Limited company (plc) A plc will normally be financed by two types of long-term capital Equity capital Debt capital

Equity capital Equity capital consists of two elements Shares Reserves

Ordinary shares par (nominal) value market value cannot be repaid except in special circumstances can be sold reward is dividend and/or capital growth limited liability

Reserves There are two types of reserves revenue reserves capital reserves

Revenues reserves retained profits realised reserves which are distributable

Capital reserves share premium capital redemption reserve revaluation reserve unrealised reserves which are not distributable

Debt capital May consist of any of the following: Preference shares Loan stock/debentures Convertible loan stock

Preference shares fixed rate of dividend par (nominal) value market value may be redeemable may be cumulative

Loan stock/debentures fixed rate of interest par (nominal) value market value usually repayable

Convertible loan stock fixed rate of interest par (nominal) value market value convertible into ordinary shares at a pre-determined rate

Debt or Equity ? A plc B plc Ordinary shares 750,000 500,000 Retained profits 250,000 Shareholders' equity 1,000,000 12% Loan stock Capital employed

Debt or Equity ? A plc B plc Trading profit 30,000 Interest payable Profit before tax - Income tax @ 35% 10,500 Profit after tax 19,500 Earnings per share 2.6p

Debt or Equity ? The shareholders of A plc are "better off" than those in B plc since, at the above level of profit there is nothing available for the shareholders of B plc, whereas the shareholders of A plc have earnings of 19,500, 2.6p per share. This can either be paid as a dividend to the shareholders or retained as a basis for future growth. The market price of the shares in A plc is likely to be greater than that of the shares of B plc.

Debt or Equity ? A plc B plc Trading profit 140,000 Interest payable 30,000 Profit before tax 110,000 Income tax @ 35% 49,000 38,500 Profit after tax 91,000 71,500 Earnings per share 12.13p 14.3p

Debt or Equity ? At the above level of profits the shareholders of B plc are "better off" than those in A plc since, although there is less total profit available for the shareholders of B plc, the amount available per share is greater, i.e. there is a smaller number of shares amongst which to share the profits. The market price of the shares in B plc is likely to be greater than that of the shares of A plc.

Debt or Equity ? A plc B plc Trading profit 100,000 130,000 Interest payable 30,000 Profit before tax Income tax @ 35% 35,000 Profit after tax 65,000 Earnings per share 8.7p 13.0p

Debt or Equity ? In order for both companies to have the same profit after tax B plc has to earn 30,000 more than A plc in trading profits, but B plc's EPS is significantly higher than that of A plc.

Debt or Equity ? A plc B plc Trading profit 90,000 Interest payable 30,000 Profit before tax 60,000 Income tax @ 35% 31,500 21,000 Profit after tax 58,500 39,000 Earnings per share 7.8p

Debt or Equity ? In order for EPS to be the same for each company trading profit needs to be 90,000.

Debt or Equity ? The above diagram shows that at profit levels up to 90,000 A plc returns a higher EPS, whereas at levels above 90,000 B plc shows the higher EPS. At these levels the shareholders of B plc receive the benefit of “leverage“, i.e. borrowing at fixed rates of interest. As long as the firm earns (before tax) a return on borrowed funds of 12% or more the shareholders will benefit. Normally returns are measured after tax and since interest on borrowing is a deductible charge in arriving at the taxable profit the net interest rate is in fact 7.8%, i.e. 12% less 35% tax saving, equivalent to the "break-even" EPS.

Debt or Equity ? The following table illustrates a constant level of profit with differing levels of leverage (gearing), ranging from 0% through to 67% As leverage increases, EPS increases The way in which EPS increases and profit falls with increases in leverage is illustrated in the graphs.

Debt or Equity ? Trading profit 100,000 Interest payable 12,000 24,000 12,000 24,000 36,000 48,000 60,000 Profit before tax 88,000 76,000 64,000 52,000 40,000 Taxation 35,000 30,800 26,600 22,400 18,200 14,000 Profit after tax 65,000 57,200 49,400 41,600 33,800 26,000 EPS 8.67p 8.80p 8.98p 9.24p 9.66p 10.40p Shares 750,000 650,000 550,000 450,000 350,000 250,000 Loan 200,000 300,000 400,000 500,000 Leverage 13% 27% 40% 53% 67%

Debt or Equity ? It would seem logical for a company to increase its gearing indefinitely on the basis of the above analysis. However, the factor which has been ignored is that the degree of risk increases as gearing increases. The profit margin of safety reduces as gearing increases since a greater proportion of profits are required to meet fixed interest charges. This means that, in reality, shareholders will not be content with the level of EPS. As risk increases their required return will increase accordingly, which means they will look for an increase in profits. If profits remain constant as gearing increases, the share price is likely to fall.

The cost of capital A firm is unable to "gear up" too much due to the increased risk factor. The degree of risk will increase as gearing increases Equity investors will require a higher rate of return to compensate for this increase in risk. This rate of return is known as the "equity cost of capital"

The cost of capital Lenders will face increased risk as borrowing increases. After a certain level of borrowing has been reached the firm may no longer be able to pledge assets as security for borrowing. Later borrowing will carry a higher degree of risk than earlier borrowing. The rate of interest demanded by lenders will increase. This rate of interest is known as the "debt cost of capital".

The cost of capital The "weighted average cost of capital" is derived from the two costs of capital. It is in the best interests of the firm to aim to minimise the weighted average cost of capital.

Proportion of Equity Proportion of Debt Cost of Equity Cost of Debt Example Proportion of Equity Proportion of Debt Cost of Equity Cost of Debt Weighted average cost 100% 0% 10% 3% 80% 20% 8% 7% 60% 40% 3.25% 5.5% 9% 6.5% 7.5% 15% 12.5% 13% 90% 25% 18% 18.7% The data in the above table can be seen in the following graph

The cost of capital The above table illustrates the way in which both equity investors and lenders might assess the potential financial risk of a firm as the level of borrowing increases. At low levels of borrowing, up to say 40% the equity investors may view the risk level as decreasing, since the firm is taking advantage of low cost debt to boost earnings. However, as the commitment to make interest payments from profits increases so the amount of risk perceived by the equity investors will increase. This may occur at any level of borrowing. The determinant factor will be the certainty of the firm's level of profitability. The more uncertain, the lower the proportion of debt which will be tolerated by the equity investors.