Question 8.3: Alpha plc and Gamma plc have both been recently created and ...
Alpha plc and Gamma plc have both been recently created and have identical operations.
The long-term capital structure of each business is as follows:
| Alpha plc | Gamma plc | |
| £m | £m | |
| £1 ordinary shares | 200 | 340 |
| 12% preference shares | 100 | 50 |
| 10% loan notes | \underline{100} | \underline{10} |
| \underline{400} | \underline{400} |
Although both businesses have the same total long-term capital, we can see that the level of financial gearing differs significantly between the two businesses.
A widely used measure of gearing, which we came across in Chapter 3, is as follows:
Financial gearing ratio=\frac{Loan capital + Preference shares (if any)}{Total long-term capital} \times 100\%
For Alpha plc and Gamma plc, the ratios are 50 per cent ((200/400) × 100%) and 15 per cent ((60/400) × 100%), respectively. These ratios indicate that Alpha has a high level of financial gearing, that is, a high proportion of fixed-return capital (loan capital plus preference shares) in relation to its total long term capital, and Gamma has a relatively low level of financial gearing.
To consider the effect of financial gearing on the returns to ordinary shareholders, let us assume that, in Year 1, the businesses generated identical PBITs of £80 million.
The earnings per share (EPS) for the ordinary share investors of each business for Year 1 can be calculated as follows:
| Alpha plc | Gamma plc | |
| £m | £m | |
| PBIT | 80.0 | 80.0 |
| Loan interest | \underline{(10.0)} | \underline{(1.0)} |
| Profit before taxation | 70.0 | 79.0 |
| Tax (say, 30%) | \underline{( 21.0)} | \underline{( 23.7 )} |
| Profit for the year | 49.0 | 55.3 |
| Preference dividend paid | \underline{( 12.0)} | \underline{( 6.0 )} |
| Profit available to ordinary shareholders | \underline{37.0} | \underline{49.3} |
The EPS for ordinary share investors of Alpha plc is 18.5p (that is, £37m/200m) and for Gamma plc it is 14.5p (that is, £49.3m/340m).