Chapter 14 Capital Structure and Financial Ratios

1. 1.1 Objectives 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 &ssess a companys financial position and financial risk in a scenario y calculating and assessing appropriate ratios. &ssess the impact of sources of finance on the financial position and financial risk of a company y considering the effect on shareholder wealth.

1.% 1.'

, a p ita l # tr u c tu re and * in a n c ia l 0 a tio s

( p e ra tin g ) e a rin g

* in a n c ia l ) e a rin g

! ffe c t o n # h a re h o ld e r . e a l th

D e t / o ld e r 0 a tio s

* in a n c ia l ris k

) e a rin g ra tio s

!"#

" $ ! r a t io

D iv id e n d cover

D iv id e n d y i e ld

-n te re s t cover

-n te re s t y i e ld

! + u i ty g e a rin g

, a p ita l g e a rin g

-n te re st g e a rin g

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2. %.1

Operating Gearing Definition Operating gearing is a measure of the e tent to !hich a fir"#s operating costs are fi ed rather than varia le as this affects the level of business ris$ in the firm. (perating gearing can e measured in a num er of different ways, including: 1. *ixed costs 1aria les costs %. *ixed costs 2otal costs '. 3 change in !4-2 (or "4-2) 3 change in turnover 5. ,ontri ution "4-2 or !4-2 ,ontri ution is sales minus varia le cost of sales. or or or or

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*irms with a high proportion of fi ed costs in their cost structures are known as having high operating gearing. % a"ple 1 2wo firms have the following cost structures: Fir" & (" #ales 6.7 1aria le costs ('.7) *ixed costs (1.7) !4-2 1.7 Fir" ' (" 6.7 (1.7) ('.7) 1.7

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.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" & *ixed costs$varia le costs 1$' 9 7.''

Fir" ' '$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+, :m 1+, increase increase #ales 6.7 -.6.7 -.1aria le 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 a out 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 varia le costs for fixed would increase the level of operating gearing.

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Financial Gearing Financial gearing is the amount of debt finance a company uses relative to its e1uit2 finance. Financial ris$ Financial ris$ 2he greater the level of debt, the "ore financial ris$ (of reduced dividends after the payment of de t interest) to the shareholder of the company, so the higher is their re+uired return.

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*inancial risk can e seen from different points of view. (a) 3he co"pan2 as a !hole < -f a company uilds up de ts that it cannot pay when they fall due, it will e forced into li+uidation. ( ) 4a2ables < -f a company cannot pay its de ts, the company will go into li+uidation owing paya les money that they are unlikely to recover in full. =enders will thus want a higher interest 2ield to compensate them for higher financial risk and gearing. (c) Ordinar2 shareholders < & company will not make any distri uta le profits unless it is a le to earn enough profit efore interest and tax to pay all its interest charges, and then tax. Ordinar2 shareholders will pro a ly !ant a bigger e pected return from their shares to compensate them for a higher financial ris$. Gearing ratios Financial Gearing *inancial gearing measures the relationship etween shareholders capital plus reserves and capital or orrowings or oth. 1. !+uity gearing 9 "reference share capital > long?tern de t (rdinary share capital > reserve %. 2otal or capital gearing 9 -nterest gearing 9 "reference share capital > long?tern de t 2otal long?term capital De t interest
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"4-2 5ote) (a) #ince preference shares are treated as debt finance , preference dividends are treated as de t 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 a sor ed 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 de t and e+uity. 2here are arguments in favour of oth approaches: (a) @arket values: (i) are "ore relevant to the level of investment made (ii) represent the opportunit2 cost of the investment made (iii) are consistent with the way investors "easure de t and e+uity. ( ) 4ook values: (i) are not subject to sudden change due to the market factors (ii) are readil2 available. % a"ple / 2he following excerpt has een o tained from the financial statements of &4, ,o. State"ent of financial position e cerpt 2+1+ 2++6 (+++ (+++ 2otal assets less current lia ilities 16B 1'C Don?current lia ilities 63 secured loan notes 57 57 11B (rdinary share capital (67c shares) B3 "reference shares (:1 shares) #hare premium account 0evaluation reserve
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'.A

CC '6 %6 1E ?

'6 %6 1E 17

-ncome statement

'1 11B

%% CC

-ncome statement excerpt 2+1+ (+++ )ross profit -nterest Depreciation #undry expenses Det profit 2axation Det profit after taxation Dividends: (rdinary shares "reference shares 0etained profit 2otal market values are$were as follows: (rdinary shares (per share) "reference shares (per share) 63 loan notes (per :177 nominal value) Calculate) (a) ( ) (c) !+uity gearing ,apital gearing -nterest gearing A % (B) C 2+1+ %75c B7c :17B % C 15 (%6) %E (17) 1E 6 % (E) A 2++6 1C6c 17%c :11A (+++ 6% (+++ % C 11 (%%) %' (17) 1' 2++6 (+++ 56

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

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Solution) (a) !+uity gearing

2+1+ 4ook values

2++6
%6 + 57 1773 CC %6 9 BE.B3 1.7% %6 +1.1A 57 1.C6 E7 9 6%.E3

@arket values

Dote: #ince preference shares are treated as de t, e+uity gearing could also e descri ed as the de t$e+uity ratio. ( ) ,apital gearing 2+1+ 4ook values
A6 1773 11B + 57 9 51.13 A'.% 1773 15%.B + A'.% 9 '7.E3

2++6
A6 1773 CC + 57 9 5A.B3 E1.C 1773 1'A.6 + E1.C 9 '5.63

@arket values

(c) -nterest gearing 2+1+ -nterest gearing

2++6
%+% 1773 %' + % 9 1A.73

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-mpact of financial gearing < where two companies have the same level of varia ility in earnings, the co"pan2 !ith the higher level of financial gearing will have increased variabilit2 of returns to 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 1aria le costs (%) *ixed costs (6) !4-2 -nterest !&-42 Solution) #ales 1aria le costs *ixed costs !4-2 -nterest !&-42 (+++ 17 (%) (6) ' (%) 1 1+, decrease .(+++0 C (1.B) (6) %.% (%) 7.% ' (%) 1

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 de t interest o ligations. 2his financial gearing has the effect of amplifying the varia ility 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 a ove the change in operating earnings is due to the use of de t finance.

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'.C

(verall therefore there is a re+uired trade?off etween:

4. 5.1

%ffect on Shareholder 7ealth -f a company can generate returns on capital in e cess of the interest pa2able on de t, financial gearing !ill raise the %4S . )earing will, however, also increase the varia ility of returns for shareholders and increase the chance of corporate failure. %arnings per share .%4S0 4asic !"# should e calculated y dividing the net profit or loss for the period attri uta le to ordinary shareholders y the weighted average num er of ordinary shares outstanding during the period. !"# 9 "rofit after tax and preference dividends .eighted average num er of shares

.&0 5.%

.'0 5.'

4rice*earnings ratio .48%0 "$! ratio is the ratio of a companys current share price to the latest !"#. & high 48% ratio indicates strong "ar$et confidence in the future profit gro!th of the company. ,onversely a low "$! ratio indicates low market confidence in the company making a profit. 2he value of the "$! ratio reflects the markets appraisal of the shares future prospects. 9f %4S falls ecause of an increased urden arising fro" increased gearing, an increased 48% ratio will "ean that the share price has not fallen
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5.5

as "uch as earnings, indicating the "ar$et vie!s positivel2 the projects that the increased gearing will fund. "$! 0atio 9 @arket price per share !"# .C0 5.6 Dividend cover -t is a measure of how many times the companys earnings could pay the dividend. 2he higher the cover, the better the abilit2 to "aintain dividends , if profits drop. 2his needs to e looked at in the context of how sta le a companys earnings are: a low level of dividend cover might e accepta le in a company with very sta le profits, ut the same level of cover in a company with volatile profits would indicate that dividends are at risk. 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 pa2"ents, then: (a) the directors may decide to make corresponding reductions in dividend to 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 pa2"ents in future 2ears, should earnings fall. Dividend cover 9 !"# D"# .D0 5.B Dividend 2ield Dividend yield is the rate of return a shareholder is e pecting on an invest"ent in shares of a company. #ince shareholders expect dividend yield and capital growth, dividend yield is an important indicator of a shares performance. 2he 2ield will e influenced b2 the dividend polic2 of an organiFationG a company which has traditionally paid high dividends will e popular with
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5.A

5.E

5.C

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5.11

some investors and this will e reflected in its share price. *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 2ield the better. & low dividend yield might persuade investors to dispose of shares and invest the proceeds elsewhere. -f the additional debt finance is expected to e used to generate good returns in the long?term, it is possi le that the dividend 2ield "ight fall significantl2 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"# @arket price per share 2he gross dividend is the dividend paid plus the appropriate tax credit. x 1773

-. .&0 6.1 6.%

Debt :older Ratios 9nterest cover -nterest on loan stock (de enture stock) must e paid whether or not the company makes a profit. -nterest cover is a "easure of the ade1uac2 of a co"pan2#s profits relative to its interest pa2"ents on its de t: -nterest cover 9 "4-2 De t interest

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-n general, a high level of interest cover is good ut may also e interpreted as a company failing to exploit gearing opportunities to fund pro;ects at a lower cost than from e+uity finance. 9nterest 2ield 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 de t holder.

.'0 6.5

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-nterest yield 9

-nterest rate @arket value of de t

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% a"ination St2le ;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 availa le:

Re1uired) (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. Dote: up to E marks are availa le for financial analysis. (1% marks)
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( )

(c)

-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 de t$e+uity ratio. (A marks) &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 redeema le in ten years time. ,urrent financial information on Droxfol ,o is as follows. 9nco"e state"ent infor"ation for the last 2ear :777 "rofit efore interest and tax E,777 -nterest (677) "rofit efore tax 2ax "rofit for the period State"ent of financial position for the last 2ear Don?current assets ,urrent assets 3otal assets %1uit2 and liabilities (rdinary shares, par value :1 0etained earnings 3otal e1uit2 173 loan notes C3 preference shares, par value :1 3otal non*current liabilities ,urrent lia ilities
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A,677 (1,C67) 5,667 :777 :777 %7,777 %7,777 57,777

6,777 %%,677 %E,677 6,777 %,677 E,677 6,777

3otal e1uit2 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 per year for the foreseea le 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 redeema le 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 Re1uired) (a) ( ) (c) ,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) !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)1 ,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)1 ,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)1 ,o has een una le 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, paya le at the end of each year. 2he onds would e redeema le 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)1 ,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)1 ,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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Re1uired) (a) ( ) ,alculate the after<tax cost of de t of the C3 onds. (5 marks) ,alculate and comment on the effect of the ond issue on the weighted average cost of capital of K)1 ,o, clearly stating any assumptions that you make. (6 marks) ,alculate the effect of using the ond issue to finance the reduction in the overdraft on: (i) the interest coverage ratioG (ii) gearing. (5 marks) !valuate the proposal to use the ond issue to finance the reduction in the overdraft and discuss alternative sources of finance that could e considered y K)1 ,o, given its current financial position. (1% marks) (2otal %6 marks) (&,,& *C *inancial @anagement Hune %717 J%)

(c)

(d)

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