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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$s per share
Current ;
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:owever! as mentioned earlier! there would be no eect on shareholder wealth
[( + marks]
-ect o ri$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
6.6
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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