In the previous exercise, we looked at the cost of interest, but not at the underlying rationale for the achieved split between debt and equity. Now we will see how this split is determined, and what limits there are on long-term borrowing. In the following exercise we will look at individual debt facilities.
Save the model as WiMAX-DSL46
- Look at the Target Gearing input and note the default value of 0.5 (Data menu/Financial Data).
This single input defines the relative proportion of debt to equity raised to satisfy the net funding requirement for the business. Press <F1> to check the definition in the help system, and click through to the section Financial Model and Network Funding to understand the precise definitions of these terms.
Save and run the model
- Draw the graph Network Target and Actual Gearing (note that the y-values are expressed as a percentage by default).
- It may be helpful to limit the scale of the y-axis on the graph to [–2, 2] (right click on the axis and select Format Axis).
Why does the actual gearing deviate from 0.5 and fall in 2009?
- Change the Target Gearing input to 1.0 and re-run the model.
- Re-draw the first few graphs from the preceding Exercise 45: Interest, tax and dividends if they are not still on the screen.
How is the Peak Borrowing Requirement affected?
Why is the Share Capital still so much higher?
- Go back to the Editor and set Target Gearing = 2.0.
- You also need to set the next input Allow Negative Equity = Yes in order to avoid STEM reporting the Target Gearing as out of range when you next check or run the model.
- Run the model and look at the results.
- Change Target Gearing to 10.0 and re-run the model.
Now the Peak Borrowing Requirement is comparable to the Share Capital, but you will notice that the Equity result goes significantly negative!
- Change Target Gearing back to 1.0 and unset Allow Negative Equity back to No.
Allow Negative Equity = No constrains the Target Gearing to a value between 0.0 and 1.0, guaranteeing that the financial model will not borrow beyond its means (which is a legal constraint for many companies).
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Run the model again and draw a new graph combining the network results Equity and Long-Term Borrowing.
You will see that, once the business is profitable and starts generating equity, the outstanding borrowing is paid back almost as quickly as equity is generated. Is this realistic?
Things that you should have seen and understood
Gearing, debt, equity
Target Gearing, Actual Gearing, Allow Negative Equity