Financing, Gearing, and Capital Structure

• Lecture 8 focuses on financing decisions, gearing, and capital structure.

Learning Outcomes

• Explain and measure business risk.
• Explain and measure financial risk.
• Explain gearing and its effects on the cost of capital.
• Explain capital structure theories, including traditional approaches, Modigliani, and Miller's views.
• Understand the effect of capital gearing on WACC, business value, and shareholders' wealth.

Business Risk

• Business risk is the risk of lower than expected profits or losses due to the nature of the business.
• It's attached to a company’s investments and is not affected by the method of financing used.
• Uncertain factors such as operating leverage, overall economic climate, changes in technology, and demand influence a firm's profitability and business risk.
• Operating leverage is the degree to which a firm incurs fixed costs versus variable costs.

Measurement of Business Risk

• Operating gearing is calculated as Contribution / (Earnings before Interest and Tax).
• Contribution equals Sales minus Variable Cost of Sales.
• Operating gearing measures the degree to which fixed costs will be covered by business profits.
• High operating gearing indicates high fixed costs needing coverage by profits.
• A high operating gearing ratio implies high business risk.

Financial Risk

• Financial gearing is the amount of debt finance a company uses relative to equity finance.
• Financial risk affects shareholders due to the increased use of debt or financial gearing.
• Financial risk results from the firm's capital structure rather than its investments.
• The higher the debt level, the greater the firm's financial risk, increasing possibilities of reduced dividends after debt interest payments.
• Shareholders seek higher returns to compensate for higher risk with more debt.
• High debt may lead to liquidation if a company cannot meet its debt obligations.

Measurements of Financial Risk

• Debt Ratio is calculated as (Total Liabilities) / (Total Assets).
• The debt ratio indicates the proportion of debt relative to assets.
• A high debt ratio escalates financial risk if the firm struggles to repay debt.
• Times Interest Earned (TIE) is calculated as (Earnings Before Interest & Tax) / (Interest).
• TIE measures a firm’s ability to meet interest obligations.
• A high TIE ratio means a company can more easily meet interest obligations.
• If the TIE is too low, profits may be insufficient to cover interest due to profit fluctuations.
• Dividend Cover is calculated as (Earnings Per Share) / (Dividend Per Share).
• Dividend Cover is the number of times the actual dividend could be paid out of current profits.
• A decreasing dividend cover indicates an increased risk that the company may not be able to maintain dividend payments.

Effects of Financial Gearing

• Financial gearing (leverage) increases potential returns (Return on Equity, or ROE) to shareholders.
• ROE increases if Return on Assets (ROA) exceeds the cost of debt, because assets generate enough returns to pay debt interest.
• Conversely, ROE decreases if ROA is less than the cost of debt, because assets can not generate sufficient returns to pay the debt.

Financial Gearing Illustration

• Firm A (Equity = $100,000): EBIT is $30,000, Interest is $0, Earnings Before Tax is $30,000, Tax at 20% is $6,000, Earnings After Tax are $24,000, Return on Equity is 24%.
• Firm B (Debt = $50,000; Equity = $50,000): EBIT is $30,000, Interest is $5,000, Earnings Before Tax is $25,000, Tax at 20% is $5,000, Earnings After Tax are $20,000, Return on Equity is 40%.

Effects of Financial Gearing: Observations

• Financial Leverage Magnifies ROE: If ROA (24%) exceeds the cost of debt (10%), debt use increases ROE. Comparing Firm A (no debt) to Firm B (debt), Firm B's ROE (40%) is higher than Firm A’s (24%).
• Firm B's ROE is higher because while interest payment lowered earnings after tax ($20,000), the earnings are divided by smaller total equity ($50,000). This magnifies Firm B's ROE. Debt benefits shareholders.
• Double-Edged Sword: If Firm A’s ROA (6.4%) is less than the cost of debt (10%), ROE is reduced.
• Financial leverage magnifies ROE on the upside with ROA, but works the same way on the downside when ROA is lower than the cost of debt.
• Financial gearing increases the variability of returns for shareholders, possibly raising the risk of corporate failure if economic conditions are suboptimal.
• Tax Deductibility: Tax paid by Firm B is $1,000 less than Firm A. The tax savings are calculated by multiplying interest expense by the tax rate (e.g., $5,000 x 20% = $1,000).
• Tax savings occur as the result of interest expense offsetting taxable income before taxation is calculated. This reduces the cost of using debt.

Suitability of Financial Gearing

• Stability is key for the suitability of the gearing mix.
• Debt financing is more appropriate when the company is in a healthy competitive position.
• Debt financing is more appropriate when cash flows and earnings are stable.
• Debt financing is more appropriate when profit margins are reasonable.
• Debt financing is more appropriate when operational gearing is low.
• Debt financing is more appropriate when liquidity and cash flow positions are strong.
• Debt financing is more appropriate when the debt-equity ratio is low.

Capital Structure

• Capital structure is the mix of debt and equity a company uses to finance its assets.
• Capital structure explores the relationship between debt use and its impact on the firm's market value and the cost of capital.
• An optimal debt to equity ratio exists when the overall cost of capital (Weighted Average Cost of Capital) is at the minimum and the market value maximizes.

Capital Structure - Traditional Theory

• The traditional theory has no theoretical foundation but is frequently accepted in finance.
• A company can benefit from moderate gearing when debt (lower cost) outweighs higher financial.
• Unacceptable financial risk above a critical level raises weighted average cost of capital and lowers market value.

Capital Structure - Modigliani and Miller Theory

• Under simplifying assumptions, gearing doesn't matter, and the weighted average cost of capital and a firm's market value are independent of capital structure
• Because increased equity costs offset benefits from debt finance, a company does not have on optimum capital structure
• The weighted average cost of capital remains constant.

Explore financing decisions, gearing, and capital structure. Understand business and financial risk, and the impact of gearing on the cost of capital. Review capital structure theories and their effect on WACC and shareholder wealth.