This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.
Long-term capital can be divided into two groups, share capital and loan capital. When a company is raising new capital, the method of finance chosen can have a considerable effect on the future of the business particularly the earnings per share (EPS).
Capital structure refers to the way in which an organisation is financed, by a combination of long-term capital i.e. ordinary shares and reserves, preference shares, loan capital such as debentures, bank loans, convertible loan stock etc., and short-term liabilities such as bank overdraft, creditors etc.
1.1 Capital requirements
The total capital should be sufficient to pay for fixed assets and provide adequate working capital.
Over-capitalisation occurs when the amount of capital is too large in relation to the volume of business, with the result that profits are insufficient to make a satisfactory return.
Excessive "ploughing back" of profits will create over-capitalisation, because the extra business created will be inadequate in relation to the costs incurred and funds invested.
Too much loan capital is another aspect of over-capitalisation. If trade declines the interest burden may become insupportable, because profits may be insufficient to cover interest charges and leave a sufficient amount after tax to pay a satisfactory dividend.
Where over-capitalisation exists, a company's management should attempt to realise surplus assets, and with the surplus cash obtained, either:
find new investments that give a satisfactory return; or,
distribute the cash as dividends, or use it to redeem loan stock.
1.2 Financial gearing
The ratio between ordinary share capital and fixed interest-bearing securities is called financial gearing, or as it is termed in the USA, leverage. The basic concept of gearing is the same, whether or not the fixed interest capital is assumed to include preference shares as well as loan stock.
A company that is financed mainly by equity is said to be low geared. The higher the proportion of fixed interest capital, the higher the gearing. A high-geared company is one in which equity capital (including reserves) is less than fixed interest capital. The most commonly used measure of gearing is based on the balance sheet values of fixed interest and equity capital.
Gearing = Prior charge capital x 100
Equity capital (including reserves)
The term "prior charge capital" refers to securities on which interest or dividends must be paid before arriving at the earnings for ordinary shareholders. It includes both preference shares and loans.
There are several ways to define prior charge capital but it should generally be assumed to include bank overdraft and short-term loans (that are reported in the balance sheet as current liabilities rather than long-term liabilities). This assumption would be based on the belief that the bank overdraft is effectively a permanent source of finance and that short-term loans will be renewed or replaced when they mature.
1.3 The effect of gearing on earnings
The amount of gearing will influence the value of earnings attributable to ordinary shareholders. A company in high gear must earn sufficient profits to cover its interest charges before any is available to equity.
Two companies are identical in every respect except for their gearing. Non-lever Ltd is all-equity financed and Levered Ltd is partly financed by debt capital as follows:
Non-Lever Ltd Levered Ltd
Assets 20,000 20,000
10% Loan stock 0 10,000
Equity Shares of $1 20,000 10,000
Calculate the EPS for each company if the PBIT is:
Both companies pay tax at 30% on profits
There are some further measures of gearing that are designed to show the effect on the earnings rather than on the balance sheet.
They give a direct indication of the ability of the company to meet its interest commitments because it is the possibility of a company failing to pay interest that represents the greatest danger of high gearing
When profit measures are calculated over several years, the results give a more dynamic picture of the effects of gearing. The balance sheet ratios are, on the other hand, static figures that may not change even when the company's true position is deteriorating.
These further measures include:
a) Interest cover = PBIT
An interest cover of less than 3 is considered low, indicating that profitability is too low given the high gearing of the company.
b) Preference dividend cover = Profits attributable to shareholders
This ratio is not generally considered to be so important as the interest cover because the preference dividend is not payable unless profits are available.
c) Financial gearing based on EBIT (PBIT) = EBIT x 100
EBIT - C
C = the interest charges and/or preference dividend adjusted to a before tax basis
Of the three ratios the financial gearing based on EBIT is probably the most useful to shareholders as it shows the sensitivity of the EPS to changes in the EBIT. The ratio increases as the EBIT falls this indicates the increased risk to shareholders.
The capital structure of two companies X Ltd and Y Ltd, is given below:
Ordinary shares of $1 9,000 1,000
Reserves 1,000 1,000
Loan stock (10% interest) 0 8,000
Total Capital 10,000 10,000
The interest cover;
Financial gearing, based on i) balance sheet values;
where the profits before interest and tax of both companies are:
Assume a tax rate of 30%
1.4 The factors to consider in choosing between equity and debt finance
1) Equity finance will decrease gearing and financial risk, while debt finance will increase
them. Gearing is important to investors and financial managers because it indicates
the amount of risk that might exist:
to the income of both shareholders and loan stock holders, and
to the capital investments of loan stock holders
It is thus a means of indicating whether a company is likely to be successful in raising
new funds by means of extra borrowing
2) A company should have a target capital structure. If it's primary financial objective is
to maximise the wealth of shareholders, it should seek to minimise its weighted
average cost of capital (WACC). In practical terms this can be achieved by having
some debt in its capital structure, since debt is relatively cheaper than equity, while
avoiding the extremes of too little gearing.
3) The amount of debt may be limited by the Articles of Association
4) There may be limits imposed by covenants made on the issue of existing debt capital
5) The availability and quality of assets that can be used as security and, in the case of
smaller companies, the willingness of the directors to give personal guarantees.
6) The availability of cash to meet interest charges and capital repayments. This will, in
time, depend upon the level of profitability
7) The cost of debt capital relative to the cost of equity. It will be found that the interest
rate demanded by potential lenders will increase as the level of gearing rises. In
addition the return required by equity shareholders will also rise as the level of
gearing increases, to compensate for the additional financial risks, i.e. the greater
uncertainty that the EBIT will cover interest payments
8) If a company expects buoyant economic conditions and increasing profitability in the
future, it will be more prepared to take on fixed interest debt commitments than if it
believes difficult trading conditions lie ahead.
9) A rights issue will not dilute existing patterns of ownership and control, unlike an issue
of shares to new investors. The choice between offering new shares to existing
shareholders and to new shareholders will depend in part on the amount of finance
that is needed, with rights issues being used for medium-sized issues and issues to
new shareholders being used for large issues. Issuing traded debt also has control
implications however, since restrictive or negative covenants are usually written
into the bond issue documents.
10) Business confidence and expectations of future profits are crucial factors in the
determination of how much debt capital investors are prepared to lend. The level of
gearing that the market will allow must therefore depend on the nature of the
company wishing to borrow more funds, and the industry in which it is engaged.
Existing industry averages are considered in any financing decision.
11) The capital structure of a company must never put shareholders at serious risk, so
a) a company that is involved in a cyclical business, where profits are subject to periodic
ups and downs, should have relatively low gearing, whereas;
b) a company in a business where profits are stable should be able to raise a larger
amount of debt.
2.0 Long-term Sources of Finance
Long-term finance is used for major investments and is usually more expensive and less flexible than short-term finance.
2.1 Debt Finance
The reasons for seeking debt finance are as follows:
Equity funding too expensive or not readily available.
Debt finance is cheaper
Debt finance is easier to arrange
To capitalise on a current low level of gearing
The availability of tax relief
The sources of debt finance are as follows:
Loan notes, these may be redeemable, and they could have conversion rights.
2.2 Choice of Debt Finance
The choice will depend upon:
Availability: The size of the business. A public issue of loan notes on a stock exchange is available to large companies. Smaller companies will have to approach their bank
Duration: If loan finance is sought to buy a particular asset to generate revenues for the business, the length of the loan should match the length of time that the asset will be generating revenues.
Fixed or floating rate: Expectations of interest movements will determine whether a company chooses to borrow at a fixed or floating rate. Fixed rate finance may be more expensive, but the business runs the risk of adverse upward rate movements if it chooses floating rate finance.
Security and Covenants: The choice of finance may be determined by the assets that the business is willing or able to offer as security, also on the restrictions in covenants that the lenders will impose.
The term bonds describes various forms of long-term debt a company may issue, such as loan notes debentures, which may be:
Bonds or loans come in various forms, including
Floating rate debentures
Zero coupon bonds
Convertible loan notes
Loan notes are long-term debt capital raised by a company for which interest is paid, usually half yearly and at a fixed rate. Holders of loan notes are therefore long-term payables for a company.
For example if a company issues 10% loan notes, the coupon (interest rate) will be 10% of the nominal value of the notes, so $100 of notes will receive $10 interest per year. This is the gross rate, before tax.
Unlike shares, debt is often issued at par, i.e. with $100 payable per $100 nominal value. Where the coupon rate is fixed at the time of issue, it will be set according to prevailing market conditions given the credit rating of the company issuing the debt. Subsequent changes in market (and company) conditions will cause the market value of the bond to fluctuate, although the coupon will stay at the fixed percentage of the nominal value.
2.4 Convertible Loan Notes
These are bonds that give the holder the right to convert to other securities, usually ordinary shares, at a pre-determined price/rate and time.
When convertible loan notes are traded on the stock market, their minimum market price or floor value will be the price of normal debentures with the same coupon rate of interest. If the market value falls to this minimum, it follows that the market attaches no value to the conversion rights, the conversion rights value must obviously be less than the floor value in this case.
The actual market price of convertible notes will depend on
The price of normal debt
The current conversion value
The length of time before conversion may take place
The markets expectation as to future equity returns and the risk associated with these returns
Most companies issuing convertible loan notes expect them to be converted. They view the notes as delayed equity. They are often used either because the company's ordinary share price is depressed at the time of issue or because the issue of equity shares would result in an immediate and significant drop in the earnings per share. There is no guarantee, however, that the security holders will exercise their option to convert; therefore the notes may run their full term and need to be redeemed.
Loan notes and debentures will often be secured. This may take the form of a fixed or floating charge.
Security relates to specific asset/group of assets (land &buildings)
Company cannot dispose of assets without providing substitute/consent of lender
Security in event of default is whatever assets of the class secured (inventory/trade receivables) company then owns
Company can dispose of assets until default takes place
In event of default lenders appoint receiver rather than lay claim to asset
2.6 Redemption of loan notes
Loan notes and debentures are usually redeemable. They are issued for a term of ten years or more, maybe 25 to 30 years. At the end of this period, they will mature and become redeemable at par or possibly above par.
Most redeemable bonds have an earliest and a latest redemption date. The issuing company can select the date.
Some loan notes do not have a redemption date, and are "irredeemable", or "undated". Security holders trade them on the stock market.
New loans may be raised to finance the redemption of long-term debt, but there is no guarantee that this will be possible. One item that you should look for in a company's balance sheet is the redemption date of current loans, to establish how much new finance is likely to be needed by the company, and when.
2.7 Tax relief on loan interest
Debt capital is a potentially attractive source of finance because interest charges reduce the profits chargeable to corporation tax.
a) A new issue of loan notes is likely to be preferable to a new issue of preference shares, the fixed dividend payable is made out of already taxed profits.
b) Companies might wish to avoid dilution of shareholdings and increase gearing in order to improve their earnings per share by benefiting from tax relief on interest payments
3.0 Equity Finance
Equity finance is raised through the sale of ordinary shares to investors either as a new issue a rights issue or a placing.
A placing, or any issue of new shares such as a rights issue or a public offer, would decrease gearing. A placing will dilute ownership and control.
A rights issue will not dilute ownership and control, providing existing
shareholders take up their rights.
Equity issues such as a placing and a rights issue do not require security.
Ordinary shares are issued to the owners of a company, they will have a nominal/face value (book value) of typically $1 or 50cents
The share price of an issue is usually advertised as being based on a certain P/E ratio, the issuer's P/E ratio can then be compared by investors with the P/E ratios of similar quoted companies.
Potential investors will consider a number points when making a decision on whether to invest in the equity of a particular company as opposed to other forms of investment:
1. Business risk: this is determined by the particular industry that the particular company operates within. Some industries are riskier than others. Food retailing is less risky that clothes retailing. The restaurant business is riskier than DIY retailing. Health & care services are less risky than engineering/manufacturing/building services.
2. Financial risk: this is determined by the way in which a company is financed. Higher levels of borrowing in a capital structure will indicate a higher degree of risk.
3. The share price
4. Potential level of future earnings and dividends
5. Company reputation and ethics
6. The nature of the industry
In both cases of risk investors would require a higher level of return to compensate for the higher levels of risk.
The issue of equity will reduce a company's gearing ratio, and is usually achieved through a rights issue. This is an offer to existing shareholders enabling them to buy more shares in proportion to their existing holding of shares at a lower than market price.
3.1 The major advantages of a rights issue are as follows:
a) A rights issue is less expensive than a public offer because a prospectus is not issued, administration and cost of underwriting is less.
b) The cost to the investor is less than the market price, they can then keep or sell the shares
c) Relative voting rights are unaffected if shareholders all take up their rights
d) The finance raised will reduce gearing in book value terms, or if it is used to pay off long-term debt it will reduce gearing in market value terms
3.2 The theoretical ex rights price
After the right issue has taken place, the market price per share will usually fall, this is because there are more shares in issue and the new shares were issued at a discount price.
In theory, the new market price will be the consequence of an adjustment to allow for the discount price of the new issue, and a theoretical ex rights price can be calculated.
Charles plc has 3,000,000 ordinary shares in issue at a market price of $5.00. The company intends to raise more capital by making a 1 for 3 rights issue at a discount of 20% to the market value.
Calculate: (a) the rights issue price per share;
(b) the cash raised;
(c) the theoretical ex rights price per share.
Answer: a) $5.00 x 0.8 = $4.00
b) 1,000,000 x $4.00 = $4,000,000
c) ((3 x 5.00) + 4.00)/4 = $4.75
4.0 Lease or buy decisions
There are two types of leasing
Operating leases (lessor responsible for maintaining asset)
Finance leases (lessee responsible for maintenance)
4.1 The nature of leasing
Rather than buying an asset outright, using either available cash resources or borrowed funds, a business may lease an asset.
4.2 Operating Leases
This is a lease where the lessor retains most of the risks and rewards of ownership. Operating leases are rental agreements between a lessor and a lessee.
The lessor supplies the equipment to the lessee
The lessor is responsible for servicing and maintaining the leased asset
The period of the lease is fairly short, less than the expected economic life of the asset. At the end of one lease agreement, the lessor can either lease the same equipment to someone else, and obtain a good rent for it, or sell the equipment second-hand.
Much of the growth in the UK leasing business in recent years has been in operating leases because operating leasing is often compared to borrowing as a source of finance and offers several attractive features in this area.
1. An operating lease is seen as protection against obsolescence, since it can be cancelled at short notice without financial penalty.
2. The lessor will replace the leased asset with a more up-to-date model in
exchange for continuing leasing business.
3. This flexibility is seen as valuable in the current era of rapid technological
4. This flexibility can also extend to contract terms and servicing cover.
5. There is no need to arrange a loan in order to acquire an asset and so the
commitment to interest payments can be avoided, as well as interest rate rises.
6. Existing assets need not be tied up as security and negative effects on
return on capital employed can be avoided.
7. Since legal title does not pass from lessor to lessee, the leased asset can be
recovered by the lessor in the event of default on lease rentals.
8. Operating leasing can be attractive to small companies or to companies who may find it difficult to raise debt.
9. Operating leasing can also be cheaper than borrowing to buy.
10. There are several reasons why the lessor may be able to acquire the leased asset more cheaply than the lessee, for example by taking advantage of bulk buying, or by having access to lower cost finance by virtue of being a much larger company. This can be passed onto the lessee in lower lease payments
11. The lessor may also be able use tax benefits more effectively than the lessee. A portion of these benefits can be made available to the lessee in the form of lower lease rentals, making operating leasing a more attractive proposition than borrowing.
12. Operating leases also have the attraction of being off-balance sheet financing, in that the finance used to acquire use of the leased asset does not appear in the balance sheet.
13. A company may also sell its property or buildings and lease them back from the buyer
4.3 Finance Leases
A finance lease is a lease that transfers substantially all of the risks and rewards of ownership of an asset to the lessee. It is an agreement between the lessee and the lessor for most or all of the assets expected useful life.
The important characteristics of a finance lease are as follows:
a) The lessee is responsible for the upkeep, servicing and maintenance of the asset.
b) The lease period is for the full life of the asset.
c) At the end of the lease agreement the lessee may continue to lease the asset at a reduced rental.
Mandingo plc is a listed company that plans to spend $5m on expanding its existing business. It is intended that the money will be raised by issuing 7% loan notes redeemable in 10 years time. Current financial information is as follows:
The Income statement for last year
Profit before interest and tax 5,000
Profit before tax 4,300
Profit for the period 3,010
The Balance sheet for last year $000 $000
Non-current assets 15,000
Current assets 10,000
Total assets 25,000
Equity and liabilities
Ordinary shares, par value $1 6,000
Retained earnings 7,000
Total equity 13,000
10% loan notes 7,000
9% preference shares par value $1 2,000
Total non-current liabilities 9,000
Current liabilities 3,000
Total equity and liabilities 25,000
The expansion of the business is expected to increase profit before interest and tax by 20% in the first year. Mandingo has no overdraft. The annual tax rate on profits is 30%.
An ordinary dividend of 30 cents has just been paid, dividends are expected to grow by 5% p.a. The current loan notes are redeemable at par in 8 years.
Average sector ratios:
Financial gearing: 70% (prior charge capital divided by equity capital on a book value basis)
Interest cover ratio: 6 times
Calculate the current financial gearing ratio based on balance sheet values.
Calculate the gearing ratio, in (a) one year after the planned expansion
Calculate the current interest cover
Calculate the interest cover after expansion
Calculate the current EPS
Calculate the EPS after expansion
Calculate the financial gearing based on earnings before and after expansion.
Comment on the way in which the expansion is being financed