Chapter 6 - Capital Structure

Question 1

How can financial risk be measured?

Answer 1

Financial risk of a company’s capital structure can be measured using gearing ratio and interest cover

Question 2

Gearing:

Answer 2

Gearing = relationship between an entity’s borrowings which include both prior charge capital (preference shares & long-term debt) and shareholders funds

Question 3

Changing financial gearing:

Answer 3

• Financial gearing is an attempt to quantify the degree of risk involved in holding equity shares within a company – in terms of the company’s ability to remain in business and in terms of expected ordinary dividends
• The more geared the company, the greater the risk that little will be available to distribute as dividends to the ordinary shareholders
• Debt creates higher variability in dividends (higher financial risk)

Question 4

Interest Cover:

Answer 4

• Interest cover = used by lenders to determine the vulnerability of interest payments to a drop in profit
• Interest cover less than 3 is considered low, indicating that profits is too low given the gearing of the company

Question 5

Impact on Covenants and decision making:

Answer 5

• Debt covenants should be considered in structuring the debt/equity profile
• Whether the use of debt could cause problems in meeting existing or new covenants

Question 6

Weighted average cost of capital

Answer 6

• A company will have to monitor its overall WACC to ensure that projects give a return that covers the cost of capital (a positive NPV)
• WACC = average cost of the company’s finance weighted according to the proportion each type of capital bears on the total pool of capital (weighted by using market values)

Question 7

WACC Calculation:

Answer 7

WACC = Keg(Ve / (Ve+Vd)) + Kd(1-t) × (Vd / (vd+ve))

• Ve = total market value of issued shares
• Vd = total market value of debt
• Keg = cost of equity in a geared company
• Kd = cost of debt

Question 8

Impact on WACC of a change in Capital Structure:

Answer 8

1. Current WACC will potentially change if an entity’s capital structure changes i.e gearing rises:
   * Shares become riskier so the Ke will rise (increase dividends)
   * More debt finance is used and the cost of debt is lower than the cost of equity
2. A fall in the WACC benefits shareholders - the PV of cash flows generated will be higher if discounted at a lower rate
   * In an efficient market this would imply the market value of equity plus debt will rise as WACC falls

Question 9

Traditional theory of Gearing:

Answer 9

• As the level of gearing increases, the cost of debt remains the same up to a certain level – beyond this level the Kd will increase as interest cover falls, the amount of assets available for security falls and the risk of bankruptcy increases
• The Ke rises as the level of gearing and financial risk increases
• The WACC falls initially as the proportion of debt capital increases (debt is cheap) and then begins to increase as the rising cost of equity becomes more significant (bankruptcy risks depress share price & make equity & debt more expensive)
• The optimum level of gearing is where the WACC is minimised

Question 10

The net operating income (M&M) theory of Gearing (no tax):

Answer 10

1. Total market value of a company, in the absence of tax, will be determine by only 2 factors:
   * Total earnings of the company
   * Level of business risk attached to those earnings
2. Total market value would be calculated by discounting the total earnings at a rate that is appropriate to the level of operating risk (rate would represent WACC)

Question 11

The net operating income (M&M) theory of Gearing (no tax) - Key propositions:

Answer 11

1. The total market value of a company is independent of its capital structure
   * Market value depends on future earnings and degree of risk attached to this, and is unaffected by the capital structure
   * The WACC is unaffected by a company’s capital structure
2. The cost of equity increases proportionately with the gearing ratio
   * Use of debt finance transfers the risk to the shareholders and increases the Ke
   * This explains why the WACC does not change – so the level of gearing does not matter

Process of Arbitrage:

• a low geared company is worth less than a high geared company, so the shareholders will take on personal debt and buy shares in the undervalued company
• This will then drive the value of the low geared company up until it is worth the same as the high geared company

Question 12

Assumptions of net operating income approach:

Answer 12

• A perfect capital market exists – investors have the same info upon which they act rationally to arrive at the same expectations about future earnings & risks
• There are no tax or transaction costs
• Debt is risk free and freely available at the same cost to investors and companies
• Arbitrage assumes that shareholders & companies can borrow at the same rate & have the same attitude to debt finance

Question 13

M&M theory of Gearing (with tax):

Answer 13

• Allowing for taxation reduced the Kd(1 - t) [assuming the debt is irredeemable]
• M&M modified their theory to admit that tax relief on interest payments does make debt capital cheaper and therefore reduces the WACC where a company is geared
• WACC will therefore continue to fall, up to a gearing of 100%
• The important assumption is that there are no financial distress costs

Question 14

Formulae and M&M Theory:

Answer 14

Vg = Vu + TB

• Vg = value of debt + equity in a geared company
• Vu = value of equity in an equivalent ungeared company
• TB = tax shield on debt (T = corporate tax rate & B = market value of geared company’s debt)
• This formula shows that the greater the value of debt, the greater the value of the company and so supports the idea that a company should be geared as highly as possible to increase its value

Keg = Keu + (Keu – Kd) x (Vd (1-t))/Ve)

• Keg = cost of equity of a geared company
• Keu = cost of equity of an ungeared company
• Kd = cost of debt (pre-tax)
• Vd Ve = market value of debt & equity

Question 15

Formulae and M&M Theory - Adjusted WACC

Answer 15

Adjusted WACC formula = Keu [1 – ((Vd t) / (Ve+vd))]

Shows that WACC is reduced when gearing increases

Question 16

Factors that can influence capital structure:

Answer 16

1. Debt capacity
2. Debt covenants
3. Cost of debt
4. Tax exhaustion

Question 17

Factors that can influence capital structure - Debt capacity:

Answer 17

• Debt capacity = maximum amount of debt that a company can support or obtain
• Company will have a greater capacity if it has a number of assets that can be offered as security
• A company can only increase its borrowing if there are lenders willing to provide finance – this may not always be easy depending on the financial position of the company and the state of the economy

Question 18

Factors that can influence capital structure - cost of debt:

Answer 18

• MM theory assumes that Kd is unchanged at all levels of gearing – in reality greater levels of debt is perceived riskier and the lenders rate of return is likely to increase

Question 19

Factors that can influence capital structure - Tax exhaustion:

Answer 19

• Benefit of tax relief is only available while the borrower is making a taxable profit
• If gearing is high enough, there will be a point where interest payments will reduce taxable profits to zero and any further debt will not benefit from tax relief (tax exhaustion)
• As the borrower would be making a loss, this would also be likely to cause debt covenants to be breached which would cause even more problems

Question 20

Practical influences on the levels of Gearing:

Answer 20

1. Life cycle:
   * A growing business will find it difficult to forecast cash flows with any certainty so high levels of gearing are unwise
2. Operational gearing (contribution/PBIT):
   * If fixed costs are high then contribution will be high relative to profits – high fixed costs means cash flow is volatile so high gearing is not sensible
3. Stability of revenue:
   * Operating in a highly dynamic business environment means that high gearing is not sensible
4. Security:
   * If unable to offer security then debt will be expensive and difficult to obtain

Question 21

Capital structure conclusions:

Answer 21

1. Low gearing:
   * Young company
   * Volatile cash flows
   * Tax benefits are likely to be exceeded by financial distress costs
2. High gearing:
   * Mature company
   * Stable cash flows
   * Tax benefits are likely to be greater than financial distress costs

Question 22

Capital Structure of Group Companies:

Answer 22

• Companies within a group can have higher levels of debt to equity by borrowing from other group companies

Question 23

Thin Capitalisation:

Answer 23

• Capital structure designed to minimise entity’s tax bill & is often used in overseas investments
• Tax authorities will often limit the amount that a company can claim as a tax deduction on interest
• Some countries simply disallow interest deductions above a certain level from all sources when the company is considered to be too highly geared under applicable tax regulations
• Thin capitalisation rules will be another practical consideration in designing an entity’s capital structure
• It will also be a consideration in designing the debt/ equity profile of subsidiaries, because the tax authorities may well judge that a subsidiary contains artificially high gearing if gearing level is higher than the groups gearing.