Capital Structure

Question 1

Define capital Structure

Answer 1

capital structure is the mix of securities used by a company to finance it’s operations

Question 2

Explain why the cost of debt finance is generally lower than the cost of equity finance

Answer 2

• There is less risk associated with debt finance (in the event of financial distress debt holders are paid first)
• Arrangement fees are less for debt issuance than equity issuance
• interest payments are a tax deductible expense

Question 3

Drawbacks of using lower cost debt to reduce capital costs instead of equity.

Answer 3

• Increasing debt raises default risk and bankruptcy risk
• increased bankruptcy risk causes shareholders/debt-holders to demand greater returns
• Flexibility Loss: More debt can limit company’s operational flexibility e.g. miss investment oportunities due to repayment obligations

Question 4

Define irrelevancy theory

Answer 4

• Modigliani, Miller 1958,
• Premise: in perfect markets, the value of a firm is unaffected by its capital structure.

Question 5

Outline the key assumptions of irrelevancy theory

Answer 5

• No taxes
• Individuals and companies can borrow unlimited amounts at the same rate of interest
• No transaction costs
• Personal borrowing is a perfect substitute for corporate borrowing
• Firms exist with the same business risk but different levels of gearing
• All projects, cash flows and debt relating thereto are perpetual
• income generated by the company confirms the company’s value

Question 6

Outline the propositions of Modigliani miller 1958

Answer 6

• The Market value of any firm is independent of its capital structure
• The expected rate of return on equity in a geared firm is proportional to it’s D/E ratio

Question 7

Define the traditional approach

Answer 7

• Premise: an optimal debt-to-equity ratio exists where the cost of capital is minimized and firm value is maximized
• Initially, more debt lowers capital costs (due to tax benefits), but past a certain point, costs increase due to higher financial risk.

Question 8

What does the optimal capital structure mainly depend on (Traditional Approach)?

Answer 8

The business of a specific firm, i.e. if a firm has volatile profits it should have low gearing

Question 9

Summarise Modigliani, Miller 1963

Answer 9

• Revised version of irrelevancy theory, now includes corporation tax
• Interest payments are tax deductible
• A geared firm is technically more valuable than an identical ungeared firm because tax bill is reduced
• A firms value is maximised by taking on as much debt as possible

Question 10

How do you calculate the value of a tax shield? (MM63)

Answer 10

Tax shield = r ate of debt * amount of debt * corporate tax rate

Question 11

how do you calculate the value of a geared firm? (MM63)

Answer 11

Value of geared firm = Value of un geared firm + PV of tax shield PV of tax shield = Amount of debt * corporation tax

Question 12

MM63 Proposition 3

Answer 12

• Proposition 3: The WACC declines as gearing increases

Question 13

MM63 Proposition 1

Answer 13

• Proposition 1: The value of a firm is increased as debt is added to the capital structure (optimal capital structure is when debt is maximised)

Question 14

MM63 Proposition 2

Answer 14

• Proposition 2: As gearing increases, the cost of equity rises at a slower rate than in MM58 due to tax shield benefits.
• This assumes all firms gain from tax shields, in reality, some do not e.g. loss-making firms

Question 15

Key limitations of Modigliani, Miller 1963

Answer 15

Does not take into account:
- Costs of financial distress (as companies take on more debt they are likely to become more financially distressed)
- personal taxes

Question 16

Define Trade off theory

Answer 16

According to trade off theory:
- Any tax advantage of using debt is eventually outweighed by expected bankruptcy costs
- implies there is an optimal capital structure

Question 17

How do you calculate the value of a geared company using trade off theory?

Answer 17

value of geared company = value of ungeared company + (corporate tax rate * amount of company debt) - expected value of bankruptcy costs Vg = Vu +(tc *D) - E(PV(bc))

Question 18

what is the empirical evidence on signalling theory

Answer 18

• empirical evidence is weak in support of signalling theory
• signalling theory predicts undervalued companies have higher gearing ratios than overvalued companies
• research supports the opposite: gearing ratios are inversely related to profitability
• signalling theory predicts growth firms or firms with high tangible assets would have higher gearing ratios, empirical evidence shows the opposite.

Question 19

Why is there a preference for debt over equity?

Answer 19

• James 1987 found that share prices typically rise when firms announce bank debt borrowing but fall with equity issuance
• this suggests information costs are higher for equity than for debt
• Gives Rise to pecking order Theory

Question 20

Define pecking order theory

Answer 20

• Myers Majiluf 1984
• premise: firms financing follows the path of least resistance, in the order:
  1- Internal funds
  2- debt
  3- equity
• suggests there is no optimal capital structure
• tax shields and financial distress costs are a second order concern

Question 21

Define financial slack

Answer 21

having cash or other liquid assets (including unused debt capacity) readily available

Question 22

Reasons for firms having financial slack

Answer 22

• investment Opportunities: Ensures funds are available for promising projects or investments
• Strategic Flexibility: Allows for quick exploitation of new opportunities without the need to secure external financing
• Internal Financing: Reduces reliance on external capital markets, lowering transaction costs

Question 23

Problems with too much financial slack

Answer 23

• best discussed by Jensen (1986)
• incentives for managers to exploit free cashflow
• i.e. managers giving themselves higher wages/bonuses
• Managers engage in empire building

Question 24

solution to financial slack problems

Answer 24

• Jensen (1986) posits that cash-rich companies should increase debt levels to limit free cash for managers, using debt as a control mechanism
• However Jensen overlooks the costs of excessive debt, which can lead to financial distress

Question 25

Draw a graphical representation of Modigliani miller 1958

Question 26

Draw a graphical representation of the traditional approach

Question 27

Draw a graphical representation of Modigliani Miller 1963

Question 28

Draw a graphical representation of Trade off theory

Question 29

What is business risk?

Answer 29

business risk is the variability of operational profit

Question 30

list Theories of Capital Structure

Answer 30

• Modigliani Miller 1958
• Traditional Approach
• Modigliani Miller 1963
• Trade off theory
• Signaling Theory
• Pecking order Theory

Question 31

Information Asymmetry and Capital Structure

Answer 31

• Companies communicate internal information and future prospects through their financing choices
• Debt Financing signals confidence in future cash flows, implying managers believe regular interest payments are manageable (increases share price)
• Equity Financing signals that managers lack confidence in future earnings, and or believe shares are overvalued (decreases share price)

Question 32

information asymmetry in finance

Answer 32

• managers have more complete or accurate information about the company

Question 33

Signaling Theory

Answer 33

• Based on Information Asymmetry
• Capital Structure depends on whether management believe company is over or under valued
• undervalued companies issue debt to try to increase the value of equity through credible signal
• overvalued issue equity, to lower gearing ratio and financial distress risk