Capital Structure

Question 1

Operating Gearing

Answer 1

Fixed costs/Total costs or Variable costs
OR
% change in EBIT/% change in revenue
OR
Contribution/EBIT

Use Fixed/Variable

Question 2

Gearing

Answer 2

Equity D/E: Debt+preference shares/share capital and reserves
Total/capital gearing: long-term debt+preference shares/all equity

Interest gearing:

Debt interest/Operating profits before debt interest and tax

Question 3

Impact of financial gearing

Answer 3

E.g. if a company has high gearing (debt), then it means even just a 10% fall in sales can mean even larger decreases percentage wise in operating PBIT and PBT

Question 4

Gearing trade off

Answer 4

Financial manager’s role to balance business risk in the market, operating gearing and financial gearing.

In reality, a manager can’t control business risk, limited opportunity to affect investment in fixed costs (e.g. service firms have mostly fixed costs)

Question 5

Optimal Capital Structure

Answer 5

If a company can increase shareholder wealth by changing gearing - it should.

MV of a company = Future cashflows/WACC
A reduction in WACC should increase the MV of a company

Question 6

Traditional view of capital structure

Answer 6

At low gearing, equity holders perceive the risk to not change, and benefit as WACC falls, however, once gearing rises, equity holders perceive:
Increased financial risk
Less assets as collateral, even debt holders may get worried
Increase in Ke to compensate
WACC rises again

Question 7

M&M Theory - No Tax

Answer 7

Argues:

Investors are rational. Linear relationship between Kd and Ke
Increase in Ke offsets the cheaper debt finance - WACC doesn’t change
Choice of finance is irrelevant
Companies value depends on it’s abiliy to make future operating income from assets

Question 8

M&M Theory with tax

Answer 8

Still argues as gearing increases, Ke increases in proportion
But the tax relief on debt if greater than the cost of Ke, therefore optimum capital structure is 99.9% debt

Question 9

Problems of high gearing

Answer 9

Bankruptcy risk as gearing increases
Agency costs: Restrictions on level of dividends, additional debt taken on, and disposal of non-current assets
Tax exhaustion: after a certain point, no more tax relief can be claimed on debt
Borrowing capacity/collateral
Cost of debt increases as higher gearing ensues

Question 10

Pecking order theory

Answer 10

Retained earnings, debt, then new issue

Issue costs are higher
Myers and Maljuf - with asymmetric (inside information), new equity issues are only made when shares are overpriced
Bennett Steward - Raising equity conveys doubt. New issues of equity ahead of rough-times through overpriced shares
Asquith and Mulins - New equity issues will decrease stock prices;