6 - Capital Structure Flashcards
Traditional view (M&M)
- optimal gearing level found through trial and error
- at low levels, increase in gearing causes WACC to fall
- and higher levels it causes WACC to rise
Modigliani & Miller’s without Tax theory
WACC is unaffected by gearing changes
Assumptions:
- shares bought and sold without dealing costs
- capital markets are efficient
- interest rates are the same for borrowing and lending
- no bankruptcy costs
- no taxation
Modigliani & Miller’s with tax theory
Increased gearing causes WACC to fall as a result of the tax relief gained on the interest
Assumptions
- no bankruptcy risk
- no tax exhaustion
- agency costs
Equity beta
Asset beta x [1 + D(1-T)/E]
4 step approach to calculating risk-adjusted WACC
1) Degear the equity beta of company B (using B’s debt:equity ratio)
2) Regear this asset beta for company A (using A’s D:E ratio)
3) Use this equity beta in the CAPM formula to find Ke for company A
4) Calculate Kd and then WACC for A
Adjusted Present Value (APV)
To be used when a new project significantly changes the gearing level
1) Discount the project using Ke rather than WACC
2) Discount tax shield on new debt finance (less issue costs) at the pre-tax cost of debt
Contents of a business plan
- Executive summary
- History/background
- Mission statement/objectives
- Products
- Markets
- Operations
- Financial information
- Summary action plan
Interest cover ratio
EBIT / Interest expense
Lower the ratio, the more burdened by debt a company is
Coverage ratio below 1.5 calls into question the company’s ability to meet interest expenses
Financial gearing
Debt / Equity
Or
D/D+E
Dividend cover ratio
PAT / Dividend paid
Dividend pay-out ratio
Annual dividend per share / EPS
Or
Dividends / PAT
Earnings Per Share
PAT / Weighted average # shares
