6. Capital Structure Flashcards
What are the 3 elements of the matching principle of choosing finance?
- Duration
- Currency
- Pattern of cash flows
What are the 4 common upfront costs of debt and equity?
- Arrangement fees
- Underwriting fees
- Prospectus printing costs
- Advisers fees
What is cheaper to raise, debt or equity?
Debt
What is cheaper to raise, rights issues or public offerings?
Rights issues
What are 3 ongoing cost implications of debt and equity?
- Returns (dividends/interest)
- Tax (deductible or not)
- Cost of reporting required
What is thin capitalisation?
A company is said to be thinly capitalised when the level of its debt is much greater than its equity capital, i.e. its gearing, or leverage, is very high
What action do tax authorities take if they deem a company to be thinly capitalised?
Only interest on the part of a loan that an independent party would be prepared to lend would be considered tax deductible
What is the WACC formula?
Keg * (Ve / Ve+Vd) + Kd * (1 - t) * (Vd / Ve+Vd)
Where Kd is the pre tax cost of debt
What is the formula for cost of irredeemable debt?
Coupon% * (1-t) / Vd
Why should WACC be used to appraise a project even if financed by debt?
It ignores the impact that the project and the loan are having on other finance providers, and should be considered to be financed out of the overall pool of funds
What 4 conditions for WACC to be appropriate for appraising new projects?
- The new project has the same business risk as existing operations
- No change in long term capital structure
- The project is relatively small
- Not using project specific finance
What are the two risk changes that might change the WACC?
- Business risk (from sector operating in)
- Financial risk (due to gearing/capital structure)
What is financial risk?
The additional exposure to systematic risk (variability in PAT) due to financial gearing and associated interest payments - have to pay interest even if profits are low
What is βeg?
The exposure of a business to all systematic risk (both business and financial, from gearing)
Which is bigger, βeg or βeu?
βeg, as it is made up of both systematic business and financial risk
As exposure to systematic risk increases (β increases), what happens to the cost of equity for a business?
It increases
Why does the risk facing shareholders increase as the level of gearing increases?
Because the volatility of potential equity returns increases