14 Financial Structure and Reconstruction

Question 1

A firm’s optimal capital structure will depend on factors such as:

Answer 1

• tax rates (esp. relevant for international capital structure. If tax rates high in target country debt more attractive).
• business risk - risky industry? maybe play it safe with less debt no interest
• operating risk - cost structure - if lots of fixed costs then if revenue goes down costs won’t go down, interest cover becomes more of a risk
• quality of assets available for security (maybe can’t raise debt finance)
• restrictions (eg loan covenants)
• cost of capital

Question 2

What’s the traditional theory?

Answer 2

The traditional theory of gearing states that as gearing initially starts to increase from very low levels, the introduction of cheap debt finance brings WACC down.

However at higher levels this is counteracted by investors demanding higher returns to compensate for extra risk taken (no dividends, or even insolvency)

Therefore an optimal gearing level that can only be found through trial and error

Question 3

Modigliani & Miller’s 1958 no tax theory

Answer 3

The no tax theory of gearing assumes perfectly rational investors and risk free debt.

This means that the gradual increase in returns demanded by equity holders as gearing increases are perfectly balanced by the reduced cost of capital due to cheap debt finance (ie as equity increases debt decreases, perfectly balanced)

Conclusion: there is no link between financial gearing and WACC or company value.

Question 4

Modigliani & Miller’s 1963 with tax theory

Answer 4

The with tax theory again assumes perfectly rational investors and risk free debt.

However this theory also accounts for the tax relief available on interest payments and therefore brings down the cost of debt even further compared with equity.

The result is that the reduction in cost of capital from having cheaper debt finance outweighs the increased cost of equity due to increased risk.

Conclusion: the optimal capital structure is 99.9% debt

Reality: this doesn’t work because risk exists.
- tax exhaustion
- agency costs (eg directors job security under threat if debt cannot be repaid)
- debt is not actually risk free

Question 5

Pecking order theory

Answer 5

This theory contrasts with he view that businesses will seek an optimal capital structure that minimises their WACC

1. Retained earnings
2. Straight debt
3. Convertible debt
4. Preference shares
5. Equity shares (rights, then new issues)

Question 6

Reasons for following pecking order

Answer 6

• more convenient to use retained earnings than obtaining external financing
• no issue costs
• investors prefer safer securities (ie debt) so easier to attract this finance
• some managers believe debt issues have a better signalling effect
• by contrast the market may interpret equity issues as a measure of last resort

Question 7

Limitations of pecking order theory

Answer 7

• it fails to take into account taxation, financial distress, agency costs or how the investment opportunities available may influence choice of finance
• pecking order theory is an explanation of what businesses actually do rather than what they should do

Question 8

Cost of capital - cost of equity

Method 1:

Answer 8

The cost of equity can be calculated using the dividend valuation model

to work out g you need either the gordon groth model or the historic dividend growth model

Question 9

Cost of capital - cost of equity

Method 2:

Answer 9

Capital asset pricing model

you need the risk free rate of return and beta factor

Question 10

Cost of preference shares

Answer 10

As preference shares usually have a constant dividend, the perpetuity valuation formula is used (kp = Do/Po)

Question 11

Cost of debt - irredeemable

Answer 11

kd = i(1-T)/(Po ex int)

Question 12

Cost od debt redeemable

Answer 12

For redeemable debt the cost is given by the internal rate of return of the cashflows involved

the gross redemption yield (pre-tax cost of debt) can be found by calculating an internal rate of return of the market value of the bond being paid at T0 followed by receipts of interest in T1-n and receipt of the redemption payment at Tn. The post tax cost of debt is then calculated by multiplying the gross redemption yield by 1-T.

The short cut method you know.

Don’t forget the current market value should be net of any arrangement costs of handling fees charged on issue.

Also, current market value would be different if trading at less than 100

Question 13

Cost of convertible debt

Answer 13

The cost of debt is calculated in the same way as redeemable debt except that the redemption payment is replaced by the higher of redemption payment or the anticipated value of shares on conversion.

Question 14

Choice of a source of debt

Answer 14

A good example is given with a dollar bond and a sterling bond. The dollar bond has the dollar depreciating by 2% per annum

Question 15

WACC

Answer 15

Equity as a percentage of equity & debt x cost of equity + cost of debt x debt percentage

Question 16

Dividend policy
Traditional view:

Answer 16

pay out a growing dividend which lags behind earnings

Question 17

Dividend policy: M&M’s irrelevance theory

Answer 17

The pattern of dividends is irrelevant as long as retained earnings are reinvested in positive NPV projects. If shareholders are reliant on dividends as a source of income, M&M advise they should sell some shares for a DIY dividend

Question 18

Problems with M&M’s irrelevance theory

Answer 18

• Clientele effect
• Signalling
• Agency (shareholders preferring to make their own choices about how to reinvest funds)
• Tax (ie CGT)
• Transaction costs

Question 19

Approaches to dividend policy

Some possible approaches:

Answer 19

• Zero dividend policy (particularly in growth phase)
• Constant (or constantly growing) dividend per share)
• Constant dividend pay out ratio
• Residual earnings paid out as dividends after all positive NPV projects are invested in

Question 20

Financial reconstructions

Answer 20

Step 1 - estimate the position of each party if liquidation is to go ahead. This will represent the minimum acceptable payment for each group (don’t forget to separate fixed & floating charge for an extra mark)

Step 2
Assess additional sources of finance (eg selling assets, issuing shares, raising loans. The company will most likely need more finance to keep going (examiner normally does this bit)

Step 3
Design the reconstruction. Often the question will give you details on how to do it

Step 4 - calculate and assess the new position and how each group has fared and compare with step 1 position.

Step 5 - check that the company is financially viable after the reconstruction (be sceptical)

Question 21

Winding up: order of payment

Answer 21

1. fixed charge creditors will appoint a receiver to sell the charged asset (surplus funds passed to liquidator).
2. Liquidator’s fee
3. Floating charges
4. Unsecured creditors (including fixed charge holders who haven’t yet received all funds owing)
5. Preference shareholders
6. Ordinary shareholders

Question 22

Why might bank be happy with a reconstruction even at a loss?

Answer 22

• it avoids delays
• it avoids uncertainty
• it avoids reputational damage

Question 23

Legal consequences of financial distress

What is the difference between fraudulent and wrongful trading

Answer 23

Fraudulent trading is deliberate
Wrongful trading is not deliberate

Question 24

What is fraudulent trading and what are the consequences

Answer 24

Fraudulent trading occurs when any business of a company is carried on with intent to defraud the creditors of the company or another person for any purpose.

The penalty is a fine and up to 10 years imprisonment for any person who is knowingly a party to the business being carried on in that manner. Directors may also be ordered by the court to make a contribution to the assets of the company.

Question 25

What is wrongful trading and what are the consequences?

Answer 25

Wrongful trading applies when a company goes into insolvent liquidation and the liquidator can show that at some point before the commencement of winding up the director(s) knew or should have known there was no reasonable prospect that the company could have avoided going into insolvent liquidation.

The director(s) may be ordered by the court to make contribution to the assets of the company.

Question 26

Corporate reporting consequences of financial distress

Answer 26

Going concern means that an entity is normally viewed s continuing in operation for the foreseeable future. Financial statements are prepared on the going concern basis unless management either intends to liquidate the company or has no realistic alternative but to do so.

IAS 1 presentation of financial statements
- in assessing whether an entity is a going concern management must look at at least 12 months into the future
- uncertainties that may cast significant doubt on an entity’s ability to continue should be disclosed
- if the going concern assumption is not followed that fact must be disclosed together with the basis on which the financial statements have been prepared and the reasons why the entity is not a going concern.

Question 27

Assurance work
Assurance tests around the going concern status of a company are likely to include:

Answer 27

• consideration of the commercial viability and financial assumptions made in any forecasts
• consideration of whether the financial forecasts produced are consistent with the assumptions in amount and timing
• assessment of whether the company is likely to meet any fresh commitments it has assumed (covenants)
• consideration of whether any proposed reconstruction is in accordance with the wishes of all the parties involved.

Question 28

Sources of financing for SMEs

Answer 28

• owner financing
• business angel financing (dragons, wealthy individuals)
• venture capital (similar to angels but companies)
• leasing (spreads cost)
• factoring (selling receivables ledger - temp fix for liquidity crisis)
• bank loans / overdrafts
• grants (employment / environmentally friendly)