CHAPTER 12 CAPITAL STRUCTURE 1.

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Presentation transcript:

CHAPTER 12 CAPITAL STRUCTURE 1

Chapter outline Introduction The different types of equity finance The different types of non-current debt finance Debt versus equity Medium-term finance Gearing Capital structure Optimal capital structure Conclusion

Learning outcomes By the end of this chapter, you should be able to: explain and discuss the different types of equity finance calculate and interpret the valuing of rights explain and discuss the different types of debt finance distinguish between equity and debt finance distinguish between long- and medium-term sources of finance evaluate and advise on whether to use borrow-and-buy or lease financing explain, calculate and interpret the different types of gearing analyse and evaluate capital structure provide recommendations for achieving an optimal capital structure.

Introduction Every business requires finance or capital Two broad categories of capital/finance exist: Equity instruments Debt instruments The above instruments can also be divided into external and internal sources Debt finance is cheaper, but increases financial risk – known as gearing The combination of equity and debt finance in an entity is known as the capital structure

Different types of equity finance External sources of equity finance include: Ordinary shares Preference shares Internal sources of equity finance include: Reserves Retained earnings Revaluation shares Share premiums

Ordinary shares Ultimate owners of the entity Highest risk for providers of capital Return in form of capital growth and dividends Dividends are not tax-deductible Can be listed on a stock exchange Stock exchange can act as a: Primary market Helps entities raise capital Secondary market Matching investors that want to buy and sell shares

Ordinary shares Methods of listing on a stock exchange include: Offer for sale Existing shareholders sell shares to public at a fixed price Offer for subscription (IPO) Entity offers unissued shares to public Offer for sale by tender (auction) Shares are not issued at fixed price but auctioned Private placement Shares are offered to institutional clients Rights issue Entity offers its existing shareholders additional shares TERP

Preference shares Entitle shareholders to a fixed rate of dividend Carry part ownership in an entity Dividends are not tax-deductible Rank ahead of ordinary shares in the event of liquidation but behind debt finance Preference shares are a hybrid instrument

Preference shares Types of preference shares include: Convertible preference shares May convert into ordinary shares or other security Cumulative preference shares Cumulative – dividend accumulates when not paid Non-cumulative – does not accrue and dividend forfeited Participating preference shares Fixed dividend and shareholders share profits with ordinary shareholders Redeemable preference shares Preference shares that will be repaid Characteristics of debt instruments

Internal sources of equity finance Reserves Includes retained earnings, revaluation reserves and share premiums Accumulated profits entity has retained Important source of finance – generally cheapest source of finance Cash is available and no transaction costs Retained earnings are not a “free” source of finance – opportunity cost involved Amount of retained earnings depends on growth strategy and dividend policy

Different types of non-current debt finance Debt may be classified as: Fixed rate Variable (floating) rate Debt may also be classified as: Secured Unsecured Types of non-current debt include: Bonds and debentures Mortgage bonds Other non-current loans (such as term loans)

Debt versus equity Characteristic Ordinary shares (equity) Preference shares (hybrid) Debt Ranking in event of liquidation Last Second First Return provided Capital growth and dividend Dividend (possible additional profits) Interest Statement of comprehensive income and tax effect Appropriation of after-tax profits; not tax-deductible Interest expense- tax deductible Risk to entity Low risk Medium risk High risk Capital repayment No: some shares may be repurchased Depends on whether they are redeemable Yes: all debt will be repaid eventually Risk to investor Low risk, if secured Control effect May affect control unless use a rights issue Yes, if shares are cumulative and dividend in arrears No, unless convertible in the future

Medium-term finance Medium-term finance generally has a maturity of between one and five years. Sources of medium-term finance include: Term loans Finance leases Operating leases Sales and leasebacks Factoring Invoice discounting Venture capital and private equity Business angels

Medium-term finance The borrow and buy versus lease decision This is a financing decision that follows on from the investing decision An entity will only investigate whether to borrow and buy or lease if the investment decision is positive (i.e. positive NPV) Separate discounted cash flow calculations should be performed to identify the lowest cost option (buy or lease) The after-tax cost of debt is the most suitable discount rate to use for the financing decision

Gearing Gearing (or leverage) refers to the amount of debt included in an entity’s capital structure Gearing can be calculated in a number of ways Market values rather than book values should be used to calculate gearing (where possible)

Capital structure Combination of debt and equity included in the long-term finance of an entity Debt generally has a lower cost than equity If entity increases the amount of debt in capital structure, it lowers its WACC and generates a higher return for the shareholders Increasing return for the shareholders means additional financial risk As financial risk increases, shareholders require a higher rate of return

Optimal capital structure Optimal capital structure is the capital structure that results in the lowest possible WACC Results in highest share price In line with maximising wealth of the shareholder Two theories explain the effect of changes in capital structure on market value of entity: Modigliani and Miller’s theory of gearing Traditional theory of gearing

Modigliani and Miller’s theory of gearing Proposed that optimal capital structure does not exist Value of a company is determined by value of assets and not method in which entity is financed Based on assumptions: Individual investors borrow at same rate and terms as entity Taxation is ignored Transaction costs are ignored Financial distress costs are ignored

Modigliani and Miller’s theory of gearing Based on premise that a business’s WACC will not change irrespective of level of gearing As more debt is added to capital structure, financial risk increases As a result, ordinary shareholders require higher return for additional risk Benefit of cheaper debt will be offset by more expensive equity Optimal capital structure does not exist

Modigliani and Miller’s theory of gearing Limitations Individuals not generally able to borrow at same rate and same terms as entities Taxation cannot be ignored in the real world – dividends are subject to additional withholding taxes and capital gains Transaction costs are incurred in the real world High levels of gearing do carry dangers and costs of financial distress

Traditional theory of gearing As the gearing ratio increases, the WACC decreases Value of the entity increases Increasing risk associated with entity leads to higher required return by shareholders Cancels out the benefits of lower debt WACC starts to increase and the value of the entity starts to decrease

Traditional theory of gearing Assumptions: Profits will remain constant in perpetuity Taxation is ignored Risk will remain constant All profits are paid out as dividends Assumes WACC is lowest at level of gearing that represents lowest point of the WACC line (optimal capital structure OPS) WACC will decrease until a certain point and then start to increase as the rising cost of equity becomes significant

Traditional theory of gearing

Traditional theory of gearing Cost of equity (Ke) increases as level of gearing increases. Financial risk causes profits to become more volatile and shareholders will require higher returns Cost of debt (Kd) increases after certain level of gearing as interest cover reduces – few assets to offer security WACC falls initially as the level of debt increases and then increases as the cost of equity becomes more expensive The optimum level of gearing is where WACC is at a minimum (OCS) Capital structure that minimises WACC will also maximise the value of the entity

Conclusion The mix of debt and equity that an entity adopts is known as the capital structure. The capital structure is a very important component of an entity’s financing. An entity’s capital structure consists of various sources of finance. Equity and debt are the two main categories of finance available to entities to finance their operations. Equity sources of finance include external sources, such as ordinary shares and preference shares.

Conclusion (cont.) Equity sources of finance include internal sources, such as retained earning. Retained earnings are not a free source of finance. Rights issues occur when an entity wishes to raise additional ordinary share capital from existing shareholders. In a rights issue, existing shareholders are given the first right to purchase shares, usually at a discount to the current market price. Non-current debt finance includes bonds and debentures, mortgages and term loans.

Conclusion (cont.) There are various implications that an entity must consider when deciding between equity and debt sources of finance. These include the tax effect, risk and return effect and effect on control. Various types of medium-term sources of finance are available to businesses, including leasing, factoring and invoice discounting. Small entities may find it more difficult to raise finance than larger entities, therefore sources such as venture capital, private equity and ‘business angels’ may be appropriate.

Conclusion (cont.) Gearing (or leverage) refers to the amount of debt included in an entity’s capital structure. The optimal capital structure refers to the point at which an entity’s WACC is at its lower point so that returns for shareholders can be maximised.