Financial Strategy

Wk 3

Paul Hammett
e-mail: paul.hammett@staffs.ac.uk

Financial Strategy Wk 3 - Paul Hammett 1

 Week 3 Learning Outcomes

 consider the capital structure of

companies and the concept of the
weighted cost of capital
 recognise the importance of gearing and
interest cover
 consider the taxation implications of
financial decisions

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 Key Differences
Ordinary Shareholders Debt Financiers
 own the company  have no formal

 have the rights of control

control, voting,  but have significant

receiving annual reports influence

 have no rights to  have right to receive

income or capital only interest and

residual after all repayment of capital
claimants have been
satisfied
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 The main methods of long-
term financing
 Equity – funds provided by owners, either by share
purchase or by re-investment of profits
 Preference shares – ‘hybrid’ finance
 Debt – borrowings from the banking system (non-
market debt), or from financial markets (traded
securities).
 Many varieties – secured/unsecured debt;

zero/deep discount bonds; convertibles; asset-

backed securities; Eurobonds,
 Sale-and-leaseback – sale of asset, but retaining right
to use it.
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Financial Strategy Wk 3 - Paul Hammett 5
 Types of firm
 Appropriate financing may depend on type of firm:
1. Proprietorial firms: relatively little potential for
growth; exist largely to provide employment for
founding families. Of little interest for outside
investors. Reluctant to release equity.
2. Entrepreneurial firms: high growth potential;
driven by businessmen pursuing wealth
opportunities. Often short of finance during fast
growth phases. Prepared to release equity.
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 General considerations
 Risk – How uncertain is the business environment?
What are the chances of inability to offer a return in a
bad year?
 Ownership – Are the owners ready to give up partial
control of the firm by issuing equity?
 Duration – Form of finance should match the
intended use e.g long-term finance for long-term
assets.
 Debt capacity – How easily can the firm meet
lenders’ requirements regarding security?

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 Overview of Capital
Structure & Gearing
It is important to:
 be able to differentiate between debt and

equity in the financial structure of a

company
 gain an appreciation of the various levels

of risk involved with gearing in different

economic circumstances
 be able to calculate gearing and interpret

the results
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 Why is Debt Usually
Cheaper than Equity ?
 pre-tax rate of interest paid invariably
lower than the return required by
shareholders because lenders have prior
claims on company’s assets
 debt interest can be charged against
profits for tax purposes
 the administrative and issuing costs are
normally lower
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 Measures of
Financial Gearing
 Capital Gearing: proportion of debt
capital in the company’s overall
capital structure.
 Income Gearing: the extent to
which the company’s income is pre-
empted by prior interest charges

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 Capital Gearing
 Debt finance is the borrowings of the
business (loans, leases, hire purchase)
 Total Equity (or shareholders funds) is
the share capital of the business plus
retained profits plus any other reserves
 Capital gearing is the ratio of debt
finance to total equity usually expressed
as a percentage
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 How is Capital Gearing
Calculated ?
Capital Gearing (1) = Long Term Borrowings x 100
Total Equity
Capital Gearing (2) = Long Term Borrowings x 100
Total Equity + Long Term Borrowings
Capital Gearing (3) = Net Debt x 100
Total Equity
Capital Gearing (4) = Long Term Borrowings x 100
Market Capitalisation
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 Levels of Capital Gearing
 a company with a high proportion of debt to
equity is said to be HIGHLY geared
 Using the first formula, a company with a low
proportion of debt to equity is said to be LOWLY
geared
 no hard and fast rules but, using the first
formula, generally accepted:
high geared = above 100% gearing
low geared = below 100% gearing
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 Capital Gearing Exercise
Company has:
 equity £100m, long term borrowings

£50m, short term borrowings £20m &

cash £10m
Calculate the following gearing ratios:
 long term borrowings to equity ratio

 net debt

 net debt to equity ratio

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 Gearing and its Implications
 Gearing is limited by lenders’ reluctance to lend
to a company without an adequate equity base
 as gearing increases, the volatility of returns on
equity also increases
 the traditional view is that there is an optimum
level of gearing which will minimise its
weighted cost of capital

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 No “One Size Fits All” in Capital Structure
Below see Long Term Debt as % of capital in
most admired international companies (2006)

Company LT Debt % Total Capital

General Electric 64.39
Toyota Motor 33.59
Procter & Gamble 36.38
FedEx 20.20
Johnson & Johnson 5.06
Microsoft 0.00
Dell 10.85
Berkshire Hathaway 11.95
Apple Computer 0.00
Wal-Mart Stores 35.58

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 Interest Cover Ratio

Number of Times Interest Covered

=
Profit before interest and tax
Interest Charges

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 Actual Net Debt/Equity &
Interest Cover Ratios 2015
Company Debt/Equity % Interest Cover
GlaxoSmithKline 339% 6.1
Marks & Spencer 57% 7.8
Next 175% 26.7
Shell 14% 13.9
Sainsburys 26% 5.3
Premier Foods 108% 0.4
Source: morningtar.co.uk (30 Sep 15))

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 Financial Gearing & Risk
Exercise (ignoring tax)
Alternative Capital Structures totalling £100 million Gearing *
1) £100 million equity 0%
2) £80 million equity + £20 million debt (@10% interest) 25%
3) £50 million equity + £50 million debt (@10% interest) 100%

* Gearing = debt / total equity (for this exercise)

Scenario A B C
Profit Before Interest £m 5 25 45

What are the % profits on equity under the different capital structures?

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 The Cost of Capital
- Three Elements

 Risk-free rate of return: return required

from a completely risk free investment e.g.
yield on government securities
 Business risk premium: increase in required
return due to uncertainty about future
 Financial risk premium: danger of high debt
levels, variability in equity earnings after
payment to debt capital holders
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 Capital structure of
businesses
 the capital structure question is concerned
with the factors that determine the optimum
balance (if any) of equity and debt used to
finance companies.
 it is one of the key areas in the economics of
corporate finance, since it has implications for
new security issues, the financing of takeover
and buyout activity, and also dividend policy,
since retained earnings - the profits retained
by a firm after payment of dividends - are a
major source of equity funding.

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 Capital Structure
– Key Points
 For companies using a mixture of debt and equity,
there may be an optimal capital structure at which
the weighted average cost of capital (WACC) is
minimised
 The WACC is found by weighting the cost of each
type of finance by its proportionate contribution to
overall financing, and may fall as gearing increases
 The increased risks imposed by gearing are likely to
cause lenders and shareholders eventually to
demand a higher rate of return, raising the WACC
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WACC – the calculations

The steps:
1. Calculate weights for

each source of capital

2. Estimate the cost of

each source
3. Multiply the weights

for each source of

capital by its cost
4. Sum the results

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Weighted Average Cost of
Capital
Example:
Company has capital structure of:
Equity £60m and Net Debt of £40m
If return required on equity is 20%
and the post tax interest payable on
debt is 10%, what is the weighted
cost of capital?
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 Answer

Weighted cost of capital =

((60 x 20%) + (40 x 10%)) / 100
=16.0%

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 Weighted Average Cost of
Capital
Exercise:
Company has capital structure of:
Equity £70m and Net Debt of £45m
If the return required on equity is
18% and the post tax interest
payable on debt is 8%, what is the
weighted average cost of capital?
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 Weighted Average Cost of
Capital
Example:
Company has capital structure of:
Equity £125m and Net Debt of £150m
If the return required on equity is
16% and the post tax interest payable
on debt is 7%, what is the weighted
average cost of capital?
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 Weighted Average Cost of
Capital
 the weighted cost of capital is perhaps the
single most important strategic variable,
providing the principal benchmark for both
investment appraisal and performance
measurement
 although WACC is a very valuable tool in
investment decision making, it is important
to realize that each project has its own
inherent WACC and not to fall into the trap
of using the same WACC for every project

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 What is the Optimum Capital
Structure
“Increasing borrowing will enhance the market
value of a company until the dangers override the
benefits of borrowing more cash. At that point - the
optimal capital structure - any further borrowing
will reduce a company’s market value. The problem
is to pinpoint where the optimal capital structure
lies but there is no definitive answer, it depends on
the financial manager making a professional
judgement”
Chin-Bun Tse (Financial Management Magazine March 2002)

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 Capital structure and WACC
By introducing debt into the capital structure
of a company:
Good Effect: debt is cheaper than equity and

would cause the WACC to fall

BUT
Bad Effect: the return required by equity

increases because of the financial risk and

would cause the WACC to rise
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 Taxation & Financial Decisions
Capital Allowances (rates for 2021/22)
Annual Investment Allowance: From January 2016, each

business has a maximum AIA of £200,000 per annum,

meaning that 100% tax relief is available on the first
£200,000 spent on qualifying expenditure (plant &
machinery).
Writing down allowances: generally 18% of the reducing

balance of the investment (depreciation not allowed in

determining taxable profits)

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 Taxation & Financial
Decisions continued
 selecting type of finance: interest paid on debt
capital is tax deductible whilst dividends to
shareholders cannot be used to reduce taxable
profits
 distribution of profit: companies pay corporation
tax on profits and from April 2016, for individual
taxpayers there is a new dividend nil rate band
of £5,000 pa, beyond which additional income
tax may be payable
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 Next Week
 sources of equity finance
 preference and ordinary shares

 rights, scrip and other methods of

equity funding
 the important role of

investment banks

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