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Chapter 14 Capital Structure and Financial Ratios

Answer 1

(a)

[6 7 marks]

Achievement o corporate o!"ectives

1. JJG Co has shareholder wealth maximisation as an objective. The wealth o

shareholdersis increased !# dividends received and capital $ainson shares owned.

Total shareholder return compares the sum of the dividend received and the capital gain

with the opening share price.

. The shareholders of JJG Co had a return o %&' in ())&! compared with a return

predicted b" the capital asset pricing model of 1#$. The lowest return shareholders

have received was (1' and the hi$hest return was &('. %n this basis! the

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shareholders of the compan" have experienced a si$niicant increase in wealth.

&. 't is de!ata!lewhether this has been as a result of the actions of the compan"! however.

Share prices ma# increase irrespective o the actions and decisions o mana$ers! or

even despite them. 'n fact! looing at the dividend per share histor" of the compan"!

there was one "ear (*) where dividends were constant! even though earnings per

share increased. 't is also diicult to know when wealth has !een ma*imised.

[( + marks]

#. Another o!"ectiveof the compan" was to achieve acontinuous increase in earnin$s

per share. +nal"sis shows that earnin$s per share increased ever# #ear! with an

average increase of 1#,-$. This o!"ective appears to have !een achieved.

[( + marks]

Comment on inancial perormance

. /eturn on capital emplo"ed (R,C-) has been $rowin$ towards the sector avera$e o

(%' on a #ear.!#.#ear !asisfrom $ in . This stead# $rowthin the primar"

accounting ratio can be contrasted with irregular growth in turnover! the reasons or

which are unknown.

*. Return on shareholders/ undshas been consistentl# hi$her than the avera$e or

the sector. This ma" be due more to the capital structureof JJG Co than to $ood

perormance b" the compan"! however! in the sense that shareholders0 funds are

smaller on a boo value basis than the longterm debt capital. 'n ever" previous "ear

but 2 the $earin$ o the compan# was hi$her than the sector avera$e.

[1 ( marks]

(b)

Calculation o theoretical e* ri$hts per share

Current share price 3 42,*# per share

Current number of shares 3 , million shares

5inance to be raised 3 41m

/ights issue price 3 46, per share7umber of shares issued 3 1m86, 3 million shares

Theoretical ex rights price per share 3 ((,m x 2,*#) 9 (m x 6,))86,m 3 42, per share

The share price would fall from 42,*# to 42, per share

:owever! there would be no eect on shareholder wealth

[( + marks]

-ect o ri$hts issue on earnin$s per share

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:owever! as mentioned earlier! there would be no eect on shareholder wealth

[( + marks]

-ect o ri$hts issue on the de!t0euit# ratio

Current debt8e>uit" ratio 3 1 x 8#6, 3 #$

/evised maret value of e>uit" 3 6,m x 2, 3 4*, million

/evised debt8e>uit" ratio 3 1 x 8*, 3 &$

The de!t0euit# ratio would all rom 4(' to +('! which is well !elow the sector

avera$evalue and would si$nal a reduction in inancial risk

[1 ( marks]

(c)

The current debt8e>uit" ratio of JJG Co is #$ (8#6,). +lthough this is less than the sector

average value of $! it is more useful from a financial ris perspective to loo at the extent

to which interest pa"ments are covered b" profits.

1. The interest on the !ond issue is 2136 million (2$ of 4m)! giving an interest

covera$e ratio o 631 times. 'f JJG Co has overdraft finance! the interest coverage ratio

will be lower than this! but there is insufficient information to determine if an overdraft

exists. The interest covera$e ratio is not onl# !elow the sector avera$e! it is also low

enou$h to !e a cause or concern. ?hile the ratio shows an upward trendover the

period under consideration! it still indicates that an issue o urther de!t would !e

unwise.

[1 ( marks]

. + placin$ or an# issue o new shares such as a rights issue or a public offer! would

decrease $earin$. 'f the expansion of business results in an increase in profit before

interest and tax! the interest coverage ratio will increase and financial ris will fall.5iven the current inancial position o 5 Co! a decrease in inancial risk is

certainl# preera!le to an increase.

&. + placin$ will dilute ownership and control ! providing the new e>uit" issue is taen

up b" new institutional shareholders! while ari$hts issue will not dilute ownership

and control! providin$ e*istin$ shareholders take up their ri$hts.

[( + marks]

#. + !ond issue does not have ownership and control implications! although

restrictive or ne$ative covenants in !ond issue documents can limit the actions o a

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compan#and its managers.

+ll three financing choices are longterm sources of finance and so are appropriate for a long

term investment such as the proposed expansion of existing business.

. -uit# issues such as a placing and a rights issue do not reuire securit#. 7o

information is provided on the noncurrent assets of JJG Co! but it is likel# that the

e*istin$ !ond issue is secured. 'f a new !ond issue was !ein$ considered! JJG Co

would need to consider whether it had suicient non.current assets to oer as

securit#! although it is liel" that new noncurrent assets would be bought as part of the

business expansion.

[( + marks]

ACCA arkin$ Scheme

Answer (

(a)

Calculation of weighted average cost of capital (?+CC)

@aret values@aret value of e>uit" 3 m x #. 3 4. million

@aret value of preference shares 3 .m x .6* 3 41.- million

@aret value of 1$ loan notes 3 m x (181) 3 4. million

Total maret value 3 .m 9 1.-m 9 .m 3 4-.* million [( marks]

Cost of e>uit" using dividend growth model 3 A(& x 1.#)8 #B 9 .# 3 1.2$ [( marks]

Cost of preference shares 3 1 x -8 6*. 3 11.21$ [1 mark]

+nnual aftertax interest pa"ment 3 1 x .6 3 46

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sing interpolation! aftertax cost of loan notes 3 9 A( x 6.-#)8(6.-# 9 .-*)B 3 *.&6$

[( marks]

?+CC 3 A(1.2 x .) 9 (11.21 x 1.-) 9 (*.&6 x .)B8 -.* 3 11.$ [( marks]

(b)

1. Droxfol Co has longterm finance provided b" ordinar" shares! preference shares and

loan notes. The rate o return reuired !# each source o inance depends on its risk

from an investor point of view! with euit#(ordinar" shares) being seen as the most

risk#and de!t(in this case loan notes) seen as the least risk#. 'gnoring taxation! the

weighted average cost of capital (8ACC) would therefore be e*pected to decrease as

euit# is replaced !# de!t! since de!t is cheaper than euit#! i.e. the cost of debt is

less than the cost of e>uit". [1 mark]

. :owever! inancial risk increases as euit# is replaced !# de!t and so the cost o

euit# will increase as a compan# $ears up ! osettin$ the eect o cheaper de!t. +t

low and moderate levels o $earin$! the !eore.ta* cost o de!t will !e constant! but

it will increase at hi$h levels o $earin$due to the possi!ilit# o !ankruptc#. +t high

levels of gearing! the cost o euit# will increase to relect !ankruptc# risk in

addition to financial ris.

&. 'n the traditional view o capital structure! ordinar# shareholders are relativel"

indierent to the addition o small amounts o de!tin terms of increasing financialris and so the 8ACC alls as a compan# $ears up.

#. +s $earin$ up continues! the cost o euit# increases to include a inancial risk

premiumand the 8ACC reaches a minimum value. Ee"ond this minimum point! the

?+CC increases due to the effect of increasing financial ris on the cost of e>uit" and!

at higher levels of gearing! due to the effect of increasing banruptc" ris on both the

cost of e>uit" and the cost of debt. ,n this traditional view! therefore! 9ro*ol Co can

$ear up usin$ de!t and reduce its 8ACC to a minimum ! at which point its market

value(the present value of future corporate cash flows) will be ma*imised.

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. 'n contrast to the traditional view! continuing to i$nore ta*ation !ut assumin$ a

perect capital market! iller and odi$liani demonstrated that the 8ACC

remained constant as a compan# $eared up! with the increase in the cost o euit#

due to inancial risk e*actl# !alancin$ the decrease in the 8ACC caused !# the

lower !eore.ta* cost o de!t. =ince in a preect capital market the possi!ilit# o

!ankruptc# risk does not arise! the 8ACC is constant at all $earin$ levels and the

market value o the compan# is also constant. @iller and @odigliani showed!

therefore! that the market value o a compan# depends on its !usiness risk alone !

and not on its inancial risk. %n this view! therefore! Droxfol Co cannot reduce its

?+CC to a minimum.

*. ?hen corporate ta* was admitted into the anal"sis of @iller and @odigliani! a

different picture emerged. The interest pa#ments on de!t reduced ta* lia!ilit#! which

meant that the 8ACC ell as $earin$ increased! due to the tax shield given to profits.

%n this view! 9ro*ol Co could reduce its 8ACC to a minimum !# takin$ on as

much de!t as possi!le.

[7 & marks]

6. :owever! a perect capital market is not availa!lein the real world and at hi$h levels

o $earin$ the ta* shield offered b" interest pa"ments is more than oset !# the

eects o !ankruptc# riskand other costs associated with the need to service large

amounts of debt. Droxfol Co should therefore be a!le to reduce its 8ACC !# $earin$

up! althou$h it ma# !e diicult to determine whether it has reached a capital

structure $ivin$ a minimum 8ACC.

[1 mark]

(c)(i)

'nterest coverage ratio

Current interest coverage ratio 3 6!8 3 1# times

'ncreased profit before interest and tax 3 6! x 1.1 3 46.2#m

'ncreased interest pa"ment 3 (1m x .-) 9 .m 3 41.#m'nterest coverage ratio after one "ear 3 6.2#8 1.# 3 .* times

The current interest covera$eof Droxfol Co is hi$her than the sector avera$eand can be

re$arded as uiet sae. 5ollowing the new loan note issue! however! interest covera$e is

less than hal o the sector avera$e! perhaps indicating that Droxfol Co ma" not ind it eas#

to meet its interest pa#ments.

[( + marks]

(c)(ii)

5inancial gearing

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This ratio is defined here as prior charge capital8e>uit" share capital on a boo value basis

Current financial gearing 3 1 x (! 9 !)8 (! 9 !) 3 6$

%rdinar" dividend after one "ear 3 .& x m x 1.# 3 41.2 million

Total preference dividend 3 ! x .- 3 4!

:ncome statement ater one #ear

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assets purchased. These are liel" to be lower in value than the new debt and so there

ma" be insufficient securit" for a new loan note issue.

&. Redemption or reinancin$ would also pose a pro!lem ! with Droxfol Co needin$ to

redeem or reinance 21) million o de!t ater !oth ei$ht #ears and ten #ears . Ten

"ears ma" therefore be too short a maturit" for the new debt issue.

#. +n euit# issue should !e consideredand compared to an issue of debt. This could be

in the form of a rights issue or an issue to new e>uit" investors.

[( + marks]

ACCA arkin$ Scheme

Answer +

(a)

Calculation of cost of debt

+ftertax interest pa"ment 3 - x .6 3 4*.& per bond [1 mark]

=ear Cash low 2 &' discount actor >? @2

'ssue price (1) 1. (1.)

1 F 1 +ftertax interest *.& *.61 #.6

1 /edemption 11 .#*& .-&(*.2)

=ear Cash low 2 6' discount actor >? @2

'ssue price (1) 1. (1.)

1 F 1 +ftertax interest *.& 6.&* #*.&6

1 /edemption 11 .2 *1.&2

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+ftertax cost of debt 3 $1.6$)*$2(*2.*6.6

6.6$* =

+

+ [+ marks]

(b)

GH Co does not currentl" have an" longterm debt and so the current weighted average cost

of capital (?+CC) is the same as the current cost of e>uit"! which is 1$. [1 mark]

Current maret capitalisation 3 1m x 4#,1 3 4#1 million

'f the compan" issues 4#m of bonds at par with an aftertax cost of debt of 6,1$! the ?+CC

will be A(#1m x 1) 9 (#m x 6,1)B8#m 3 11,*$ [( marks]

The effect of the bond issue is therefore to reduce the ?+CC from 1$ to 11,*$ per "ear.

[1 mark]

This calculation assumes that the current share price does not chan$e as a result o the

!ond issue. :n realit#! the share price mi$ht chan$e as a result o the chan$e in inancial

risk. This calculation also assumes that the overdrat is not relevant in calculatin$ the

8ACC! when in realit" the siIe of the overdraft might mae it a significant factor.

[1 mark]

-*aminer/s noteuit"

ratio on a maret value basis increases rom ero to ;3&'. 'f the overdrat is included!

there is no chan$e in $earin$! since the !ond issue replaces an eual amount o the

overdrat. Given the sector avera$e de!t0euit# o 1)'! there does not appear to !e an#

concernsabout gearing as a result of the bond issue.

[1 ( marks]

Securit#

't is ver" liel" that the !ond issue would need to !e secured against the tangible non

current assets of GH Co! especiall# in li$ht o the recent decline in proita!ilit#.

:owever! the!ond issue is or 24 million while the tan$i!le non.current assetsof GH

Co have a value o onl# 2+ million. 't is not known whether the intan$i!le non.current

assets can !e used as securit#! since their nature has not been disclosed.

[( + marks]

Advisa!ilit# o usin$ the !ond issue to reduce the overdrat

Considering the si$niicant decrease in the interest covera$e ratioas a result o the !ond

issue and the lack o tan$i!le non.current assets to oer as securit#! it appears that theproposed !ond issue cannot !e recommendedand would probabl" be unsuccessful. GH

Co should therefore consider alternative sources of finance in order to reduce the overdraft.

[1 ( marks]

Alternative sources o inance

Given the recent fall in profit before interest and tax from 4 million to 41 million! an"

potential investor would initiall" see reassurances that GH Co would continue to be a

viable business. The reason for the decline in profitabilit" needs to be determined and the

longerterm sustainabilit" of the compan" needs to be confirmed before further financing is

considered.

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1. 'f longerterm viabilit" is assured! the need for further finance could be reduced b"

taing measures to reduce costs and increase income! for example throu$h improved

workin$ capital mana$ement.

. 'f the compan" pa#s dividends! consideration could be given to reducin$ or passin$

the dividend in order to increase the low o retained earnin$sin the compan".

&. Given the pro!lems with interest covera$e and securit#! and the lack o availa!ilit#

o urther overdrat inance! euit# inance is the irst alternative choicethat could

be considered. ?hile no information has been provided on recent share price changes

or on the dividend polic" of GH Co! existing shareholders could be consulted about a

rights issue. sing a discount to the current maret price of $ gives a rights issue

price of 4&,2. + 1 for 2 rights issue at this price would raise 4#,1 million! increasing

the interest coverage ratio to (1m8,m) if the proceeds were used to reduce the

overdraft to 4#!.

#. 'f shares were oered to new shareholders! the dilution o e*istin$ ownership and

control would !e small! $iven that 24 million is onl# ;' o 24% million (#1 9 #).

7ew shareholders would be unliel" to invest! however! if no dividend were on offer.

. Sale and lease!ack would not raise suicient inance! given that tangible noncurrent

assets are onl" 4& million! but this avenue could be explored in conjunction with

another source of finance.

[4 % marks]

*. ,ther inance sourcesthat could be considered include converti!le !onds or !onds

with warrants attached. :mproved workin$ capital mana$ement could also

decrease the amount of finance re>uired.

[1 ( marks]

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ACCA arkin$ Scheme