Measuring Gearing :

Gearing is two types.

 Financial Gearing:
The use of debt finance to increase the return on equity by
deploying BORROWED FUNDS in such a way that the RETURN
generated is GREATER than the COST OF THE DEBT.
 Operational Gearing :
Relationship of the FIXED COST to the TOTAL COST of an
operating unit.

Advantage of using debt as a source of finance and the impact

of gearing on the cost of the capital of a firm :Benefits of debt
for tax purposes as being deductible in arriving the entity's
taxable profits. (Tax shields)

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 Measuring Gearing :

 High gearing Debt is HIGH in proportion to the equity.

 Low gearing Debt is LOW in proportion to the equity.

 Disadvantage of using DEBT as a source of finance and the

impact of gearing on the cost of the capital of a firm :
-Increasing the debt will cause additional interest payable and it
reduces earning available for shareholders.
-Increase financial risk of investors; consequently increase the
cost of the capital.
-The level of an entity‘s gearing can affect both EPS & dividend
policy decisions.

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 Measuring Gearing :

 Capital Gearing :
This concerned with , THE LEVEL OF DEBT in co's capital
structure and DIFFERENT GROUPS OF CAPITAL.

-Equity (E) :
This is the portion of the company that's financed by the ordinary
shareholders.

-Prior Charge Capital (PCC)

This serviced prior to the equity capital receiving any return.
This represented by "Preference share capital + Long-term
liabilities“

Capital Gearing Ratio = PCCX 100%

E+PCC
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 Measuring Gearing :
 Capital Gearing ratio can be calculated in both Book
values and market values ;
-When Equity is valued using BOOK values, Must include any
reserves + retained profits that are attributable to the
ordinary shareholders.
Book value of Equity =Ordinary share capital + Reserves
-When Equity is valued using MARKET values, Must exclude
reserves as they are already incorporated into the market
price of the share.
Market value of Equity = number of shares X share price

MV of the share ( eg ; Ve+Vp+Vd)

High gearing exists when a company has a large proportion of PCC in relation
to E.
Low gearing exists when a company has a small proportion of PCC in relation
to E.

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Measuring Gearing :
 Factors which affecting the (increase of ) capital gearing :
-Types of industry within which the co. operates.
-The cost of funds in the market.
-The availability of investment opportunities
-Company's "tax shield " benefits

 Interest Cover :
A measure of safety whereby higher the rate the greater the
protection for shareholders and lenders.
This is link with GEARING with PROFITABILITY .

Interest Cover = Operating Profit

Interest payable

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Measuring Gearing :
 Leverage :
-This considers the relationship between fixed and variable
chgs and their effect on profits.
-This can be calculated using TWO ratios.

(1) Operating Leverage = Contribution (sales - variable costs)

Operating Profit (profit b4 Int & tax)

This indicates how much fixed costs could increase without the
company making an operating loss.

(2) Financial Leverage = Operating Profit (Profit b4 int & tax)

Profit b4 tax

This indicates how much interest payments could increase without

the company making a pre-tax loss.
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 Cost of Capital :
 This is the discount rate (cut-off rate) which firm uses to
evaluate investments (viable from non-viable opportunities) of a
firm.

In other words this is the investors "Required Rate of Return"

(RRR)

Cost of Capital has three RISK elements:-

COC =Risk free rate+ Premium for Business risk +Premium for
Financial risk

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 Cost of Capital :

 Risk free Rate :-

This is the rate of return in risk free investments such as
treasury bills +bonds.

 Premium for business risk :-

This will be arising due to a type of business and the type of
industry in which the firms operates.
This depend on the type of project that company undertake.

 Premium for financial risk :-

This will be arising due to a level of borrowing in the company
(gearing)
If the gearing is high , premium for financial risk also will be
high.

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 Cost of Capital :

 Three types of Cost of Capital :-

-Cost of Equity
-Cost of Debt (Loan Stocks)
-Cost of Preference shares

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 Cost of Capital :
Cost of Equity :
 Equity may raise "externally" through a "share issue" OR
"internally" through "retained profits".

 Models of calculating the cost of Equity (Ke) :

 Dividend Valuation Model :
-This indicates the market price (Present Value) of a share is related
to the future dividend income from that share.

-This modules assumes a constant rate of dividends to perpetuity

and ignores taxation.
Ke = d
Po
Ke = cost of equity
d=annual dividend (dividend just paid )
Po=market value of equity (ex-dividend)

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 Cost of Capital :
If Po is stated as "cum-div" OR "dividend proposed to be paid" then
it should reduce from market value of ex-dividend.
Ke = d
Po -d

 Dividend Growth Model :

-This indicates the dividend increase by a constant annual
growth rate ,(g).

Ke = do(1+g) +g
Po
Ke - Cost of equity
do - Current dividend
Po - Market value of equity (ex-dividend)
g -expected annual growth rate in dividends

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 Cost of Capital :
 If the dividend expected to be declined , then the formula will be,

Ke =do(1-g) -g
Po

 If, market value of equity (ex-dividend) -Po needs to find , then

formula will be .
Po = do(1-g)
(Ke-g)

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 Cost of Capital :
 Find the growth rate 'g' ( in Dividends)-
Two methods are used
(1) Extrapolating Historical Growth Rate :
Need to extrapolate growth from historical data assuming the
historical avg.annual growth rate will continue in perpetuity.
(using compound interest formula can find "g" )
S =X(1+g)n

(2) Gorden's Growth Model (GGM)

As per GGM future dividend growth will be determining two
factors:-
-The rate of re-investment by the company
-The return generated by the investments

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 Cost of Capital :
g =bR
Where, b = Proportion of earnings retained each year
b = Earnings – Dividend
Earnings
Where, R = Average rate of return on investment
R= Earnings  
Book value of capital employed

 Following assumptions needs to be applied when using GGM

1. The company must be all equity financed;
2. Retained profits are the only source of additional investment;
3. A constant proportion of each year's earnings is retained for re-
investment;
4. Projects financed from retained earnings earn a constant rate of
return.

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 Cost of Capital :
 Capital asset pricing model (CAPM)

Risk here is the risk that actual returns (dividends) will not be
the same as expected returns.

Ke = Rf + B[Rm - Rf ]

Ke - Cost of equity
Rf - Risk -free rata of return
Rm -Expected return from the market portfolio
B - equity beta

© 2005 Prentice Hall Inc. All rights reserved. 5–15

 Cost of Capital :
 Limitations of using dividend valuation models when finding the
cost of equity.

 The method could be used only if company pays dividend (as

certain co's don't pay dividend)
 Determining the growth rate sometime will be difficult.
 These models ignores "issuing cost " (ordinary shares/right
issues) In investment appraisal these issuing cost have to be
considered.

 Two methods are available to incorporate issuing cost :-

 Ke = do
Po – X
Where x - Issuing cost
 An alternative method would be to deduct issue cost as a Yo
cash outflow for the project(s).

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 Cost of Capital :
Cost of Debt (Loan Stocks) :
 Any fixed interest debt (bonds, debentures) when issue will
carry a coupon rate (the rate of interest payable on the face OR
nominal value of the debt.)
 After issue of the debt it's market value will depend on the
-Relationship of the coupon rate to the rate of required by
investors at any particular time.

Cost of Irredeemable Debt :

This is the debt which is after tax cost.(net)
Kd net = I (1-t)
Po
Kd net - Cost of debt (after tax)
I - annual interest
t - rate of Corp.tax (assumed immediately recoverable)
Po - Market value of debt (ex-interest)

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 Cost of Capital :
If there is a "cumulative interest market price (CUM-Int)" then interest
% should deduct from Po.

Kd net = I (1-t)
Po-I

Cost of Redeemable Debt :

This is calculated using IRR approach.
This is basically the cash flows associated with the debt from
today's market value through to the redemption value (Red) are
discounted on a trial and error basis to find the internal rate of
Return ( IRR)

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 Cost of Capital :
Cost of Convertible Debt :
These are loan stocks which will carry an option ,permitting to
which convert into different types of capital (generally into ordinary
shares) at a given future time and at a given ,pre-determined rate.

Pn =Po x (1+g ) n

Where,Pn - Cost of convertible debt

Eg: Dividend growth of 9.2 % pe annum and Po of 250p then in 4

years time , what's the convertible value ?

P4 = 250 x (1.092)4 ----------> 355 p

© 2005 Prentice Hall Inc. All rights reserved. 5–19

 Cost of Capital :
Cost of Preference shares :
The cost of preference share is related to the amount of dividend
payable on the Preference share.

K pref = dPo
Where ,K pref - cost of preference shares
d - annual dividend
Po - current ex-div market price

Eg :Assuming a dividend of 7p per L 1 preference share and a market

value of 60p(ex-div) , calculate the cost of the preference share.

7= 11.7 %
60

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 Weighted Average Cost of Capital ( WACC) :
 When a potential investment project is identified, the project
is assumed to be finance from the "pool of funds."(Pool of funds
firm uses to finance long term operations/projects)

 Pool of funds is a mix of Equity (ord,shares+Reserves),Debt

(Loan stocks) and Preference shares .

 The pool of funds assumes to remain constant over time and

and applying the discount rate (Avg.cost of capital ) company
could appraise the project . (Why WACC is using because its
difficult to associatea particular project with a particular form of
finance.)
 The weightings could be Market values OR Book values.
However market values are more accurate measure of
company’s value as it reflect the current cost of acquiring the
capital. Where as Book values reflects the historic cost of
acquiring the capital.

© 2005 Prentice Hall Inc. All rights reserved. 5–21

 Weighted Average Cost of Capital ( WACC) :
WACC (Ko) = KeVe + KpVp + KdVd
Ve + Vp +Vd

Where,
Ve -market value of equity
Vp -market value of preference shares
Vd - market value of debt.

 Assumptions in use of WACC :

1. The capital structure is reasonably constant ( if this changes
weightings in the WACC will change).

2. The new investment does not carry a significant different risk

profile from existing entity. (meaning the new investment will
have a similar risk profile to existing investment.)

3. The new investment is marginal to the entity.

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 Marginal Cost of Capital ( MCC) :
 If a large project is under consideration , WACC may not be
ideal technique to use as cause it remain unchanged the firms
capital structure when there is a new project.

 Appropriate technique for investment appraisal is "Marginal

Cost of capital". This reflecting the changes in the TOTAL COST
OF CAPITAL STRUCTURE BEFORE AND AFTER
INTRODUCTION OF NEW CAPIATAL.

 Marginal cost = Total cost of - Total cost of

Cost of capital Existing capital New Capital

© 2005 Prentice Hall Inc. All rights reserved. 5–23

 The traditional Theory of Gearing :
This considers the effect that a change in gearing has on the WACC
and on the value of the company.
Assumptions :
 Earnings remain constant in perpetuity and all investors have
the same expectations about future earnings ;
 Taxation is ignored ;
 Risk remains constant , no matter how funds are invested ;
 All earnings are paid out of dividends ;

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 Risks and Rewards :
 The "risk" and "return" are positively co-related. High risk -High return ;
Low risk - Low return
 The measurement of "RETURN" related to any given time period. (actual
OR expected return)

Return (r) = [End value - starting value] +

any other income (e.g.: dividends) X 100%
Investment (starting value)

 The return can be either "actual return" OR "expected return“

 Actual return :
This is a "historic return“
Eg : A share was bought for L 10 one yer ago. The share is currently
trading at L 11 .During the past one year , dividends on the share was
paid L 0.5 .
The return would be ;r =(11-10) + 0.5 x 100%15% per annum10(capital
gain of 10% ; dividend yield of 5%)

© 2005 Prentice Hall Inc. All rights reserved. 5–25

 Risks and Rewards :
The "risk" and "return" are positively co-related.High risk -High return ; Low
risk - Low returnThe measurement of "RETURN" related to any given
time period. (actual OR expected return)Return (r) =[End value - starting
value] + any other income (eg:dividends)Investment (starting value)The
return can be either "actual return" OR "expected return"Actual return :
This is a "historic return"Eg : A share was bought for L 10 one yer ago.
The share is currently trading at L 11 .During the past one year ,
dividends on the share was paid L 0.5 . The return would be ;r =(11-10)
+ 0.5 x 100%15% per annum10(capital gain of 10% ; dividend yield of
5%)Expected return : This is a most "probable return"Eg : The current
value of a particular share is L 11 . Its likel a price of the share would
be,L 13 in one years time. A dividend of L 1 is expected. The return
would be ;r =(13-11) + 1.0 x 100%27.27 % per annum11(capital gain of
18% ; dividend yield of 9%)Quantifying an expected return fot the next
period is more difficult as both the dividend andthe shareprice at the
end of the period needs to be estimated.(Usually assumed, any share
will have a "range of possible returns " that are
distributedsymmetrically.)The risk of a share is usually expressed as a
measure of the dispersion of the possible returns.In otherwords, risk is
the "variation of returns", therefore , it has to be measured in terms of
"standard diviation"

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