Capital Structure Flashcards
What is business risk ?
Business risk is a risk which results from the company or industry for example an ice cream shop sales may soar over summer however, during winter they may dip as a result of the weather
What is financial risk?
Financial risk is risk that occurs as a result of financial decisions such as taking on debt
What is financial gearing ?
Financial gearing looks to identify how much equity vs debt a company may be using for their investment decisions.
Should you use the statement of financial position or market values to measure capital ?
Market values
What financial spreadsheet measures i interest gearing
statement of profit or loss
Why may a debt holder not be worried about providing debt ?
- Debt ranks higher than shares meaning they would receive money first upon liquidation.
- Debt can be secured on assets
- Interest is also paid
Why are 3 reasons that a company may not mind having a high gearing ?
- Good liquidity
- Good business position position
- Good profit margins
- High tangible assets that can be secured
- Consistent fixed costs
- Predictable revenue
Explain the traditional theory of capital structure low gearing ?
At lower levels of gearing investors debt perceive debt as risky so WACC may drop
What happens in the traditional theory of capital structure with high gearing ?
With higher gearing shareholders will become more worried and could demand higher returns on their investment. This increase in returns for investors will lead to wacc increasing and nullify the cheapness of the debt.
What happens in the tradition theory of capital structure with very high levels of gearing ?
Both debt holders and equity holders become worried. The equity holders demand higher returns for their risk with higher debt and that increases the wacc once again.
What does M&M no tax theory suggest?
This theory suggests that it doesn’t matter if gearing drops and increases because cost of equity is linear levels of gearing cancelling it out
What does M&M with tax theory suggest ?
Explain the pecking order theory ?
This theory suggests that companies have an order in which they would like to use finance for projects. they would prefer to use retained earnings first, debt and then equity as a means of raising finance.
