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
Why is βeg > βeu?
The risk facing shareholders in a geared company > the risk facing shareholders in an ungeared company
What is larger, Keg or Keu?
Keg, as risk is higher
Which β is known as the ‘equity β’?
Geared β (βeg)
Which β is known as the ‘Asset β’?
Ungeared β (βeu)
What is the formula to ungear β (find βeu from βeg)?
βeg * (Ve/(Ve + Vd(1-t)) + βd * (Vd(1-t)/(Ve + Vd(1-t))
What is the formular to regear β (find βeg from βeu)?
βeu + (βeu - βd) * Vd(1-t) / Ve
Unless otherwise stated, what is the debt β assumed to be?
Zero
What does the CAPM give if the debt β is inserted?
The pre-tax cost of debt
If the debt β equals zero, what does the formula to ungear βeg become?
βeg * (Ve/(Ve + Vd(1-t))
If the debt β equals zero, what does the formula to regear βeu become?
βeu + βeu * Vd(1-t) / Ve
What are the 5 steps taken when looking to find a new project specific Keg and WACC, when investing in a different industrial sector?
- Take the βeg of a typical company in the sector
- Ungear the βeg for that company > βeu
- Regear using our own gearing values > βeg
- Use the CAPM to calculate a project specific Ke using the new βeg
- Use the CAPM generated Keg to find the WACC
What consequence of increasing the level of debt suggests that it is a good idea to use more debt?
Debt is cheaper than equity, and therefore the WACC reduces
What consequence of increasing the level of debt suggests that it is a bad idea to use more debt?
Shareholder’s financial risk increases, so Keg increases and so WACC increases
Why do we want to minimise the WACC?
Because the value of the company (the PV of future cash flows) is maximised with a lowest discount rate
What is the traditional theory of the relationship between gearing and WACC? (3 steps and conclusion)
- Adding debt initially reduces WACC (benefit of cheap debt)
- Cost of equity increases due to risk on returns and eventually outweighs the benefit of cheaper debt
- Eventually, at high gearing levels even the cost of debt increases as lenders are secured
THEREFORE THERE IS AN OPTIMUM WACC AT THE LOWEST POINT
What is Mogdigliani and Millier’s theory (no tax) of the relationship between gearing and WACC?
In the absence of tax, as the level of debt increases, the benefit of debt is exactly offset by increasing Keg so WACC remains constant - SO WACC IS NOT AFFECTED BY GEARING
What is Mogdigliani and Millier’s theory (with tax) of the relationship between gearing and WACC?
If you include the tax saving on debt, you should gear up as much as possible, as the tax saving on debt outweighs the higher Keg and so WACC falls
What are M&M’s 4 main assumptions?
- Debt is always risk free, so Kd remains at the risk free rate regardless of gearing
- Perfect capital markets
- Individuals and companies can borrow at the same rate
- Investors are indifferent between personal and corporate reporting
What is M&Ms formula to go from the ungeared Keu to geared Keg?
Keu = (Keu - Kd) * (Vd(1-t)/Ve)
What is M&Ms formula to go from ungeared Keu to WACC?
WACC = Keu (1 - (Vd*t)/(Ve + Vd))
Assuming dividend and interest payments are constant, what is the equation for the basic value of a company?
Annual Payments / WACC
What is the traditional theory of the impact of capital structure on company value?
Value increases to a maximum and then falls, as WACC goes to a minimum and then rises
What is Mogdigliani and Millier’s theory (no tax) of the impact of capital structure on company value?
No change, as WACC is unaffected by gearing
What is Mogdigliani and Millier’s theory (with tax) of the impact of capital structure on company value?
A geared company will have a lower WACC and hence a higher value, because it will pay less tax and so can pay out more to it’s investors
What is M&Ms formula to find the value of a geared company from the value of an identical equity financed company?
Vg = Vu + TB
Where TB is the value of the tax shield:
i x t / pre tax Kd, or MV of debt * tax rate
If a company is investing in a new project with a known NPV, what is M&Ms formula to find the value of a geared company from the value of an identical equity financed company?
Vg = Vu + Capital Invested + NPV of project + TB
