1. Limited company (plc)
A plc will normally be financed by two types of long-term capital
Equity capital
Debt capital

2. Equity capital
Equity capital consists of two elements
Shares
Reserves

3. Ordinary shares par (nominal) value market value
cannot be repaid except in special circumstances
can be sold
reward is dividend and/or capital growth
limited liability

4. Reserves There are two types of reserves revenue reserves
capital reserves

5. Revenues reserves retained profits realised reserves
which are distributable

6. Capital reserves share premium capital redemption reserve
revaluation reserve
unrealised reserves
which are not distributable

7. Debt capital May consist of any of the following: Preference shares
Loan stock/debentures
Convertible loan stock

8. Preference shares fixed rate of dividend par (nominal) value
market value
may be redeemable
may be cumulative

9. Loan stock/debentures
fixed rate of interest
par (nominal) value
market value
usually repayable

10. Convertible loan stock
fixed rate of interest
par (nominal) value
market value
convertible into ordinary shares at a pre-determined rate

11. Debt or Equity ? A plc B plc Ordinary shares 750,000 500,000
Retained profits
250,000
Shareholders' equity
1,000,000
12% Loan stock
Capital employed

12. Debt or Equity ? A plc B plc Trading profit 30,000 Interest payable
Profit before tax -
Income 35%
10,500
Profit after tax
19,500
Earnings per share
2.6p

13. Debt or Equity ?
The shareholders of A plc are "better off" than those in B plc since, at the above level of profit there is nothing available for the shareholders of B plc, whereas the shareholders of A plc have earnings of 19,500, 2.6p per share. This can either be paid as a dividend to the shareholders or retained as a basis for future growth. The market price of the shares in A plc is likely to be greater than that of the shares of B plc.

14. Debt or Equity ? A plc B plc Trading profit 140,000 Interest payable
30,000
Profit before tax
110,000
Income 35%
49,000
38,500
Profit after tax
91,000
71,500
Earnings per share
12.13p
14.3p

15. Debt or Equity ?
At the above level of profits the shareholders of B plc are "better off" than those in A plc since, although there is less total profit available for the shareholders of B plc, the amount available per share is greater, i.e. there is a smaller number of shares amongst which to share the profits. The market price of the shares in B plc is likely to be greater than that of the shares of A plc.

16. Debt or Equity ? A plc B plc Trading profit 100,000 130,000
Interest payable
30,000
Profit before tax
Income 35%
35,000
Profit after tax
65,000
Earnings per share
8.7p
13.0p

17. Debt or Equity ?
In order for both companies to have the same profit after tax B plc has to earn 30,000 more than A plc in trading profits,
but B plc's EPS is significantly higher than that of A plc.

18. Debt or Equity ? A plc B plc Trading profit 90,000 Interest payable
30,000
Profit before tax
60,000
Income 35%
31,500
21,000
Profit after tax
58,500
39,000
Earnings per share
7.8p

19. Debt or Equity ?
In order for EPS to be the same for each company trading profit needs to be 90,000.

21. Debt or Equity ?
The above diagram shows that at profit levels up to 90,000 A plc returns a higher EPS, whereas at levels above 90,000 B plc shows the higher EPS. At these levels the shareholders of B plc receive the benefit of “leverage“, i.e. borrowing at fixed rates of interest. As long as the firm earns (before tax) a return on borrowed funds of 12% or more the shareholders will benefit. Normally returns are measured after tax and since interest on borrowing is a deductible charge in arriving at the taxable profit the net interest rate is in fact 7.8%, i.e. 12% less 35% tax saving, equivalent to the "break-even" EPS.

22. Debt or Equity ?
The following table illustrates a constant level of profit with differing levels of leverage (gearing), ranging from 0% through to 67%
As leverage increases, EPS increases
The way in which EPS increases and profit falls with increases in leverage is illustrated in the graphs.

23. Debt or Equity ? Trading profit 100,000 Interest payable 12,000 24,000
12,000
24,000
36,000
48,000
60,000
Profit before tax
88,000
76,000
64,000
52,000
40,000
Taxation
35,000
30,800
26,600
22,400
18,200
14,000
Profit after tax
65,000
57,200
49,400
41,600
33,800
26,000
EPS
8.67p
8.80p
8.98p
9.24p
9.66p
10.40p
Shares
750,000
650,000
550,000
450,000
350,000
250,000
Loan
200,000
300,000
400,000
500,000
Leverage
13%
27%
40%
53%
67%

26. Debt or Equity ?
It would seem logical for a company to increase its gearing indefinitely on the basis of the above analysis. However, the factor which has been ignored is that the degree of risk increases as gearing increases. The profit margin of safety reduces as gearing increases since a greater proportion of profits are required to meet fixed interest charges. This means that, in reality, shareholders will not be content with the level of EPS. As risk increases their required return will increase accordingly, which means they will look for an increase in profits. If profits remain constant as gearing increases, the share price is likely to fall.

27. The cost of capital
A firm is unable to "gear up" too much due to the increased risk factor.
The degree of risk will increase as gearing increases
Equity investors will require a higher rate of return to compensate for this increase in risk.
This rate of return is known as the "equity cost of capital"

28. The cost of capital
Lenders will face increased risk as borrowing increases.
After a certain level of borrowing has been reached the firm may no longer be able to pledge assets as security for borrowing.
Later borrowing will carry a higher degree of risk than earlier borrowing.
The rate of interest demanded by lenders will increase.
This rate of interest is known as the "debt cost of capital".

29. The cost of capital
The "weighted average cost of capital" is derived from the two costs of capital.
It is in the best interests of the firm to aim to minimise the weighted average cost of capital.

30. Proportion of Equity Proportion of Debt Cost of Equity Cost of Debt
Example
Proportion of Equity
Proportion of Debt
Cost of Equity
Cost of Debt
Weighted average cost
100% 0%
10% 3%
80%
20% 8% 7%
60%
40%
3.25%
5.5% 9%
6.5%
7.5%
15%
12.5%
13%
90%
25%
18%
18.7%
The data in the above table can be seen in the following graph

32. The cost of capital
The above table illustrates the way in which both equity investors and lenders might assess the potential financial risk of a firm as the level of borrowing increases. At low levels of borrowing, up to say 40% the equity investors may view the risk level as decreasing, since the firm is taking advantage of low cost debt to boost earnings. However, as the commitment to make interest payments from profits increases so the amount of risk perceived by the equity investors will increase. This may occur at any level of borrowing. The determinant factor will be the certainty of the firm's level of profitability. The more uncertain, the lower the proportion of debt which will be tolerated by the equity investors.