Financial_Statement_Analysis (7)

PAT
ROE
140
7%
70
7%
Байду номын сангаас
280
14%
210
21%
70
3.5%
0
0%
Cost of finance
Cost of Equity – the return required by the
shareholders Cost of Debt – the return required by the debt providers net of corporate taxes Cost of finance for a company is usually calculated as a weighted average (weighted by market values) of the cost of equity and the cost of debt….. …..it is commonly referred to as the “WACC”
debt is not risk free) Agency costs Restrictive covenants Tax exhaustion
13
Gearing Ratio
Gearing ratio = Debt/Capital employed (%) Or Debt/Equity (%) How much debt?
15
Interest Cover
A measure of a company’s ability to meet its interest
payments = PBIT/interest payments (No. of times) Basic rule 2 = bad, 3 = minimum, 4+ = ok (the higher the better) “Debt service coverage ratio” is the same calculation but includes any repayment of principal due with the interest payments.
7
Modigliani and Miller – no tax
Based on the following assumptions A perfect capital market exists There are no transactions costs There is no tax Debt is risk free and freely available Shareholders are indifferent to personal and corporate
10
Financial Structure and Risk
Co A is financed entirely by equity of £2m and Co B is
financed by £1m equity and £1m debt at 10%
£’000s (A) PBIT Interest PBT Tax (30%) PAT 200 0 200 60 140 £’000s (B) 200 100 100 30 70 £’000s (A) 400 0 400 120 280 £’000s (B) 400 100 300 90 210 £’000s (A) 100 0 100 30 70 £’000s (B) 100 100 0 0 0
than the all equity company Companies should issue as much debt as possible!
12
Practical limitations on issuing debt
Bankruptcy costs (risk to debt providers may mean
100 +100 = 400 200
M & M – with corporate tax
When M&M introduced corporate tax into their model
they showed that the introduction of debt should reduce the WACC and increase the market value of the company
Co A is financed entirely by equity of £2m and Co B is
financed by £1m equity and £1m debt at 10%
£’000s (A) ROCE PBIT Interest PBT Tax (30%) 10% 200 0 200 60 £’000s (B) 10% 200 100 100 30 £’000s (A) 20% 400 0 400 120 £’000s (B) 20% 400 100 300 90 £’000s (A) 5% 100 0 100 30 £’000s (B) 5% 100 100 0 0
gearing
8
Financial Structure and Risk
Co A is financed entirely by equity of £2m and Co B is
financed by £1m equity and £1m debt at 10%
£’000s (A) PBIT Interest PBT(= PAT) Total paid to all finance providers 200 0 200 200 £’000s (B) 200 100 100 £’000s (A) 400 0 400 £’000s (B) 400 100 300 100 + 300 = 400 £’000s (A) 100 0 100 100 £’000s (B) 100 100 0 100
18
Next plc – Cash flow ratio
2014: 615/1858 = 33% 2013: 659/1608 = 41% 2012: 526/1632 = 32% 2011: 452/1560 = 29%
19
Predicting corporate failure
Lecture 5
1
Recap – lecture 4
Liquidity Working Capital Current Ratio Quick Ratio Inventory (Stock) Turnover Receivables (Debtors) time to pay Payables (Creditors) time to pay Working capital cycle Overtrading
17
Cash flow ratio
Will the company generate enough cash to meet its
debt obligations = Net annual cash inflow from operations/Total debts, where total debts = total liabilities (current and non current)
14
Next plc Gearing Ratio

2014 Debt/Equity = 801/286 = 280% 2014 Debt/ Capital Employed = 801/1087 = 74% 2013 Debt/Equity = 567/286 = 198% 2013 Debt/ Capital Employed = 567/853 = 66% 2012 292% / 75% 2011 203% / 67% The problem here is more to do with the use of book value of equity For Next the 2014 debt of £801m is only 8% of current market capitalisation(£9.84bn at 29 October 2014) However, it is not covered by book value of non current assets (£676m)
Total paid to all finance providers
140
100 + 70 = 280 170
100 + 210 70 = 310
100
M&M with tax
The total paid to providers will always be greater By the amount of tax saved (£1000000 x 10% X 30%) The geared company, therefore, must have more value
16
Next plc Interest cover
2014: 723.5/28.3 = 26 times 2013: 650.6/29.0 = 22 times 2012: 608.4/28.9 = 21 times 2011: 24 times Note – why less finance costs but more debt?
6
Traditional Theory
No mathematical models/equations At low levels of gearing the cheap debt will outweigh
the extra return required by the shareholders – the WACC will fall At higher levels of gearing the extra return required by the shareholders will out weigh the cheap debt – the WACC will rise There should be a minimum level for the WACC – an “ideal” level of gearing
2
Gearing
Also known as “leverage” The proportion of a company’s finance that comes
from external providers Seen as a key indicator of risk
3
Financial Structure and Risk
Can a single ratio (univariate approach) or a
combination of ratios (multivariate approach) be used to predict company failure Key ratios – liquidity or gearing? Or profitability?
5
Theories of Gearing
What happens to the WACC if we add debt to a
company? Debt will be cheaper than Equity – this will cause the WACC to fall More debt means that there will be more risk for the shareholders, so they will want a higher return – the cost of equity will rise – this will cause the WACC to rise But what will be the net effect?