Capital Structure

Question 1

Operating Gearing

Answer 1

refers to the extent to which a firm’s total non-financing costs are rather than variable (impact on PBIT)

Question 2

Financial Gearing

Answer 2

concerns the proportion of debt in the capital structure.

Question 3

Ways to measure financial gearing

Answer 3

• balance sheet figures or market values
• capital gearing focuses on the extent to which a firms total capital is in the form of debt (B/S)
• income gearing is concerned with the proportion of the annual income stream which is devoted to the prior claims of debt holders (pre-interest profits)(I/S)

Question 4

Capital gearing using market value formula

Answer 4

long - term debt / total market capitalisation

• Vd/ Ve+Vd

Question 5

income gearing using interest cover formula

Answer 5

profit before interest and tax / interest charges

• lower interest cover means the higher the income gearing

Question 6

positives when a company borrows more

Answer 6

• debt is cheaper than equity
• more debt should push the WACC down, all else equal
• lower WACC = higher NPVs = more shareholder wealth

Question 7

negatives when a company borrows more

Answer 7

• more interest means shareholders have to wait longer for dividends
• shareholders’ risk increases - financial risk
• so cost of equity rises pushing up WACC, all else equal
• Higher WACC lower NPVs

Question 8

Value formular

Answer 8

V= total cash flows to debt and equity (C) / WACC

Question 9

M&M 58

Answer 9

• total market value of any company is independent of its capital structure
• the WACC is constant because the cost of equity capital rises exactly offset the effect of cheaper debt

Question 10

M&M 58 Assumptions

Answer 10

• no taxation
• perfect capital markets, perfect information available to all and no transaction costs
• no costs of financial distress and liquidation
• firms can be classified into distinct risk and classes
• individuals can borrow as cheaply as companies

Question 11

M&M 63

Answer 11

• the more you give to debt holders the bigger the value becomes.
• introduces corporation tax to bring an additional advantage of using debt capital

Question 12

M&M 63 Optimal capital structure

Answer 12

• 100% debt finance.
• WACC would be at its lowest

Question 13

Cost of financial distress - Indirect examples

Answer 13

• uncertainties in customers minds
• uncertainties in suppliers mids
• assets sold quickly, price may be very low
• delays, legal imposition and the tangles of financial reorganisation may place restrictions on management action, interfering with the efficient running of the business
• management may give excessive emphasis to short-term liquidity
• temptation to sell healthy businesses
• loss of staff morale, difficulty in recruiting talented people

Question 14

costs of financial distress- direct examples

Answer 14

• lawyers fees
• accountants fees
• court fees
• management time

Question 15

financial distress

Answer 15

where obligations to creditors are not met or are met with difficulty

Question 16

trade off model

Answer 16

• amends M&M 63 to include costs of financial distress
• optimal solution depends on outside factors

Question 17

factors influencing the risk of financial distress costs

Answer 17

• sensitivity of the company’s revenue to general level of economic activity.
• proportion of fixed to variable costs
• liquidity and marketability of the firms assets
• cash generative ability of the business

Question 18

agency costs

Answer 18

direct and indirect costs of attempting to ensure that agents act in the best interest of principles

Question 19

information asymmetry

Answer 19

managers know more than lenders so restrictions (covenants) are built into a lending agreements
- lenders will require a premium on the debt interest to compensate the cost of monitoring

Question 20

Pecking order

Answer 20

• firms prefer to finance with internally generated funds
• if the firm needs more they seek debt.
• as a last resort the companies raise external equity finance