2What is gearing Capital structure = equity + debt Gearing is a general term used to describe borrowing within an investment contextIt refers to the use of borrowed funds to earn a return greater than the interest paid on the debt
3Gearing measuresGearing is usually expressed as the ratio of debt to total assetsGearing ratio (debt ratio) = Debt / Total AssetsExample:Total assets – $100mDebts – $25mGearing ratio?Relatively low gearing ratios for LPTsING (Argosy) – 0.39, AMP (Precinct) – 0.29, KIPT – 0.37
4The effect of gearing on returns More debt means more fixed costsThus, in good years, there will be enough to pay off the fixed costs and leftovers for the shareholdersIn bad years, we might not make enough to pay debt service, and we could be in troubleEffectively, variation of income and ROE will increase with increasing debt
7The effect of gearing on investment risk The higher the ratio the more the business is exposed to interest rate fluctuations and to having to pay back interest and loans before being able to re-invest earningsIncreases the investment payback period
8Leverage exampleABC Corporation currently has no debt but is considering restructuring. In the restructure, it would borrow and buy back some shares. The company has 400,000 shares issued and the market value is $8 million. In the restructure, the company will issue $4 million of debt with 10% annual interest. The share market price remains at $20/share. The company has an annual NOI of $1,000,000. Examine the impact of the proposed restructure on the investment return (ROE and EPS) and risk (Payback period)
9Leverage example Current Proposed Assets $8,000,000 Debt $0 $4,000,000 CurrentProposedAssets$8,000,000Debt$0$4,000,000EquityDebt/Equity Ratio1Share Price$20Shares Outstanding400,000200,000Interest rate-10%
10Leverage example Current Capital Structure: No Debt Expected NOI ExpectedNOIInterestNet Income (distributable)ROEEPSProposed Capital Structure: Debt = $4 million
11Leverage example Current Capital Structure: No Debt Expected NOI ExpectedNOI$1,000,000InterestNet Income (distributable)ROE12.50%EPS$2.50Proposed Capital Structure: Debt = $4 million400,000$600,00015.00%$3.00
12Leverage example Variability in ROE Variability in EPS Current: ROE – 12.5%Proposed: ROE – 15%Variability in EPSCurrent: EPS – $2.50Proposed: EPS – $3.00The variability in both ROE and EPS increases when financial leverage is increased
13Leverage example Variability in payback period Current: 8 yearsProposed: yearsIt increases the payback period and therefore decreases the certainty of being able to recover the original investmentIf the building becomes untenanted for a period the investor has to find the cashflow necessary to service the debt from other sources and the investment will make loss sooner.
14The effect of taxesThe preceding analysis was under the idealization that there are no corporate taxes.Interest are a tax deductible expense and thus the firm can get a tax shieldThis is an added benefit of debt financingOn the negative side of debt financing is the absolute obligation to meet promises of debt service payments.Not meeting them could result in bankruptcy.
15Interest tax shield example Unlevered FirmLevered FirmNOI5000Interest500Taxable Income4500Taxes (28%)14001260Net Income(ATCF)36003240
16Interest tax shield example Annual interest tax shieldTax rate times interest paymentAnnual tax shield = $140PV of annual interest tax shieldDiscount rate = 10%, investment term = 10 yearsPV of annual $140 tax shield = $860.24The value of the firm increases by the PV of the interest tax shield
17Interest tax shieldFirms with accumulated losses will get little benefit from the interest tax shield, especially since their benefits will come later, after the losses carry forward and are finally offset by gains (loss of PV of tax benefits).Also, firms with other large tax shield forms, e.g., depreciation will benefit less from debt.
18The effect of gearing on risks If the level of debt increases, the riskiness of the firm increasesFinancial risk – ability to pay the interestDefault risk – ability to pay back the principalThis fact is largely neglected by equity holdersPayback period of the investment significantly increases
19Default on debt The risk that the firm cannot pay back the loans When a debtor defaults on payments, the lenders can take him to court and lay claim to assetsBankruptcy can result from default on debt obligations: it is a legal processA firm becomes bankrupt, in principle, when A <= L, so E <= 0, and transfer of control goes from owners to creditors
20Default risk measurement – Solvency ratio Measures the portfolio’s ability to meet long-term obligations= After tax cash flow / long term liabilitiesAcceptable solvency ratios will vary from industry to industry, but as a general rule of thumb, a solvency ratio of greater than 20% is considered financially healthy.The lower the solvency ratio, the greater the probability that the portfolio will default on its debt obligations.
21Bankruptcy Reasons for bankruptcy Business failure – business has terminated with a loss to creditorsTechnical insolvency – firm is unable to meet debt obligationsAccounting insolvency – book value of equity is negativeVoluntary bankruptcy – petition for bankruptcyCreditor bankruptcy – under the Insolvency Act creditors can file a creditor’s petition with the Insolvency and Trustee Service
24Bankruptcy Process Liquidation Reorganization Covered under the the Insolvency Act 2006Firm is terminated as a going concernTrustee takes over assets, sells them and distributes the proceedsReorganizationKeep firm as going concernInvolves issuing new securities to replace old securitiesDepends on whether the company is worth more dead or alive
25Liquidation processPetition filed voluntarily by company or involuntary petition by creditorsAdministrator is appointed to assume control of assets and oversee liquidationAfter liquidation and payment of administrative costs, proceeds are distributed to creditorsAny leftovers go to the owners
26Order of liquidation payments The Official Assignee’s costs of administering your bankruptcy estatePetitioning creditor’s costs and disbursementsAny GST and any wages you owe to employeesSecured creditorsUnsecured creditors
27Agreements to avoid bankruptcy Instead of letting things go too far once a default event has occurred, it is better for all parties to negotiate a way to avoid bankruptcy and liquidationDebt might be rescheduled, and the firm’s capital might be reorganized voluntarily with the help of creditors and companyRemedies – extension, postponing payment, or recomposition, allowing for a reduced payment
28Avoid bankruptcy Get budgeting advice Sell assets Get refinancing adviceReach an agreement with your creditorsDeal with IRD firstCreate a Creditors’ PoolPay back your debts in instalments
29Minimizing gearing risks Don’t over-commit. Only borrow as much as you can comfortably afford to repay, remembering that there might be periods when your investments don’t generate income.Diversify your investments so that you aren’t relying on just one or two investments.Invest only in quality growth assets which have proven track records of reliable income streams and capital growth.Invest for the long term to give your investments sufficient time to generate enough capital growth.Fix your loan to protect your cash flow in case interest rates rise.
30Conclusions on capital structure Need to make calculations as we did, but should also recognize inputs are “guesstimates”As a result of imprecise numbers, capital structure decisions have a large judgmental contentWe end up with capital structures varying widely among firms, even similar ones in same industry