Chapter14-CapitalStructureFinancialRatios

8/13/2019 Chapter14-CapitalStructureFinancialRatios

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Chapter 14 Capital Structure and Financial Ratios

1. Objectives

1.1 Define, calculate and explain the significance to a companys financial

position and financial risk of its level of the following ratios:

(a) operating gearing

() financial gearing

(c) interest cover

(d) interest yield

(e) dividend cover

(f) dividend per share

(g) dividend yield

(h) earnings per share (!"#)

(i) price$earnings ("$!) ratio

1.% &ssess a companys financial position and financial risk in a scenario y

calculating and assessing appropriate ratios.

1.' &ssess the impact of sources of finance on the financial position and financial

risk of a company y considering the effect on shareholder wealth.

( p e r a t i n g

) e a r i n g

* i n a n c i a l

r i s k

! + u i t y

g e a r i n g

, a p i t a l

g e a r i n g

- n t e r e s t

g e a r i n g

) e a r i n g

r a t i o s

* i n a n c i a l

) e a r i n g

! " # " $ ! r a t i o D i v i d e n d

c o v e r

D i v i d e n d

y i e l d

! f f e c t o n

# h a r e h o l d e r

. e a l t h

- n t e r e s t

c o v e r

- n t e r e s t

y i e l d

D e t

/ o l d e r

0 a t i o s

, a p i t a l # t r u c t u r e

a n d

* i n a n c i a l 0 a t i o s

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2. Operating Gearing

%.1 Definition

Operating gearingis a measure of the etent to !hich a fir"#s operatingcosts are fiedrather than variale as this affects the level of business ris$

in the firm. perating gearing can e measured in a numer of different

ways, including:

1. *ixed costs or

ariales costs

%. *ixed costs or

2otal costs

'. 3 change in !4-2 (or "4-2) or

3 change in turnover

5. ontriution or

"4-2 or !4-2

ontriution is sales minus variale cost of sales.

%.% *irms with a high proportion of fied costsin their cost structures are known

as having high operating gearing.

%.' %a"ple 1

2wo firms have the following cost structures:

Fir" & Fir" '

(" ("

#ales 6.7 6.7

ariale costs ('.7) (1.7)

*ixed costs (1.7) ('.7)

!4-2 1.7 1.7

hat is the level of operating gearing in each and what would e the impact

on each of a 173 increase in sales8

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Solution)

perating gearing can e calculated as follows:

Fir" & Fir" '*ixed costs$variale costs 1$' 9 7.'' '$1 9 '

*irm 4 carries a higher operating gearing ecause it has higher proportion

of fixed costs.

-ts operating earnings will therefore e "ore volu"e*sensitive:

*irm & Fir" & *irm 4 Fir" '

m 1+,

increase

m 1+,

increase

#ales 6.7 -.- 6.7 -.-

ariale costs ('.7) /./0 (1.7) 1.10

*ixed costs (1.7) 1.+0 ('.7) /.+0

!4-2 1 1.2 1 1.4

*irm 4 has en;oyed an increase in !4-2 of 573 whilst *irm & has had an

increase of only %73. -n the same way a decrease in sales would ring

aout a greater fall in 4s earning than in &s.

%.5 %a"ple 2

-f a company were to automate its production line to replace the workers

currently paid an hourly wage, what would e the expected effect on its

operating gearing8

Solution)

#wapping variale costs for fixed would increase the level of operating

gearing.

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/. Financial Gearing

'.1 Financial gearingis the amount of debt financea company uses relative to

its euit finance.

&0 Financial ris$

'.% Financial ris$

2he greater the level of debt, the "ore financial ris$ (of reduced

dividends after the payment of det interest) to the shareholder of the

company, so the higher is their re+uired return.

'.' *inancial risk can e seen from different points of view.

(a) 3he co"pan as a !hole< -f a company uilds up dets that it cannot

pay when they fall due, it will e forced into li+uidation.

() aables< -f a company cannot pay its dets, the company will go

into li+uidation owing payales money that they are unlikely to recover

in full. =enders will thus want a higher interest ieldto compensate

them for higher financial risk and gearing.

(c) Ordinar shareholders< & company will not make any distriutale

profits unless it is ale to earn enough profit efore interest and tax to

pay all its interest charges, and then tax. Ordinar shareholderswill

proaly !ant a bigger epected return from their shares to

compensate them for a higher financial ris$.

'0 Gearing ratios

'.5 Financial Gearing

*inancial gearing measures the relationship etween shareholders capitalplus reserves and capital or orrowings or oth.

1. !+uity gearing 9 "reference share capital > long?tern det

rdinary share capital > reserve

%. 2otal or capital

gearing 9

"reference share capital > long?tern det

2otal long?term capital

'. -nterest gearing 9 Det interest

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"4-2

5ote)

(a) #ince preference shares are treated as debt finance, preferencedividends are treated as det interest in this ratio.

() *or comparison purposes, the same ratio must e used consistently.

(c) apital gearing is used more than e+uity gearing.

(d) -nterest gearing is an income statement measure rather than a

statement of financial position one. -t considers the percentage of the

operating profit asored y interest payments on orrowings and as a

result measures the impact of gearing on profits. -t is more normally

seen in its inverse form as the interest cover ratio.

'.6 2he ratios can e calculated on either ook or market values of det and

e+uity. 2here are arguments in favour of oth approaches:

(a) @arket values:

(i) are "ore relevantto the level of investment made

(ii) represent the opportunit costof the investment made

(iii) are consistentwith the way investors "easuredet and e+uity.

() 4ook values:

(i) are not subject to sudden changedue to the market factors

(ii) are readil available.

'.A %a"ple /

2he following excerpt has een otained from the financial statements of

&4 o.

State"ent of financial position ecerpt

2+1+ 2++6

(+++ (+++

2otal assets less current liailities 16B 1'C

on?current liailities

63 secured loan notes 57 57

11B CC

rdinary share capital (67c shares) '6 '6

B3 "reference shares (1 shares) %6 %6

#hare premium account 1E 1E

0evaluation reserve 17 ?

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-ncome statement '1 %%

11B CC

-ncome statement excerpt2+1+ 2++6

(+++ (+++ (+++ (+++

ross profit 6% 56

-nterest % %

Depreciation C C

#undry expenses 15 11

(%6) (%%)

et profit %E %'

2axation (17) (17)

et profit after taxation 1E 1'

Dividends:

rdinary shares A 6

"reference shares % %

(B) (E)

0etained profit C A

2otal market values are$were as follows: 2+1+ 2++6

rdinary shares (per share) %75c 1C6c

"reference shares (per share) B7c 17%c

63 loan notes (per 177 nominal value) 17B 11A

Calculate)

(a) !+uity gearing

() apital gearing

(c) -nterest gearing

*or &4 o using oth statement of financial position and market values.

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Solution)

(a) !+uity gearing

2+1+ 2++6

4ook values3177

%611B

57%6

+

9 AC.C3

3177%6CC

57%6

+

9 BE.B3

@arket values

E775.%

577B.1%6B.7

+

9 55.'3

E7C6.1

571A.1%67%.1

+

9 6%.E3

ote: #ince preference shares are treated as det, e+uity gearing could also

e descried as the det$e+uity ratio.

() apital gearing

2+1+ 2++6

4ook values3177

5711B

A6

+

9 51.13

317757CC

A6

+

9 5A.B3

@arket values3177

%.A'B.15%

%.A'

+

9 '7.E3

3177C.E16.1'A

C.E1

+

9 '5.63

(c) -nterest gearing

2+1+ 2++6

-nterest gearing3177

%%E

%%

+

+

9 1'.B3

3177%%'

%%

+

+

9 1A.73

'.E -mpact of financial gearing < where two companies have the same level of

variaility in earnings, the co"pan !ith the higher level of financial

gearingwill have increased variabilit of returnsto shareholders.

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'.B %a"ple 4

alculate the impact on *irm of a 173 fall in sales and comment on your

results:

(+++

#ales 17

ariale costs (%)

*ixed costs (6)

!4-2 '

-nterest (%)

!&-42 1

Solution)

(+++ 1+, decrease (+++0

#ales 17 C

ariale costs (%) (1.B)

*ixed costs (6) (6)

!4-2 ' %.%

-nterest (%) (%)

!&-42 1 7.%

2he impact of a 173 decrease in sales has reduced operating earnings y ('

< %.%)$' 9 %A.AE3.

2he increased volatility can e explained y the high operating gearing in .

/owever, also has det interest oligations. 2his financial gearing has the

effect of amplifying the variaility of returns to shareholders. 2he 173 drop

in sales has caused the overall return to fall y (1 < 7.%)$1 9 B73. 2he

additional 6'.''3 variation over and aove the change in operating

earnings is due to the use of det finance.

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'.C verall therefore there is a re+uired trade?off etween:

4. %ffect on Shareholder 7ealth

5.1 -f a company can generate returns on capital in ecess of the interest

paable on det, financial gearing !ill raise the %S. earing will,

however, also increase the variaility of returns for shareholders and increase

the chance of corporate failure.

&0 %arnings per share %S0

5.% 4asic !"# should e calculated y dividing the net profit or loss for the period

attriutale to ordinary shareholders y the weighted average numer of

ordinary shares outstanding during the period.

!"# 9 "rofit after tax and preference dividends

eighted average numer of shares

'0 rice*earnings ratio 8%0

5.' "$! ratio is the ratio of a companys current share price to the latest !"#. &

high 8% ratio indicates strong "ar$et confidence in the future profit

gro!th of the company. onversely a low "$! ratio indicates low market

confidence in the company making a profit.

5.5 2he value of the "$! ratio reflects the markets appraisal of the shares future

prospects. 9f %S fallsecause of an increased urden arising fro" increased

gearing, an increased 8% ratiowill "eanthat the share price has not fallen

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as "uch as earnings, indicating the "ar$et vie!s positivel the projects

that the increased gearing will fund.

"$! 0atio 9 @arket price per share

!"#

C0 Dividend cover

5.6 -t is a measure of how many times the companys earnings could pay the

dividend. 2he higher the cover, the better the abilit to "aintain dividends,

if profits drop.

5.A 2his needs to e looked at in the context of how stale a companys earnings

are: a low level of dividend cover might e acceptale in a company with very

stale profits, ut the same level of cover in a company with volatile profits

would indicate that dividends are at risk.

5.E 2o ;udge the effect of increased gearing on dividend cover, you should

consider changes in the dividend levels and changes in dividend cover. -f

earnings decrease ecause of an increased burden of interest pa"ents,

then:

(a) the directors may decide to make corresponding reductions in

dividendto maintain levels of dividend cover.

() &lternatively the directors may choose to maintain dividend levels, in

which case dividend cover will fall. 2his will indicate to shareholders

an increased risk that the company will not be able to "aintain the

sa"e dividend pa"ents in future ears, should earnings fall.

Dividend cover 9 !"#

D"#

D0 Dividend ield

5.B Dividend y ield is the rate of return a shareholder is epecting on an

invest"ent in sharesof a company. #ince shareholders expect dividend yield

and capital growth, dividend yield is an important indicator of a shares

performance.

5.C 2he ieldwill e influenced b the dividend policof an organiFationG a

company which has traditionally paid high dividends will e popular with

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some investors and this will e reflected in its share price.

5.17 *rom investors standpoint, the dividend yield indicates the return that an

investor earns from holding shares in a particular company, and the higher the

dividend ield the better. & low dividend yield might persuade investors to

dispose of shares and invest the proceeds elsewhere.

5.11 -f the additional debt financeis expected to e used to generate good returns

in the long?term, it is possile that the dividend ield "ight fall significantl

in the short*ter" ecause of a fall in short?term dividends, ut also an

increase in the market price reflecting market expectations of enhanced long?

term dividends.

Dividend yield 9 ross D"# x 1773

@arket price per share

2he gross dividend is the dividend paid plus the appropriate tax credit.

-. Debt :older Ratios

&0 9nterest cover

6.1 -nterest on loan stock (deenture stock) must e paid whether or not the

company makes a profit.

6.% -nterest cover is a "easure of the adeuac of a co"pan#s profits relative

to its interest pa"entson its det:

-nterest cover 9 "4-2

Det interest

6.' -n general, a high level of interest cover is goodut may also e interpreted asa company failing to exploit gearing opportunities to fund pro;ects at a lower

cost than from e+uity finance.

'0 9nterest ield

6.5 2he interest yield is the interest or coupon rate expressed as a percentage of

the market price. -t is a measure of return on investment for the det holder.

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-nterest yield 9 -nterest rate

@arket value of det

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%a"ination Stle ;uestions

;uestion 1

HH o is planning to raise 16 million of new finance for a ma;or expansion of

existing usiness and is considering a rights issue, a placing or an issue of onds. 2he

corporate o;ectives of HH o, as stated in its &nnual 0eport, are to maximise the

wealth of its shareholders and to achieve continuous growth in earnings per share.

0ecent financial information on HH o is as follows:

2he par value of the shares of HH o is 1I77 per share. 2he general level of inflation

has averaged 53 per year in the period under consideration. 2he onds of HH o are

currently trading at their par value of 177. 2he following values for the usiness

sector of HH o are availale:

Reuired)

(a) !valuate the financial performance of HH o, and analyse and discuss the

extent to which the company has achieved its stated corporate o;ectives of:

(i) maximising the wealth of its shareholdersG

(ii) achieving continuous growth in earnings per share.

ote: up to E marks are availale for financial analysis.

(1% marks)

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() -f the new finance is raised via a rights issue at EI67 per share and the ma;or

expansion of usiness has not yet egun, calculate and comment on the effect of

the rights issue on:

(i) the share price of HH oG

(ii) the earnings per share of the companyG and

(iii) the det$e+uity ratio.

(A marks)

(c) &nalyse and discuss the relative merits of a rights issue, a placing and an issue

of onds as ways of raising the finance for the expansion. (E marks)

(2otal %6 marks)

(&& *C *inancial @anagement Hune %77C J5)

;uestion 2

Droxfol o is a listed company that plans to spend 17m on expanding its existing

usiness. -t has een suggested that the money could e raised y issuing C3 loan

notes redeemale in ten years time. urrent financial information on Droxfol o is as

follows.

9nco"e state"ent infor"ation for the last ear

777

"rofit efore interest and tax E,777

-nterest (677)

"rofit efore tax A,677

2ax (1,C67)

"rofit for the period 5,667

State"ent of financial position for the last ear 777 777

on?current assets %7,777

urrent assets %7,777

3otal assets 57,777

%uit and liabilities

rdinary shares, par value 1 6,777

0etained earnings %%,677

3otal euit %E,677

173 loan notes 6,777

C3 preference shares, par value 1 %,677

3otal non*current liabilities E,677

urrent liailities 6,777

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3otal euit and liabilities 57,777

2he current ex div ordinary share price is 5.67 per share. &n ordinary dividend of '6

cents per share has ;ust een paid and dividends are expected to increase y 53 peryear for the foreseeale future. 2he current ex div preference share price is EA.% cents.

2he loan notes are secured on the existing non?current assets of Droxfol o and are

redeemale at par in eight years time. 2hey have a current ex interest market price of

176 per 177 loan note. Droxfol o pays tax on profits at an annual rate of '73.

2he expansion of usiness is expected to increase profit efore interest and tax y

1%3 in the first year. Droxfol o has no overdraft.

&verage sector ratios)

*inancial gearing: 563 (prior charge capital divided y e+uity capital on a ook value

asis)

-nterest coverage ratio: 1% times

Reuired)

(a) alculate the current weighted average cost of capital of Droxfol o. (C marks)

() Discuss whether financial management theory suggests that Droxfol o can

reduce its weighted average cost of capital to a minimum level. (B marks)

(c) !valuate and comment on the effects, after one year, of the loan note issue and

the expansion of usiness on the following ratios:

(i) interest coverage ratioG

(ii) financial gearingG

(iii) earnings per share.

&ssume that the dividend growth rate of 53 is unchanged. (B marks)

(2otal %6 marks)(&& *C *inancial @anagement "ilot "aper %77B J1)

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;uestion /

K o is a listed company selling computer software. -ts profi t efore interest and

tax has fallen from 6 million to 1 million in the last year and its current fi nancial

position is as follows:

K o has een advised y its ank that the current overdraft limit of 5I6 million

will e reduced to 677,777 in two months time. 2he finance director of K o has

een unale to find another ank willing to offer alternative overdraft facilities and is

planning to issue onds on the stock market in order to finance the reduction of the

overdraft. 2he onds would e issued at their par value of 177 per ond and would

pay interest of C3 per year, payale at the end of each year. 2he onds would eredeemale at a 173 premium to their par value after 17 years. 2he finance director

hopes to raise 5 million from the ond issue.

2he ordinary shares of K o have a par value of 1I77 per share and a current

market value of 5I17 per share. 2he cost of e+uity of K o is 1%3 per year and

the current interest rate on the overdraft is 63 per year. 2axation is at an annual rate

of '73.

ther financial information:

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Reuired)

(a) alculate the after

Chapter14-CapitalStructureFinancialRatios

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