SBM Chapter-14
1 Capital structure: The mix of finance can be assessed using the suitability,
acceptability and feasibility framework.
1.2 Suitability of capital structure
Stability of company: Companys’
stability is most important factor of the gearing.
Matching assets with funds: Assets which yield profits over a long period of time should be
financed by long-term funds. In this way, the returns made by the asset should
be sufficient to pay either the interest cost of the loans raised to buy it, or
dividends on its equity funding.
Long-term capital requirements for replacement and growth:
Long-term capital is needed to
finance the replacement of worn-out (extremely tried) assets, and capital that
is needed to finance growth.
Aims Main funding sources
Signalling : Some
investors may see the issue of debt capital as a sign that the directors are
confident enough of the future cash flows of the business to be prepared to
commit the company to making regular interest payments to lenders.
Clientele effect: When
considering whether to change gearing significantly, causes of changes the
profile of shareholders. This may unsuitable for many shareholders. These shareholders
will look to sell their shares, while other investors, who are now attracted by
the new gearing levels, will look to buy shares.
Domestic and international borrowing: If the company is receiving income in a foreign currency
or has a long-term investment overseas, it can try to limit the risk of adverse
exchange rate movements by matching. It can take out a long-term loan and use
the foreign currency receipts to repay the loan. Similarly, it can try to match
its foreign assets (property, plant etc) by a long-term loan in the foreign
currency. However, if the asset ultimately generates domestic currency
receipts, there will be a long-term currency risk.
Cost and flexibility: Interest
rates on longer-term debt may be higher than interest rates on shorter-term
debt. However, issue costs or arrangement fees will be higher for shorter-term
debt as it has to be renewed more frequently.
1.3 Acceptability of capital structure
Risk attitudes
Loss of control
Costs
Commitments: The
interest and repayment schedules that the company is required to meet may be
considered. The directors are themselves required to provide personal
guarantees.
Present sources of finance
1.4 Feasibility of capital structure: Even if directors and shareholders are happy with the implications
of obtaining significant extra finance, the company may not be able to obtain
that finance.
Lenders' attitudes :
Shareholder willingness to invest : If the stock market is depressed, it may be difficult to
raise cash through share issues, so major amounts will have to be borrowed.
Future trends : Likely
future trends of fund availability will be significant if a business is likely
to require a number of injections of funds over the next few years.
Restrictions in loan agreements
Maturity dates: If
a business already has significant debt repayable in a few years' time, because
of cash flow restrictions it may not be able to take out further debt which is
repayable around the same time.
1.5 Pecking order theory
Retained earnings*
Straight debt
Convertible debt
Preference shares
Equity shares (rights then new
issues)
1.6 Cost of capital :
1.6.1 Cost of equity :
a) Dividend growth valuation model:
D(1+g)
k= --------------- +g
K
(b) Capital
Asset Pricing Model (CAPM) : The
CAPM is based on a comparison of the systematic risk of individual investments
with the risks of all shares in the market and is calculated as follows:
ke = rf + Be (rm – rf)
Interactive question 2: Cost of equity
[Difficulty level: Easy] : The
following data relates to the ordinary shares of Stilton.
Current market price, 31 December 20X1 250
pence
Dividend per share, 20X1 3 pence
Expected growth rate in dividends and earnings 10% pa
Average market return 8%
Risk-free rate of return 5%
Beta factor of Stilton equity shares 1.40
(a) What is the estimated cost of equity using the
dividend growth model?
(b) What is the estimated cost of equity using the
capital asset pricing model?
Interactive question 3: CAPM and beta factor
[Difficulty level: Easy]
(a) What does beta measure, and what do betas of 0.5, 1
and 1.5 mean?
(b) What factors determine the level of beta that a
company may have?
Answer to Interactive question 3
(a) Beta measures the systematic risk of a risky
investment. The systematic risk depends on the sensitivity of the return of the
share to general economic and market factors such as periods of boom and
recession. The CAPM shows how the return which investors expect from shares
should depend only on systematic risk, not on unsystematic risk, which can be
eliminated by holding a well-diversified portfolio.
Average risk of stock market investments has a beta of
1. Thus shares with betas of 0.5 or 1.5 would have ½ or 1½ times the average
sensitivity to market variations, respectively.
b) The beta of a company will be the weighted average of
the beta of its shares and the beta of its debt. The beta of debt is very low,
but not zero, because corporate debt bears default risk, which in turn is dependent
on the volatility of the company's cash flows. Factors determining the beta of
a company's equity shares include:
(i) Sensitivity of the company's cash flows to economic
factors.
(ii) The company's operating gearing. A high level of
fixed costs in the company's cost structure will cause high variations in
operating profit compared with variations in sales.
(iii) The company's financial gearing. High borrowing
and interest costs will cause high variations in equity earnings compared with
variations in operating profit.
1.6.2 Cost of debt :
(a) Irredeemable
debt capital
(b) Redeemable debt : The procedure is to calculate an internal rate of return on the
pre-tax cash flows.
(c) Cost of preference shares
(d) Cost of convertible debt: Conversion value = P0 (1 + g)n R
Interactive question 5: Cost of debt (with tax)
(a) A company has outstanding £660,000 of 8% loan notes
on which the interest is payable annually on 31 December. The debt is due for
redemption at par on 1 January 20X6. The market price of the loan notes at 28
December 20X2 was £103 cum interest. Ignoring taxation, what do you estimate to
be the current cost of debt as at 28 December 20X2?
(b) If the cost of debt rose to 12% at the beginning of
20X3, just after the notes had gone ex interest, what effect would this have on
the market price?
(c) If the effective rate of tax was 21% what would be
the after-tax cost of debt of the loan notes in (a) above?
1.6.3 Weighted average cost of capital (WACC)
1.6.4 Effective interest rates : The effective interest rate is the rate on a loan that has been
restated from the nominal interest rate to one with annual compound interest.
It is used to make loans more comparable by converting interest rates of
individual loans into equivalent annual rates. It is calculated using the
following formula: r = (1 + i/n)n – 1
Where: r
= the effective interest rate
i = the nominal interest rate
n = number of compounding periods pa (eg 12 for
monthly compounding)
1.7 Portfolio theory and CAPM
1.7.1 Portfolio theory : Modern portfolio theory is based around the premise that an
investor will want to minimise risk and follows the 'do not put all your eggs
in one basket' theory.
1.7.2 CAPM : CAPM
is used to calculate the required rate of return for any particular investment
and is based on the assumption that investors require a return in excess of the
risk-free rate to compensate them for systematic risk.
1.7.3 CAPM and cost of capital : The CAPM can be used to produce a cost of capital for an
investment project, based on the systematic risk of that investment.
1.7.4 CAPM and the cost of equity when financial risk or
business risk changes: One approach to establishing the
cost of equity for an investment, when there will be a significant change in
gearing or business risk as a result of the investment, is to estimate a new
equity beta for the investment and, from this, an appropriate cost of equity.
The formula relating a company’s equity beta (reflecting
its gearing level) and the all-equity beta (asset beta) is:
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2 Dividend policy
2.1 Relevance of dividend policy: The traditional view is that £1 of dividend income
received now is more certain than £1 of capital gain in the future. Therefore,
greater value would be put on a firm paying a dividend rather than one using
retentions.
In contrast to the
traditional view, Modigliani and Miller (MM) proposed that in a tax-free world,
shareholders are indifferent between dividends and
capital gains, and the value of a company is
determined solely by the 'earning power' of its assets
and investments.
Loss of value in existing shares = Amount of dividend
paid
There are strong arguments against MM's view that
dividend policy is irrelevant as a means of affecting shareholder's wealth.
Clientele: In
theory, a company should choose between dividend payout and earnings retention
so as to maximise the wealth of its shareholders. However, not all shareholders
are likely to have the same tax situation and after-tax cost of capital. Hence
there might not be an optimum policy which satisfies all shareholders.
Signalling: Dividends
can be used to convey good (or bad) information. A firm that increases its
dividend payout ratio may be signalling that it expects future cash flows to
increase as this ratio tends to remain steady over time.
Agency: Dividend
payments can be an instrument to monitor managers. When firms pay dividends
they subsequently often need to go to the capital markets to fund new projects.
When firms go to the financial markets, investors will analysis of the creditworthiness of the firm.
Therefore, if shareholders force managers to keep dividends high, as already
stated, managers will have to go to the capital markets to obtain funding for new
investments and have to justify the use they will make of the funds raised.
Life cycle: Under this theory, a company's dividend policy will vary
depending on the stage of the company's life cycle.
A young, growing company with numerous profitable
investment opportunities is unlikely to pay dividends as its earnings will be
used for investment purposes. Shareholders should therefore have low or no
expectations of receiving a dividend.
Pecking order: How
much do they pay out to shareholders each year to keep them happy, and what
level of funds do they retain in the business to invest in projects that will
yield long-term income? In addition, funds available from retained profits may be
needed if debt finance is likely to be unavailable.
Dividend capacity: The
dividend capacity of a corporation determines how much of a company's income
can be paid out as dividend. The dividend capacity of the company is also known
as the free cash flow to equity (FCFE).
The level of dividends paid by a company may also be
influenced by various other factors.
Loan agreements
Tax rules
Legal factors
Inflation
Maintaining control
2.3 Approaches to dividend policy : The Modigliani and Miller argument that dividend policy
is irrelevant should have led to a random pattern of dividend payments. In
practice, dividend payments tend to be smoothed over time. Various explanations
have been offered for this.
Residual theory of dividends : According to this theory, firms will only pay dividends
if all the profitable investment opportunities have been funded. This theory
assumes that internal funds are the cheapest source of financing, and the company
will resort to external financing only if the available internal funds, current
and retained earnings have been exhausted.
Target payout ratio: According
to the target payout theory, companies pay out as dividends a fixed proportion
of their earnings. Firms have long-run target dividend payout ratios, which are
designed to reduce uncertainty.
2.4 Impact of changes in dividend policy : The impact of changes in dividend policy on the value of
the firm can be assessed through a valuation model, such as the formula:
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Where: ROA =
return on the net assets of the company
b = retention rate D =
book value of debt
E = book value of equity
i = cost of debt t
= corporate tax rate
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Worked example: Dividend policy: A firm currently has a debt-equity ratio of 0.12 and a
return on assets (ROA) equal to 15%. The current interest rate is 7%. The tax
rate is 24%. The retention rate has been 50%. However the firm plans to reduce
its dividend payout to 30%. Find the impact of the change in dividend policy on
the growth rate.
Solution
Before the change in dividend policy we have:
ROA = 0.15 D/E = 0.12 i
= 0.07
b
= 0.50 t = 0.24
g = 0.5(0.15 + 0.12(0.15 – 0.07(1 – 0.24))) = 0.0808
The growth rate after the decrease in the pay-out rate (ie increase
in b) is:
g = 0.7(0.15 + 0.12(0.15 – 0.07 (1 – 0.24))) = 0.1131
The increase in the retention rate will raise the growth rate from
8.08% to 11.31%, that is by more than three percentage points.
Interactive question 8: Dividend policy : Summarised financial data for TYR plc is shown below.
Requirements : Explain, with supporting numerical evidence, the current
dividend policy of TYR plc, and briefly discuss whether or not this appears to
be successful.
3 Financial reconstruction
3.1 Reconstruction schemes: Financial restructuring takes place when firms get into
financial difficulty, or as part of an overall strategy to increase firm value.
3.1.3 Types of reconstruction:
Financial reconstruction which involves changing the capital structure of the
firm.
Portfolio reconstruction, which involves making additions to, or disposals from,
a company's businesses, eg through acquisitions or spin-offs.
Organisational restructuring, which involves changing the organisational structure
of the firm.
3.2 Financial reconstructions: A financial reconstruction scheme is a scheme whereby a
company reorganises its capital structure, including leveraged buyouts,
leveraged recapitalisations and debt for equity swaps.
Leveraged buyouts:
A leveraged buyout (LBO) is the acquisition of another company using a
significant amount of borrowed money to meet the cost of acquisition. The
assets of the company being acquired are often used as collateral for the
loans, along with the assets of the acquiring company
Leveraged capitalisations: In leveraged recapitalization a firm replaces the majority of its
equity with debt securities. Leveraged capitalisations are employed by firms as
defence mechanisms to protect them from takeovers.
Debt for equity swaps: A
second way in which a company may change its capital is to issue a debt/equity
or an equity/debt swap.
3.3 Financial reconstruction and firm value:
3.4 Effect on growth rate:
Worked example: Financing policy: A firm currently has a debt-equity ratio of 0.12 and a
return on assets (ROA) equal to 15%. The firm could raise the debt-equity ratio
up to 0.30 without increasing the risk of bankruptcy. The firm plans to borrow
and repurchase equity shares to reach this optimal ratio. The interest rate is
expected to increase from 7% to 9%. The tax rate is 21% and the retention rate
is 50%. Find the impact of the increase in debt on the growth rate.
3.4.1 Effect on systematic risk: The effect of a reconstruction on the systematic risk of
a company can be considered by calculating the revised geared beta using the
formula:
A higher level of debt will increase the geared beta of
a company, and a lower level of debt will reduce it.
Worked example: Effect on risk: A firm currently has a debt equity ratio of 0.12 and an
asset beta of 0.9. The firm could raise the debt equity ratio up to 0.30
without increasing the risk of bankruptcy. The firm plans to borrow and repurchase
stock to reach this optimal ratio. The interest rate is expected to increase
from 7% to 8%.
The tax rate is 21%. Find the impact of the increase in
debt on the geared beta.
Solution: Before
the increase in the debt ratio we have:
D/E = 0.12
T = 0.21
βa = 0.9
βe = βa(1 + [D(1 – T)/E]) = 0.9(1 +
0.12[1 – 0.21]) = 0.985
After the increase in the debt ratio we have:
D/E = 0.30
T = 0.21
βa = 0.9
The new beta following the change in the level of debt
will be:
βe = βa(1 + [D(1 – T)/E]) = 0.9(1 +
0.30[1 – 0.21]) = 1.113
3.6 Case study in financial reconstruction
Interactive question 9: Proceeds from liquidation
[Difficulty level: Intermediate] : Ascertain
the likely result of Crosby & Dawson Limited (see above) going into
liquidation as at 31 March 20X2.
3.7 Refinancing: The replacement of existing finance with new finance.
Typically when existing debt matures and reaches its redemption date, new debt
is issued and the proceeds from the new issue are used to redeem the maturing
debt.
Refinancing
to reduce interest payments
Refinancing
to reduce risk
Refinancing
to pay off debts
3.8 Securitisation: Securitisation is the process of converting illiquid
assets or a future revenue stream into marketable securities.
When a portfolio of assets is securitised, the
newly-issued debt securities are called asset-backed securities (ABS). When a
bank securitises a portfolio of mortgage loans, the new securities are called mortgage-backed
securities (MBS).
3.9 Legal consequences of financial distress: You will recall from your law studies that directors have
to be very careful if their company gets into financial difficulties. Carrying
on trading for too long before taking action may mean that they are guilty of
fraudulent or wrongful trading.
3.9.1 Fraudulent and wrongful trading: The criminal offence of fraudulent trading occurs under
the Companies Act where a company has traded with intent to
defraud creditors or for any fraudulent purpose.
There is also a civil offence but it only applies to
companies which are in liquidation. Under this offence courts may declare that any persons who were knowingly parties to carrying on the business in this
fashion shall be liable for the debts of the company.
3.10 Management of companies in financial
distress N/A
3.11 Corporate reporting consequences: Going concern means that an entity is normally viewed as
continuing in operation for the foreseeable future.
Financial statements are prepared on the going concern basis unless management
either intends to liquidate the entity or to cease trading or has no realistic
alternative but to do so.
IAS 1 Presentation of Financial Statements makes the following points:
In assessing whether the entity is
a going concern management must look at least twelve months into the
future measured from the end
of the reporting period (not from
the date the financial statements are
approved).
Uncertainties that may cast significant doubt on the entity's ability
to continue should be disclosed.
If the going concern assumption is
not followed that fact must be disclosed together with:
– The basis on which financial statements have
been prepared
– The reasons why the entity is not considered to
be a going concern
Following indications taken from
International Standard on Auditing, ISA 570 Going Concern may be
significant:
(a) Financial
indicators, e.g. recurring operating losses,
net liability or net current liability position, negative cash flow from
operating activities, adverse key financial ratios, inability to obtain financing
for essential new product development or other essential investments, default
on loan or similar agreements, arrears in dividends, denial of usual trade
credit from suppliers, restructuring of debt, non-compliance with statutory
capital requirements, need to seek new sources or methods of financing or to dispose
of substantial assets.
(b) Operating
matters, e.g. loss of key management
without replacement, loss of a major market, key customers, licence, or
principal suppliers, labour difficulties, shortages of important supplies or
the emergence of a highly successful competitor.
(c) Other
matters, e.g. pending legal or regulatory
proceedings against the entity, changes in law or regulations that may
adversely affect the entity; or uninsured or underinsured catastrophe such as a
drought, earthquake or flood.
In relation to going concern, IAS 10 Events After the Reporting Period states that, where operating results and the financial
position have deteriorated after the reporting period, it may be necessary to
reconsider whether the going concern assumption is appropriate in the
preparation of the financial statements.
Interactive question 10: Financial reconstruction
[Difficulty level: Intermediate]
4 Demergers and disposals: Unbundling can be either voluntary or it can be forced
on a company. A company may voluntarily decide to divest part of its business
for strategic, financial or organisational reasons. An involuntary unbundling,
on the other hand, may take place for regulatory or financial reasons. The main
forms of unbundling are:
4.1 Divestments: The partial or complete sale or disposal of physical and
organisational assets, the shutdown of facilities and reduction in workforce in
order to free funds for investment in other areas of strategic interest.
4.2 Demergers: The opposite of a merger. It is the splitting up of a corporate
body into two or more separate independent bodies.
4.3 Sell-offs: A form of divestment, involving the sale of part of a company to
a third party, usually another company. Generally cash will be received in
exchange.
4.4 Spin-offs: The creation of a new company, where the shareholders of the
original company own the shares.
4.5 Carve-outs: The creation of a new company, by detaching parts of the
original company and selling the shares of the new company to the public.
4.6 Going private
4.7 Management buyouts (MBO): The purchase of a business from its existing owners by
members of the management team, generally in association with a financing
institution.
4.8 Leveraged buyouts: is the purchase of another company using a very significant
amount of debt (bonds or loans). Often the cash flows and assets of the company
being purchased are used as collateral as well as the assets of the company
making the acquisition.
4.10 Use of distributable profits
4.11 Valuation issues: Unbundling will impact upon the value of a firm through
its impact upon different factors in the valuation models.
Impact on growth rate: When
firms divest themselves of existing investments, they affect their expected
return on assets, as good projects increase the return on assets (ROA), and bad
projects reduce the return.
Worked example: Divestment policy: A firm is expected to divest itself of unrelated
divisions, which have historically had lower returns on assets. As a result of
the divestment the return on equity is expected to increase from 10% to 15%.
Requirement: Calculate the effect on the earnings growth rate if the debt to
equity ratio is 0.30, the tax rate is 25%, the retention rate is 50% and the
interest rate on debt is 8%.
Worked example: Divestment policy and business
risk
The business risk (asset beta) of an oil company which
has diversified into a number of other activities such as leisure and tourism
is 1.3. If the oil company divested itself of all other activities and concentrated
on its core business, its equity beta, based on the observed beta of oil
companies with similar financial structure is expected to be 1.4. The tax rate
is 21% and the debt to equity ratio is 0.30.
Requirement: Calculate the business risk following the divestment of the other
businesses.
4.13 Application of IFRS 5:
4.13.1 Recognition of disposals
Discontinued operation: A component of an entity that has either been disposed
of, or is classified as held for sale
Measurement issues: A
non-current asset (or disposal group) that is held for sale should be measured
at the lower of its carrying
amount and fair value less costs to sell (net realisable value). Non-current assets held for sale
should not be depreciated, even if they are still being used by the entity.
5 Small and medium-sized company financing
5.2 Sources of finance for SMEs: Potential sources of funding for SMEs include:
Owner financing
Equity finance
Business angel financing
Venture capital
Leasing
Factoring
Bank loans
5.2.3 Business angels: A
business angel is an independent individual who provides capital for the
development of a business. Typically wealthy individuals, business angels (or
angel investors) aim to help entrepreneurial individuals succeed with a
business idea by investing their own money.
5.2.4 Venture capital: VC
is risk capital, normally provided in return for an equity stake. For.
Business
start-ups
Business
development
Management
buyouts
Helping
a company where one of its owners wants to realise all or part of their
investment.
5.2.8 Microfinance: Microfinance
involves the provision of financial services to very small business and
entrepreneurs who lack access to banking services. Microfinance is provided by:
Relationship-based banking
for individual businesses.
Group-based models, where lots of entrepreneurs apply for finance and
other services, such as insurance and money transfer, as a group.
Interactive question 11: SME finance [Difficulty
level: Intermediate]: DF is a
manufacturer of sports equipment. All of the shares of DF are held by the Wong
family.
The company has recently won a major three-year contract
to supply FF with a range of sports
equipment. FF is a large company with over 100 sports
shops. The contract may be renewed after three years.
The new contract is expected to double DF's existing
total annual sales, but demand from FF will vary considerably from month to
month.
The contract will, however, mean a significant
additional investment in both non-current and current assets. A loan from the
bank is to be used to finance the additional non-current assets, as the Wong family
is currently unable to supply any further share capital. Also, the Wong family
does not wish to raise new capital by issuing shares to non-family members.
The financing of the additional current assets is yet to
be decided. In particular, the contract with FF will require orders to be
delivered within two days. This delivery period gives DF insufficient time to manufacture
items, thus significant inventories need to be held at all times. Also, FF
requires 90 days' credit from its suppliers. This will result in a significant
additional investment in accounts receivable by DF.
If the company borrows from the bank to finance current
assets, either using a loan or an overdraft, it expects to be charged annual
interest at 12%. Consequently, DF is considering alternative methods of financing
current assets. These include debt factoring, invoice discounting and offering
a 3% cash discount to FF for settlement within ten days rather than the normal
90 days.
Requirements
(a) Write a report to the Wong family shareholders
explaining the various methods of financing available to DF to finance the
additional current assets arising from the new FF contract. The report should
include the following headings:
Bank loan
Overdraft
Debt factoring
Invoice discounting
(b) Discuss the factors that a venture capital
organisation will take into account when deciding
whether to invest in DF.
Self-test question 1
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