6. Capital Structure and Assessing financing options

Question 1

operating gearing

Answer 1

the extent to which a firm’s operating costs are fixed as opposed to variable. high gearing = high fixed costs

Question 2

what does modigliani and miller (M&M) theory demonstrate?

Answer 2

M&M showed that with no corporation tax, there is no advantage for firms to issue debt (gear up).

Question 3

what effect does corporation tax have on investors?

Answer 3

geared companies pay less tax which means they have more cash to pay out to investors and are worth more.

Question 4

APV

Answer 4

1. Calculate the base value of the project as if it were ungeared (NPV)
2. Add the PV of the tax shield (interest * CT Rate)
3. Less the costs of issuing the finance

Question 5

hard rationing

Answer 5

where the external capital market limits the supply of funds

Question 6

soft rationing

Answer 6

where internally the firm imposes its own constraint on the amount of funds raised. this investment limit may be used as a surrogate for other constraints e.g. insufficient managerial capacity to handle all positive NPV projects