7 - Capital Structure Flashcards
What is Financial Risk?
The additional variability in returns as a result of having fixed-interest debt in the capital structure
What is the problem with M&M 1963?
Not based in the real world.
Ignores bankruptcy risk.
Investors in both debt and equity will ask for higher rates of return
The existing WACC can be used unless…
Project Specific finance
Business risk change (Diversification)
Financial Risk Change (gearing)
If you see the work diversification think…
Business risk! You need to perform a risk adjusted discount rate
What are the three sources of equity finance?
New Issue
Rights Issue
Retained Earnings
M&M said that Dividend policy is…
Irrelevant (for determining shareholder wealth)
M&M believe a dividend should only be paid when…
There are no more positive NPV projects available
What is the traditionalist approach to dividends?
Firms that pay a regular dividend are better because shareholders would rather have £1 in dividend NOW, rather than the potential for capital gain (bird in the hand)
What is signalling in dividends?
Shareholders invest in companies based on their dividend trends (they want high or low), so companies should not radically change their tactics as this will be disturbing to investors.
What is the Gordon growth model?
Growth in future div’s = accounting rate of return * proportion of retained earnings
Ke (cost of equity) calculation:
Ke = Rf + Bj(Rm-Rf)
