Page 21 - SCS May 2018 - Day 2 Suggested Solutions

SUGGESTED SOLUTIONS

The importance of this is that a lower cost of capital (WACC) means the company’s earnings will
be discounted by the market at a lower rate thus increasing the total market value of the
company. That increase will be reflected in a higher share price.

Despite theoretical arguments to the contrary, it is generally accepted that at low levels of debt
an increase in debt funding will reduce WACC but at high levels any further increase in debt
funding will increase WACC. There is no theoretical way to find the optimum level.

The gearing effect

The presence of debt finance “gears up” the effect of changes in earnings on the shareholders. A
given increase in company earnings will result in a bigger increase in equity earnings. Thus if
company earnings are increasing this is desirable, but the reverse is also true. If earnings fall a
high level of gearing will result in a larger fall in equity earnings which is of course
disadvantageous to the shareholders.

This effect can be seen by looking at our most recent results. In 2018 the return on total capital
employed (debt plus equity) rose from 11.95% in 2017 to 12.09%; an increase of just 0.14%
points. At the same time the return on the equity element of the funding rose from 17.54% in
2017 to 18.79%; an increase of 1.25% points.

(Tutorial note: These two results are not strictly comparable since ROCE is based on operating
profit and Return on Equity is based on profit after tax. Nonetheless it serves to illustrate the
point.)

The practicality

There are a number of practical considerations involved in the decision on the gearing level but
the main ones are the company’s “debt capacity” and the optimum level of gearing to minimise
the WACC, as discussed above.

The company’s debt capacity essentially means how much debt the market is prepared to give the
company. This will itself depend on a number of factors such as credit ratings, available security,
and interest cover, and will be determined by the debt investors. The optimum level of gearing is,
as stated above, a more complex thing to determine but a reasonable guide to the best level of
gearing is to look at what other companies in the same industry are doing.

Conclusion

Looking at our situation at the end of the financial year 2017 from the debt investor’s point of
view presents an interesting picture. The interest cover on the debt was approximately 5
compared to a generally accepted minimum of around 3 which suggests an acceptable level of
debt, but the available security in the form of tangible assets was very small. This may have led
our merchant bankers to think that we were approaching the limit of our debt capacity because of
the security situation.

Looking at a comparison to what other companies are doing, whilst the figures available are based
on book values which may be misleading, at the end of the financial year 2017 our level of gearing
was somewhat in excess of that of HomeVideo which could have been interpreted as indicating
that our gearing could be higher than the optimum level.

KAPLAN PUBLISHING 77