Capital Structure

Question 1

Business risk

Answer 1

~ determined by general business and economic condiions

~ variability in EBIT in industry

Question 2

Financial risk

Answer 2

risk due to having a fixed-interest debt in the capital structure

Question 3

Operational gearing

Answer 3

RATIO
Total contribution : EBIT
~ extent which operating costs are fixed vs variable

Question 4

Gearing (formula)

Answer 4

= D / E

= D / (E + D)

Question 5

Interest Cover (formula)

Answer 5

= EBIT / Interest

Question 6

M+M Theory

Answer 6

~ NO TAX: the WACC is constant, independent of gearing = no optimal lvl of gearing
~ TAX: advantageous to gear up, as pay less tax (thro paying interest)

Question 7

M+M Theory: Limitations in Real World

Answer 7

~ assumes perfect capital markets
~ bankruptcy risk from high gearing
~ restrictive loan covenants
~ tax exhaustion ( no taxable income so no need for tax shield)

Question 8

Adjusted present value

Answer 8

1. calc base case value using Keu = value of ungeared project
2. calc PV of tax shield
3. sum two figures
   DECISION: +ve value = increase in S/H wealth so proceed

Question 9

Base case value (Keu)

Answer 9

Keu = Rf + (Rm - Rf) x betaA

Question 10

BetaA (Ba)

Answer 10

a.k.a. asset beta
systemic business risk of the assets in a business
Ungeared co: Be = Ba
Geared increases: Be > Ba

Question 11

Risk-adjusted discount rate

Answer 11

~ uses Be, Ba and gearing lvl

(formula given

Question 12

Pricing issue of new shares

Answer 12

Too high: not fully taken up
Too low: detriment of current S/Hs
~ problem bypassed by a rights issue

Question 13

Pecking order of equity finance

Answer 13

1. Retained earnings: cheapest source, no issue costs
2. Rights issues + placing
3. New issues: most expensive

Question 14

Placing

Answer 14

issuing shares to few large co, not general public

Question 15

Types of dividend policy

Answer 15

~ M+M irrelevance
~ traditional theory
~ signaling
~ clientele
~ cash availablility
~ agency issues

Question 16

Dividend policies: M+M Irrelevance

Answer 16

~ pattern of divs is irrelevant in determining S/H wealth
~ paying or not paying doesn’t matter as long as +ve NPV projects undertaken to maximise S/H wealth (increase value of shares)

Question 17

Dividend policies: Traditional Theory

Answer 17

~ greater value is put on dividend now compared to retention

~ money now mroe valuable than money later as more certain

Question 18

Dividend policies: Signalling

Answer 18

~ pattern of div payments needed for investors to predict performance of co
~ a stable (and rising) div payout maintains investor confidence

Question 19

Dividend policies: Clientele

Answer 19

~ high payouts attract those who prefer current income

~ low payouts attract those who prefer capital gains income

Question 20

Dividend policies: Cash availability

Answer 20

if no cash available to pay div, borrow or reduce investment to avoid adverse signalling effects

Question 21

Dividend policies: Agency issues

Answer 21

~ mgt do not necessarily have S/H interests at heart

~ S/H’s can maintain control by insisting on high div payouts