13.1 Capital Structure - No Taxation

Question 1

What is capital structure

Answer 1

How a business finances its long-term capital, via debt and equity

Question 2

What is the opportunity cost of capital

Answer 2

• The rate of return required by the lenders
• Lenders are both the debt holders and shareholders

Question 3

What is financial gearing

Answer 3

• The existence of debt in the capital structure is known as financial gearing.
• The increase in riskiness in equity earnings brought about by the existence of debt in the capital structure is known as financial risk.
• In geared companies equity holders (s/h’s) are faced with both financial risk and business risk

Question 4

What is business risk

Answer 4

• When a company starts off it is financed by equity, also known as risky capital.
• All the earnings of the company are attributed to the shareholders.
• Operating earnings (EBIT) are not certain. Just how risky they are will depend on the sort of business the company operates – this is known as business risk.
• The level of business risk faced by all companies will vary

Question 5

What is financial risk

Answer 5

• With the introduction of debt there is a prior charge on earnings, Interest, which has to be paid regardless of the level of earnings.
• So EBIT – Interest = equity earnings (available to shareholders)
• This fixed absolute amount, Interest, aggravates the effects of fluctuations in the operating earnings and hence in the net earnings stream available to shareholders.

Question 6

What are the relative costs to debt to equity

Answer 6

• Cost of equity > Cost of debt
• Due to equity being riskier

Question 7

How can you use debt to generate returns

Answer 7

• If they borrow at 5% and get a return of 8%. 3% goes to the shareholders. They demand this return.
• If the amount of debt increases, equity returns increase
• But there is more risk as there is a larger pool pf debt so more chance the repayments might not be met so equity holders demand more returns
• This is financial risk

Question 8

What are the two main views in capital structure

Answer 8

• Traditionalist View
• Modigliani and Miller

Question 9

What is the traditionalist view of capital structure

Answer 9

• Argue that although debt interest has to be paid before equity holders get any return, with relatively low levels of debt there is perhaps little chance of the company not being able to make the interest payments.
• As the level of gearing increases over moderate debt ranges the average cost falls, for the debt capital has a lower cost than the equity capital.
• As more and more debt is introduced, the increase in the rate of return required by the equity holders begins to offset the ‘beneficial’ effect of the lower cost of debt, and the overall cost of capital levels out, and then after a certain point begins to rise.
• There is no supporting evidence for this but anecdote

Question 10

What is Modigliani and Miller’s View on capital structure (without taxes)

Answer 10

• MM argue that the overall cost of capital to a company is not affected by the company’s capital structure.
• The market value of an ungeared company is equal to the market value of a geared company. (Proposition I)
• MM underlying logic is that the value of a company is determined by the operating earnings which is generated by the company’s assets and by the riskiness of those earnings.
• Neither of these is affected by the capital structure.
• As soon as you introduce the cheaper debt the shareholders will demand a higher return
• Perfectly negative the benefit through arbitrage

Question 11

What is arbirage

Answer 11

• The purchase of currencies, securities, or commodities in one market for immediate resale in others in order to profit from unequal prices.
• Arbitrage is worthwhile when two identical assets are trading at different prices

Question 12

What is Modigliani and Miller’s Proposition 1

Answer 12

Ko = EBIT / (D + E)
* Ko=Overall Cost of Capital
* Assumes earnings are perpetuities and borrow costs are the same
* Needs to be market value and not book value of D + E
* Can rearrange to find company value or appropriate EBIT
* Companies in the same risk class
* Have the same Ko
Just the EBIT will act as a scale factor

Question 13

What is Modigliani and Miller’s Proposition 2

Answer 13

• The cost of equity increases proportionally with the gearing ratio.
• As s/h’s see the riskiness of their investment increase due to increase in debt they demand a higher return.
• The geared firm will pay a risk premium for the financial risk.
• The increase in Ke exactly offsets the cheaper debt.

Question 14

Does Modigliani and Miller’s hypothesis represent reality

Answer 14

• To answer this one needs to look at the assumptions underlying the theory
• A theory is as good as the realism of the assumptions upon which it is based.

Question 15

What are the assumptions of Modigliani and Miller

Answer 15

• Perfect capital markets, with all the implications.
• Homogenous expectations.
• Firms can be divided into risk classes.
• The return on debt is risk free, irrespective of the borrower, and there is one rate of interest for all.
• Expected cash flows are level perpetuities.

Question 16

Do Modigliani and Miller’s assumptions hold

Answer 16

• Clearly these assumptions are unrealistic. What matters is how unrealistic they are. Are they sufficiently realistic for the hypothesis to be a good explanation of reality.
  o Clearly markets are not perfect.
   Taxes are ignored
   Transaction costs: Critics suggest that the existence of transaction costs will hinder the arbitrage process.
• Probably most of the criticism is about debt.
  o Clearly the return on debt cannot be risk free over all levels of gearing.
  o Companies have limited liability.
   So if Mr D takes on financial risk by buying shares in a geared company, the maximum loss he can suffer, if the company goes bankrupt, is his investment. If he takes on financial risk by personal gearing, then if the company goes bankrupt, he loses his investment and he is still liable to repay the loan.
   This presents a difference between personal liability and corporate liability