Capital Structure

Question 1

Business Risk

Answer 1

Operating activities:

• The leverage gained/ lost on fixed costs

Operating leverage:

• The leverage gained/ lost on interest expenses

Question 2

Financial Risk

Answer 2

Equity:
- Dividend
- Not compulsory
- funds supplied by shareholders
- reward: dividends and capital growth
- low risk for a company
- event of economic hardship: div need not be paid

Debt:
- contractual obligations (interest and capital repayments)
- Interest and capital
- Contractual

Question 3

Return on assets

Answer 3

= Earnings before interest and tax (EBIT) / Total assets

Or

= Earnings before interest, but AFTER-tax (EBIAT) / Total assets

= Net operating profit after tax (NOPAT) / total assets

Or

= Net profit (after interest and tax) / Total assets

Question 4

Return on equity

Answer 4

=Net profit/ Equity

Question 5

Gearing

Answer 5

Using relatively more debt in Capital Structure = leverage (or gearing) → increase return on shareholders’ funds in exchange for greater financial risk

Positive Gearing:
When EBIT and as a result net profit is high enough that shareholder ROE increases
Increasing debt increases ROE, when ROA > Kd(1-t)

Negative is the opposite: When EBIT and as a result net profit is low enough that shareholder ROE decreases

Question 6

Optimal Capital Structure: Traditional

Answer 6

• There an optimal capital structure and it depends on the level of gearing
  is
• Optimal capital structure maximises S-H wealth

Question 7

Optimal Capital Structure: Modigliani-Miler

Answer 7

• Based on certain assumptions
• Assets determine the value of the company and not how they are financed
• WACC independent of gearing, so no optimal cap structure
• Kd doesn’t change, regardless of level of debt
• Ke increases with debt – keeping WACC constant

Question 8

Optimal Capital Structure: Trade- off

Answer 8

• Companies limit the use of debt, as they trade-off the advantages of debt financing and costs of financial distress
• Ke increase with debt
• Debt ratio influenced by lender’s willingness to lend
• WACC first declines slightly (due to cheaper debt), then remains fairly constant for a range of Cap Structures, eventually WACC increases as the degree of financial risk to high

Question 9

Optimal Capital Structure: Pecking Order and Signalling

Answer 9

• No optimal capital structure
• Finance in order of preferred hierarchy
• Use of specific financing methods may send signals to the market

Question 10

Flexibility:

Answer 10

1. Target capital structure
   - It is a moving target
   - Not a permanent position
   - Re-balancing the balance sheet: Share buybacks, Debt, Special dividends
2. Short-term deviations from the target
   - The theory offers a guideline (not rigidly applied)
   - Co should take advantage of opportunities
3. Financial flexibility
   - Maintain borrowing capacity to
   - quickly take advantage of opportunities or
   - Survive cyclical downturns
4. Market timing theory
   - Adjust capital structure in accordance with market conditions