Capital Structure Flashcards
What is the capital structure?
The mixture of equity and debt finance used by a company
Disadvantages of debt?
Debt creates higher variability in dividends > finance risk
Use of debt worsens interest cover and gearing
Debt payments must be made
Why is debt creates higher variability in dividends > finance risk?
There is a dramatic cut in funds available to pay a dividend because of the need to pay interest first
Why is more debt bad?
Creates higher default risk leading to financial distress costs (e.g. lower sales or higher supplier costs)
What is a key advantage of equity?
Dividend payments are at the discretion of the board
Debt > equity characteristic (cheaper)
Debt is a cheaper source of finance
Debt > equity characteristic (EPS)
Debt has a better impact on EPS
Debt > equity characteristic (Share issue)
Debt is quicker and cheaper to issue compared to a share issue
Debt > equity characteristic (Interest)
Interest repayments attract tax relief
Debt > equity characteristic (management)
Use of debt is a discipline on management
Debt > equity characteristic (confidence)
Using debt can be interpreted as a singal of confidence in company’s cash flows
Why does issuing debt have a better impact than issuing equity on EPS?
Has no dilutive effect
One of the key reasons debt is cheaper than equity
Reduce taxable profits as interest repayments attract tax relief
What is the link between life cycle and gearing?
A new, growing business will find it difficult to forecast cash flows. So high gearing is not recommended
What is the link between operational gearing and gearing?
if fixed costs high, contribution will be high relative to profits. Leading to volatile cash flows
