This is easily remedied by expressing long-term liabilities as a fraction of all forms of long-term finance, thus setting the upper limit at per cent. A third problem is the treatment of provisions made out of previous years income. Technically, provisions represent expected future liabilities. Companies provide for contingencies, such as claims under product guarantees, as a matter of prudence. Provisions thus result from a charge against profits and result in lower stated equity.
However, some provisions turn out to be unduly pessimistic, and may be written back into profits, and hence equity, in later years. A good example is the provision made for deferred taxation. This is a highly prudent device to provide for possible tax liability if the firm were to sell its fixed assets. Provisions could thus be treated as either equity or debt according to the degree of certainty of the anticipated contingency. If the liability is highly certain, it is reasonable to treat it as debt, but if the provision is the result of ultra-prudence i.
Although, in reality, cash flow is the more important consideration, the ability of a company to meet its interest obligations is usually measured by the ratio of profit before tax and interest, to interest charges, known as interest cover, or times interest earned:. Strictly, the numerator should include any interest received and the denominator should become interest outgoings.
This adjustment is rarely made in practice; net interest charges are commonly used as the denominator. The inverse of interest cover is called income gearing, indicating the proportion of pre-tax earnings committed to prior interest charges. Arguably, cash flow-to-interest is a better guide to financial security, given that profits are expressed on the accruals basis, i. Hence, the formula below is sometimes used:.
A major reason for using debt is to enhance or gear up shareholder earnings. When a company is financially geared, variations in the level of earnings due to changes in trading conditions generate a more than proportional variations in earnings attributable to shareholders if the interest charges are fixed.
This effect is very similar to that exerted by operating gearing. Most businesses operate with a combination of variable and fixed factors of production, giving rise to variable and fixed costs respectively. The particular combination is largely dictated by the nature of the activity and the technology involved.
As sales rise above the break-even point, there will be a more than proportional upward effect on profits before interest and tax, and on shareholder earnings. Firms with high operating gearing, mainly capital-intensive ones, are especially prone to fluctuations in the business cycle.
In the downswing, as their sales volumes decrease, their earnings before interest and tax decline by a more than proportional amount; and conversely in the upswing.
Hence, such companies are regarded as relatively risky. If such companies borrow, they add a second tier of fixed charges in the form of interest payments, thus increasing overall risk, the higher the interest charges, the greater the risk of inability to pay. Consequently, the risk premium required by investors in such companies is relatively high.
It follows that companies that exhibit high operating gearing should use debt finance sparingly. A solution commonly adopted in practice is to specify a target capital structure. Here, the firm defines what it regards as the optimal long-term gearing ratio, and then attempts to adhere to this ratio in financing future operations.
If for example, the optimal ratio is deemed to involve 50 per cent debt and 50 percent equity i. For example, a 10 million project would be financed by 5 million debt and 5 million equity, via retained earnings or a rights issue.
The corollary is to use the WACC as the cut-off rate for new investment. The WACC is recommended because it is difficult to anticipate with any precision how shareholders are likely to react to a change in gearing. The somewhat pragmatic solution proposed assumes that the new project will have no appreciable impact on gearing: Additionally, we have discussed about the ownership of the firm with regards to the latter mentioned, i.
We have also identified that capital structure is divided between debt capital and equity. Following, we have also examined the issue of asymmetric information to a firms capital structure, i. Finally, practical methods by which management within firms may use to determine their optimal financial mix are critically analysed.
They are capital gearing, interest cover and income gearing, operating and financial gearing, and lastly, the target capital structure. It will be worthwhile to conclude that gearing can lower the overall or weighted average cost of capital that the company is required to achieve on its operations, and can raise the market value of the enterprise.
However, this benign effect can be relied upon only at relatively safe gearing levels. Companies can expect the market to react adversely to excessive gearing ratios. Strictly, the appropriate cut-off rate for new investment is the marginal cost of capital, but if no change in gearing is caused by the new activity, the WACC can be used. Also considerable care should always be given when prescribing the appropriate use of debt that will enhance shareholder wealth without ever threatening corporate collapse, a major trend with regards to the agency problem.
Many people argue that the beneficial impact of debt is largely an illusion. Clever financing cannot create wealth although it may enable exploitation of projects that would not otherwise have proceeded.
It may however, transfer wealth if some stakeholders are prepared, perhaps due to information asymmetry, to accept too low a return for the risks they incur, or if the government offers a tax subsidy on debt interest. The decision to borrow should not be over-influenced by tax considerations. There are other ways of obtaining tax subsidies, such as investing in fixed assets, which qualify for tax subsidies. A highly, geared company could find itself unable to exploit the other tax-breaks offered by governments when a favourable opportunity is uncovered.
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Corporate Finance Essay Introduction Most corporate financing decisions in practice reduce to a choice between debt and equity. Capital Gearing A widely-used measure of capital gearing is the ratio of all long-term liabilities LTL , i.
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