

kpref = cost of preference shares

d = annual dividend

P0 = current ex-div market price

Front 22

The WACC can be found ?.

Back 22

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