FM - C11 - WACC & GEARING

11.2

Why does high gearing increase vulnerability during economic downturns?

• In economic downturns, revenues tend to decline, making it harder for a highly geared company to meet interest payments and debt obligations.

• The company may need to sell assets or cut costs, which can impair long-term competitiveness and increase the risk of financial distress.

What is financial gearing, and why does high gearing increase financial risk?

• Financial gearing refers to the extent to which a company’s capital structure is funded by debt relative to equity.

• High gearing increases financial risk because fixed interest payments must be made even when profits decline. This heightens the risk of financial distress and default if cash flows become insufficient.

How does high gearing affect earnings per share (EPS) and investor confidence?

• High debt levels increase the volatility of net profits and EPS.

• Small changes in operating profits have a larger impact on net profits after interest, leading to unpredictable EPS. This reduces investor confidence and may cause declines in the company’s stock price.

How does high financial gearing limit a company’s future financing options

• Lenders view highly geared companies as risky and may charge higher interest rates or restrict additional loans.

• The company may also face restrictive covenants limiting its ability to raise more debt or pay dividends, thereby reducing its financial flexibility.

What are agency costs, and how are they related to high gearing?

• Agency costs arise from conflicts between shareholders and lenders.

• Shareholders may pursue high-risk projects to maximize returns, while lenders prefer safer strategies to preserve capital. Lenders may impose restrictive covenants to limit these risks, adding operational constraints on the company.

How does high gearing impact a company’s debt capacity and future investments?

• A company with high debt levels may exhaust its debt capacity, meaning it cannot borrow further without increasing its risk profile.

• This restricts the company’s ability to invest in growth opportunities, which could hinder its long-term competitiveness.

Explain how high gearing increases financing costs.

• Lenders charge higher interest rates to compensate for the increased risk of lending to a highly geared company.

• High debt levels may also lead to credit rating downgrades, further raising borrowing costs and limiting access to capital markets.

What is tax exhaustion, and how does it affect the benefits of debt financing?

• Tax exhaustion occurs when a company’s taxable profits are too low to fully utilize the tax shield from debt interest deductions.

• At this point, additional debt provides no further tax benefits, reducing one of the primary incentives for debt financing.

What happens if a company breaches debt covenants due to high gearing?

• Breaching debt covenants can trigger penalties or early repayment demands from lenders.

• This may worsen the company’s financial position, forcing it to renegotiate terms, restrict operations, or even liquidate assets to meet obligations.

How does high gearing affect a company’s overall cost of capital?

• Initially, debt financing lowers the weighted average cost of capital (WACC) due to tax-deductible interest.

• However, excessive debt increases the company’s risk profile, resulting in higher interest rates and equity costs, ultimately raising WACC and limiting the ability to fund profitable projects.

What are business risk and financial risk? How do they differ?

• Business risk is the variability in operating earnings caused by factors inherent to the industry and economic conditions. It affects a company’s profits regardless of its capital structure.

• Financial risk arises from the use of fixed-interest debt in the capital structure, making net profits more volatile for shareholders. Even with stable operations, high interest obligations can reduce the amount available for dividends, increasing shareholders' risk.

How does financial gearing affect shareholder returns in unfavorable trading conditions?

• Gearing introduces fixed interest payments that must be paid regardless of profits.

• In poor trading conditions, a company with high gearing may struggle to meet these obligations, leaving little or no profits for shareholders.

• This makes the company more vulnerable, as seen with G Co, whose shareholder returns decrease by 62.5% when profits halve, compared to U Co, where returns drop only by 50%.

What impact does higher gearing have on a company’s weighted average cost of capital (WACC)?

• As gearing increases, shareholders demand a higher return to compensate for the increased financial risk, which pushes the cost of equity up.

• At the same time, debt financing is cheaper initially due to tax-deductible interest, which lowers WACC.

• The net effect on WACC depends on the balance between these opposing forces—increased equity costs and lower debt costs.

What are the two primary views on how gearing affects capital structure and WACC?

• Traditional View:

  • WACC decreases initially as more debt is introduced, but after a certain point, additional debt raises the cost of equity sharply, leading to higher WACC.

  • There is an optimal capital structure where WACC is minimized.

• Modigliani and Miller (M&M) Theory:

  • Without taxes, M&M argue that capital structure is irrelevant, and WACC remains constant.

  • With taxes, the theory suggests that more debt lowers WACC due to the tax shield, but excessive debt increases the risk of financial distress.

Explain with an example how operating profits affect returns for geared and ungeared companies.

• Consider U Co (ungeared) and G Co (geared). Both companies initially earn $2,000 in profits. If profits halve to $1,000:

  • U Co’s profit available to shareholders also halves from $1,600 to $800.

  • In G Co, profits after interest fall more sharply, reducing shareholder returns from $1,280 to $480, a 62.5% drop.

• The greater variability in G Co’s returns shows how gearing amplifies financial risk, adding to business risk.

Why do shareholders require higher returns as a company increases gearing?

• With more debt, the company must pay fixed interest even during downturns, raising the risk that dividends might not be paid.

• As a result, shareholders demand a higher return on equity to compensate for this additional risk.

• This increases the company’s cost of equity and can affect the WACC if not balanced properly.

How does the capital structure decision affect WACC?

• A company’s capital structure is the mix of debt and equity financing. If the structure changes (e.g., more debt or more equity), WACC will automatically adjust to reflect the new levels of risk.

• Key Point: If the gearing ratio remains unchanged, the WACC will stay constant. But if the company gears up or down, WACC changes due to the shifting balance of financial risk and tax benefits.

What is the financing decision, and why is it important?

• The financing decision determines the mix of debt and equity the company will use to finance its operations and growth.

• It affects the company’s capital structure, risk profile, and WACC. Proper balancing ensures the company can minimize costs while maintaining financial stability.

Why does high gearing increase vulnerability to poor trading conditions?

• High gearing means the company has fixed interest obligations that must be paid regardless of profits.

• During poor trading conditions, reduced profits make it harder to cover these fixed costs, increasing the risk of financial distress.

• This was evident in G Co’s case, where shareholder returns dropped by 62.5% compared to only 50% for U Co, indicating higher financial risk due to gearing.

How do tax benefits from debt impact the WACC?

• Debt provides a tax shield because interest payments are tax-deductible, which initially reduces WACC.

• However, excessive debt increases the company’s financial risk and the cost of equity, potentially raising WACC.

• The net effect depends on whether the tax savings from debt outweigh the increased financial risk.

What are the key risks and challenges associated with high financial gearing?

High financial gearing, or heavy reliance on debt financing over equity, can enhance returns when conditions are favorable, but it brings multiple risks that can jeopardize a company’s financial health:

1. Increased Bankruptcy Risk

   • Fixed Obligations: Interest and principal payments must be made even when revenues decline, leading to liquidity issues and potential default.

   • Bankruptcy: Failure to meet obligations may force the company to file for bankruptcy, leading to asset liquidation or reorganization.

2. Agency Costs & Restrictive Covenants

   • Agency Costs: Conflict between shareholders (seeking high returns) and lenders (focused on risk reduction).

   • Covenants: Restrictions on actions (e.g., dividend payments or new borrowing) limit management flexibility and response to opportunities.

3. Debt Capacity

   • Limited Borrowing Capacity: High gearing exhausts a company’s ability to borrow more, especially in emergencies.

   • Impact on Investments: Reduced access to capital may cause missed growth opportunities.

4. Increased Financing Costs

   • Higher Interest Rates: As debt levels rise, lenders demand higher interest rates.

   • Credit Downgrade: Increased debt may result in credit rating downgrades, raising borrowing costs and limiting market access.

   • Stricter Terms: Lenders may require additional security or impose tighter conditions.

5. Tax Exhaustion

   • Interest Tax Shield Limitation: When profits decline, the company may not generate enough taxable income to fully benefit from the tax shield of interest payments, reducing the benefit of additional debt.

6. Volatility in Earnings & EPS

   • Fixed Costs (like interest) magnify the impact of revenue fluctuations on net profit, causing volatile Earnings per Share (EPS) and potentially lowering stock prices.

7. Vulnerability During Downturns

   • Economic Slowdowns: Highly geared companies are more exposed to downturns, risking asset sales or cost-cutting to meet debt obligations.

8. Loss of Financial Flexibility

   • High debt reduces the company’s ability to raise funds quickly, and new financing becomes more expensive, limiting profitability.

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Conclusion: While debt financing can boost returns, excessive gearing makes a company vulnerable to financial distress, reduces flexibility, and increases financing costs. Companies must balance debt and equity to maintain stability and preserve long-term growth.