Capital Structure

Question 1

What is meant by operating gearing and how is this calculated?

Answer 1

Operating gearing is a measure of how much of a companies costs are fixed or variable.

It is closely linked to the type of industry a company operates in.

Consider - a high ratio of fixed costs will mean that even if activity drops costs will not see a matching decrease. = High gearing.

Can be measured as:

Fixed costs/Variable costs

Fixed costs/ Total costs

% change in EBIT/% change in revenue

Contribution/EBIT

Question 2

What is meant by Financial gearing and how is it measured?

Answer 2

Financial gearing is looking at the extent of debt in the companies capital structure.

It can be measured as:

Equity Gearing - LT Debt + preference share capital /Ordinary share capital & reserves.

Capital Gearing - LT debt & P shares/ Total long term capital

Interest gearing - Debt interest/PBIT

Financial Gearing - higher gearing will result in higher variability of returns to shareholders.

Question 3

How do company value and cost of capital relate to each other and what impact does this have on capital structure?

Answer 3

Consider - MV of a company is the sum of the market values of it’s various forms of finance (all equity plus debt)

MV of each type of debt or equity is linked to required rate of return.

The MVs are used to calculate WACC.

If WACC can be reduced the overall MV of a company will increase, which equates to an increase in shareholder wealth.

SO……

using cheaper sources of finance (Debt instead of equity) should reduce WACC and increase company NPV.

This will be a balancing act because:

• Debt is cheaper - lower risk & tax relief on interest.
• Increasing debt makes equity more risky - increased financil gearing = increased cost of equity.

Question 4

What is the traditional view of capital structure, the under laying assumptions?

Answer 4

• At low gearing levels - Equity Risk is perceived as relatively unchanged, increasing the proportion of cheaper debt will have greater effect and WACC will fall.
• Mid levels of gearing - Equity returns become riskier, Ke increases faster, WACC starts to rise.
• High levels of gearing - Risk of bankruptcy a concern to debt & equity holders, cost of both rise and WACC rises further.
• Optimal gearing sits around the mid point where WACC is stable.

Question 5

What is the M&M theory on capital structure without taxes?

Answer 5

Basically concludes that gearing levels are irrelevant because:

• Assuming investors are rational - Return on equity is directly proportional to increase in gearing.
• The increase in the cost of equity exactly offsets the benefit of cheaper debt.

So implication is that:

• Finance choice is irrelevant to shareholder wealth, any mix of funds can be used.

Assumptions are:

• No taxation
• Perfect capital markets, all investors have the same information and react rationally.
• No transaction costs
• Debt is risk free.

Question 6

What is the M&M theory on Capital structure with taxes?

Answer 6

Basic conclusion is the Gearing up reduces WACC and increases MV, Optimal capital structure is 99.9%.

Still assumes that Ke will increase in direct proportion to gearing. With:

• Kd being replaced by Kd(1-T), so cost of debt is lower. reducing risk for the same level of gearing Ke increases at a lower gradient.
• Ke increase does not completely offset cheaper debt benefit so WACC falls as gearing increases.

Question 7

What are market imperfections aka problems with high gearing?

Answer 7

The reasons below result in firms avoiding high levels of gearing, instead sticking to practical concerns and usually following industry averages:

• Bankruptcy risk - shareholders will be concerned Ke will rise.
• Agency Costs - restrictive conditions imposed by lenders.
• Tax exhaustion - insufficient tax liability to offset interest against.
• Impact on borrowing/debt capacity - running out of assets to secure finance against.
• Difference in risk tolerance levels between Shareholders and Directors.
• Restrictions in the articles of association
• Increases in cost of borrowing as gearing increases.

Question 8

What is pecking order theory and how does this apply to capital structure?

Answer 8

Firms will raise new funds in the following order (common but not generally recommended) there is no theorised process.:

• Internally generated funds
• Debt
• New issue of equity.

Question 9

When is it appropriate to use WACC in investment appraisal?

Answer 9

• If the historic proportions of Debt and Equity will not change - change here would change the weightings.
• Operating risk of the business will not change - change here would affect Ke.
• Finance is not project specific - in this case it would be best to asses on the specific cost of finance.

Question 10

When is it appropriate to use CAPM in project appraisal? And how is this approached.

Answer 10

• When the project risk is different from the companies normal business risk.

A different risk profile in CAPM essentially relates to the beta value.

So the Beta value for a company operating in the new investment area would be used a s a base to extrapolate from.

Question 11

What are the two types of Beta and how does this relate to identifying a beta to use in CAPM appraisal?

Answer 11

Asset Beta - relates solely to business risk, as it is for an ungeared company - all-equity financed. Systemic risk only.

Equity beta - relates to both business and financial risk, a geared company. both systemic and unsystematic risk.

To extrapolate the appropriate Equity beta for a company from another companies values:

1. De-gear proxy Equity Beta (unless given asset beta) B_a = (V_e/(V_e +V_d(1-T)) B_e
2. Regear the Asset Beta based on the gearing levels of the company undertaking the project. Same formula as above.
3. Use regared beta in CAPM.