Capital Structure

Question 1

What is an optimal capital structure and why does a firm need one?

Answer 1

The optimal capital structure is the perfect balance between debt and equity finance that causes the Weighted average cost of capital to be at its lowest

Companies desire this because, the less costs, the more the business can grow

Question 2

What is a target capital Structure?

Answer 2

the capital structure at which you will experience the lowest WACC

Question 3

What are the advantages and disadvantages of raising Capital as debt?

Answer 3

Advantages
- interest costs are tax deductible
- debt holders are limited to a fixed return and so they don’t have to share extra profits with them
- no loss of control

Disadvantages
- the higher your debt ratio, the higher the interest will be and therefore the increase in risk
- if the company falls on hard times, if they cant pay the interest, they will be forced into bankruptcy

Question 4

what are the advantages of raising equity as capital?

Answer 4

• dividends is not compulsory to pay each and every year
• ## no repayment needs to occur at the end of period

Question 5

What is leverage and how does it work?

Answer 5

• also known as gearing
• it is the measure of risk associated with the company as a result of their debt borrowings
• the higher your debt, the higher your leverage and therefore the more risky your business is

Question 6

what is the trade off theory?

Answer 6

it is the theory of taking advantage of the debt benefits up until the point where the risk becomes too high and WACC starts increasing. The theory suggests that it will stay the same for a range of combinations until the debt risk becomes too much

Question 7

What is the pecking order theory?

Answer 7

This theory assumes there is no target capital structure, and that capital will be raised in the following order as it becomes available
- Internally generated funds (retained earnings)
- Debt
- convertible debt and preference shares
- New equity

Question 8

What is the singaling theory?

Answer 8

It is the idea that everyone assumes that management knows better than outsiders and therefore if they issue shares, the public might assume that the shares are overvalued because they wouldn’t issue them when they are under valued and if they buyback shares, the public would assume they are undervalued.