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2022 - BAG > 6) Capital Structure & Financing > Flashcards

6) Capital Structure & Financing Flashcards

1
Q

what are the two financing options?

A
  • debt
  • equity
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2
Q

what are the characteristics of debt?

A

cheaper but risker

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3
Q

what kind of risk does debt pose?

A

financial risk = risk of not having enough money to pay both capital repayments and interest

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4
Q

what is the difference between short-term and long-term debt?

A
  • s/t = riskier, must be paid faster
  • l/t = less risky, more time to plan
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5
Q

what is the difference between secured and unsecured debt?

A

secured is more risky as you are limited to what you can do with your assets

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6
Q

what are the characteristics of equity?

A

presents less risk as company can choose when to pay dividends

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7
Q

what is leverage?

A

using debt to increase returns (while simultaneously increasing risk)

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8
Q

what should not be used if earnings are volatile?

A

debt

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9
Q

what does the theory by Modigliani and Miller state?

A

that the capital structure of a firm is irrelevant to its value

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10
Q

what are the assumptions for the M&M theory?

A
  • individuals can borrow on same terms as the company
  • no taxes or transaction costs
  • no financial distress costs
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11
Q

the possibility of what threat is increased by higher debt?

A

costs of bankruptcy

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12
Q

what are some of the costs of bankruptcy?

A
  • higher interest rates
  • loss of investment opportunities
  • loss of focus on core business
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13
Q

what does trade-off theory state?

A

states that mgmt needs to consider the benefit of taking on more debt as it increases returns and decreases cost of capital, but only to a certain point, and we can start incurring costs of bankruptcy

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14
Q

how does debt decrease WACC?

A

using debt gives us tax benefits

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15
Q

what is pecking order theory?

A

the company will prefer to finance itself in the following order (cheapest first):
1) retained earnings
2) debt
3) convertible debt / pref shares
4) equity

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16
Q

why do companies keep low debt-equity levels?

A

to be able to quickly take advantage of inv opportunities without having to issue equity

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17
Q

what does the signaling effect do?

A

shows SH that their shares are overvalued and share price will drop

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18
Q

what will be signaled if the company buys back shares?

A

will signal to the market that shares are undervalued

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19
Q

what is the effect on the market of issuing equity?

A

signaling effects – can create share price volatility

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20
Q

what is the treasury function used for?

A

measures the money/financial risks of the business through managing day-to-day obligations and developing l/t strategy

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21
Q

what are the types of external risks?

A
  • currency risk
  • interest rate risk
  • market risk
  • inflation risk
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22
Q

what are the types of internal risks?

A
  • liquidity risk
  • credit risk
  • refinancing risk
  • regulatory/legal risk
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23
Q

how can we mitigate currency risk?

A

entering into forward contracts, options, swaps

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24
Q

how can we mitigate interest rate risk?

A

using a fixed/floating interest rate, swapping rates, matching interest income to expenses

25
Q

how can we mitigate market risk?

A

forwards, futures, swaps, options to manage input prices; hedging

26
Q

how can we mitigate inflation risk?

A

cost management, operating in other countries with lower inflation

27
Q

how can we mitigate liquidity risk?

A

holding sufficient cash reserves, monitoring CF budgets

28
Q

how can we mitigate credit risk?

A
  • controlling overdue accounts
  • credit evaluation / maintaining terms and limits
  • insurance
29
Q

how can we mitigate refinancing risk?

A
  • spread out loan maturities and interest rates
  • multiple sources
30
Q

how can we mitigate legal risk?

A
  • actively monitor compliance
  • have a good lawyer
31
Q

what impact can issuing equity have on existing SH?

A

can dilute their control and some existing SH may oppose this

32
Q

what control implications can debt have?

A

debt provider may impose restrictions on the company as a condition of the loan

33
Q

what restrictions can a loan covenant have?

A

restrictions on the:
- ability to pay dividends
- disposal of assets
- maintaining certain working capital ratios

34
Q

what happens in capital structure as per trade-off theory?

A

as leverage increases, so does cost of equity and cost of debt

35
Q

what do we want our debt-equity to look like?

A

they must not be equal

36
Q

what is degree of financial leverage formula?

A

EBIT / EBIT - interest

37
Q

what kind of risk does DOFL look at?

A

financial risk

38
Q

what does DOFL represent?

A

how changes in sales impact changes in profits as a result of capital structure

39
Q

what kind of risk does DOOL look at?

A

operational risk

40
Q

what is the cost of debt?

A

nominal interest rate (1 - t)

41
Q

what does DOOL represent?

A

how changes in sales impact changes in profits as a result of cost structure

42
Q

what is WACC?

A

the total cost of financing for a company

43
Q

how to calculate WACC?

A

(cost of E)(weighting) + (cost of D)(weighting)

44
Q

what do we use WACC for?

A
  • evaluating capital projects
  • valuation of companies
  • determining EVA
  • determining FV of assets
45
Q

what are the key principles for WACC?

A

we use:
1) marginal costs (costs of new financing)
2) discount rate AFTER tax
3) nominal rates

46
Q

what do we use for weightings?

A
  • target structure
  • MVs
  • book value
47
Q

how to calculate the cost of debt?

A

nominal int rate x (1 - tax rate)

48
Q

when do we remove tax from cost of debt?

A

only for interest-bearing loans, not pref shares (as they get no tax deductions)

49
Q

how to calculate the cost of non-redeemable pref shares?

A

dividend paid / share MV (1 - flotation costs)

50
Q

how to calculate the cost of equity through Div Yield and Growth?

A

[div next year / share market price (1 - flotation costs)] + growth rate

51
Q

how to calculate the cost of equity through CAPM?

A

risk free rate + B (market rate - risk free rate)

52
Q

where do we get risk free rate?

A

rate for government bonds (they are free of risk)

53
Q

what happens if B is negative?

A

company risk is lower than market risk

54
Q

what is market premium?

A

Rm - Rf

55
Q

which equity method is preferred?

A

use CAPM

56
Q

what do we do when risks of the company as a whole do not reflect the risk of individual divisions?

A

divisions should calculate their own cost of capital and base the investment decision for the division on that

57
Q

what other things do we consider for debt/equity?

A
  • lifecycle stage of the business
  • is there additional value an entity partner could bring
58
Q

what is operating leverage?

A

the effect of change in sales on operating income

59
Q

what is financial leverage?

A

using debt to increase return on equity

2022 - BAG (9 decks)

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