6) Capital Structure & Financing

Question 1

what are the two financing options?

Answer 1

• debt
• equity

Question 2

what are the characteristics of debt?

Answer 2

cheaper but risker

Question 3

what kind of risk does debt pose?

Answer 3

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

Question 4

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

Answer 4

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

Question 5

what is the difference between secured and unsecured debt?

Answer 5

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

Question 6

what are the characteristics of equity?

Answer 6

presents less risk as company can choose when to pay dividends

Question 7

what is leverage?

Answer 7

using debt to increase returns (while simultaneously increasing risk)

Question 8

what should not be used if earnings are volatile?

Answer 8

debt

Question 9

what does the theory by Modigliani and Miller state?

Answer 9

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

Question 10

what are the assumptions for the M&M theory?

Answer 10

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

Question 11

the possibility of what threat is increased by higher debt?

Answer 11

costs of bankruptcy

Question 12

what are some of the costs of bankruptcy?

Answer 12

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

Question 13

what does trade-off theory state?

Answer 13

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

Question 14

how does debt decrease WACC?

Answer 14

using debt gives us tax benefits

Question 15

what is pecking order theory?

Answer 15

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

Question 16

why do companies keep low debt-equity levels?

Answer 16

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

Question 17

what does the signaling effect do?

Answer 17

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

Question 18

what will be signaled if the company buys back shares?

Answer 18

will signal to the market that shares are undervalued

Question 19

what is the effect on the market of issuing equity?

Answer 19

signaling effects – can create share price volatility

Question 20

what is the treasury function used for?

Answer 20

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

Question 21

what are the types of external risks?

Answer 21

• currency risk
• interest rate risk
• market risk
• inflation risk

Question 22

what are the types of internal risks?

Answer 22

• liquidity risk
• credit risk
• refinancing risk
• regulatory/legal risk

Question 23

how can we mitigate currency risk?

Answer 23

entering into forward contracts, options, swaps

Question 24

how can we mitigate interest rate risk?

Answer 24

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

Question 25

how can we mitigate market risk?

Answer 25

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

Question 26

how can we mitigate inflation risk?

Answer 26

cost management, operating in other countries with lower inflation

Question 27

how can we mitigate liquidity risk?

Answer 27

holding sufficient cash reserves, monitoring CF budgets

Question 28

how can we mitigate credit risk?

Answer 28

- controlling overdue accounts - credit evaluation / maintaining terms and limits - insurance

Question 29

how can we mitigate refinancing risk?

Answer 29

- spread out loan maturities and interest rates - multiple sources

Question 30

how can we mitigate legal risk?

Answer 30

- actively monitor compliance - have a good lawyer

Question 31

what impact can issuing equity have on existing SH?

Answer 31

can dilute their control and some existing SH may oppose this

Question 32

what control implications can debt have?

Answer 32

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

Question 33

what restrictions can a loan covenant have?

Answer 33

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

Question 34

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

Answer 34

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

Question 35

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

Answer 35

they must not be equal

Question 36

what is degree of financial leverage formula?

Answer 36

EBIT / EBIT - interest

Question 37

what kind of risk does DOFL look at?

Answer 37

financial risk

Question 38

what does DOFL represent?

Answer 38

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

Question 39

what kind of risk does DOOL look at?

Answer 39

operational risk

Question 40

what is the cost of debt?

Answer 40

nominal interest rate (1 - t)

Question 41

what does DOOL represent?

Answer 41

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

Question 42

what is WACC?

Answer 42

the total cost of financing for a company

Question 43

how to calculate WACC?

Answer 43

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

Question 44

what do we use WACC for?

Answer 44

- evaluating capital projects - valuation of companies - determining EVA - determining FV of assets

Question 45

what are the key principles for WACC?

Answer 45

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

Question 46

what do we use for weightings?

Answer 46

- target structure - MVs - book value

Question 47

how to calculate the cost of debt?

Answer 47

nominal int rate x (1 - tax rate)

Question 48

when do we remove tax from cost of debt?

Answer 48

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

Question 49

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

Answer 49

dividend paid / share MV (1 - flotation costs)

Question 50

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

Answer 50

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

Question 51

how to calculate the cost of equity through CAPM?

Answer 51

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

Question 52

where do we get risk free rate?

Answer 52

rate for government bonds (they are free of risk)

Question 53

what happens if B is negative?

Answer 53

company risk is lower than market risk

Question 54

what is market premium?

Answer 54

Rm - Rf

Question 55

which equity method is preferred?

Answer 55

use CAPM

Question 56

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

Answer 56

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

Question 57

what other things do we consider for debt/equity?

Answer 57

- lifecycle stage of the business - is there additional value an entity partner could bring

Question 58

what is operating leverage?

Answer 58

the effect of change in sales on operating income

Question 59

what is financial leverage?

Answer 59

using debt to increase return on equity