Capital Structure (2)

Question 1

What if debt is lower than WACC?

Answer 1

Shareholders will benefit since market value depends on its cost of capital

Question 2

The lower the company’s WACC?

Answer 2

The higher the NPV of its future cash flows and therefore the higher its market value

Question 3

Traditional theory of gearing?

Answer 3

Debt brings benefits up to a certain level of gearing

Question 4

What is the optimal level in traditional gearing?

Answer 4

Where WACC is at its lowest

Question 5

Issue with traditional theory?

Answer 5

Fails to consider the impact of tax on the cost of debt finance

Question 6

How is the total market value of M&M determined?

Answer 6

Through the total earnings of the company and the level of risk attached to those earnings.

Tax relief on debt interest is ignored

Question 7

How is total market value computed?

Answer 7

Discounting the total earnings at a rate that is appropriate level of of business risk

Question 8

What does M&M conclude?

Answer 8

Capital structure of a company has no effect on its overall value or WACC

Question 9

Similarity with M&M and traditional theory?

Answer 9

Debt is cheaper than equity and that use of high levels of debt makes equity riskier so cost of gearing rises

Question 10

When WACC remains constant in M&M?

Answer 10

Debt and equity offset each other

Question 11

What is an arbitage?

Answer 11

When purchase and sale of a security takes place simultaneously in different markets

Question 12

Aim of arbitage?

Answer 12

To make risk free profit through the exploitation of any price difference between the markets

Question 13

M&M assumptions

Answer 13

Perfect capital market exists
No tax or transaction costs
Debt is riskfree

Question 14

What is the tax shield?

Answer 14

The savings arising from tax relief on debt interest

Question 15

When tax shield is taken into account in M&M?

Answer 15

Debt brings an extra benefit

Question 16

What should be done when tax is included in M&M?

Answer 16

Company should use as much debt finance as it can

WACC continues to fall as gearing rises

Question 17

Disadvantages of M&M with tax?

Answer 17

Direct financial distress

Indirect financial distress

Agency costs

Question 18

M&M disadvantage with higher levels of gearing

Answer 18

Higher levels of gearing means company is unable to meet interest payments. And shareholders and debt providers would want greater compensation

Question 19

M&M disadvantage with stakeholders and gearing

Answer 19

Customers may not buy from financially unstable company

Suppliers won’t want to supply an unstable firm

Question 20

M&M disadvantage with agency costs?

Answer 20

Providers of debt finance likely to impose restrictive covenants, such as restriction of future dividends

Question 21

M&M disadvantage for when companies increase their gearing?

Answer 21

May reach a point where there are not enough profits from which obtain all available tax benefits. Meaning less protection from bankruptcy and agency costs

Question 22

Pecking order theory ranking?

Answer 22

1. Use internal funds available
2. Use debt
3. Convertible debt
4. Preference shares
5. issue new equity

Question 23

Issue costs and pecking order theory?

Answer 23

Zero if retained cash is used

issue costs of debt lower than equity

Question 24

What does investor preference for safer securities mean?

Answer 24

Debt has guaranteed income and priority on liquidation

Question 25

Why do debt issues have a better signalling effect than equity issues?

Answer 25

The market will interpret debt issues as a sign of confidence

Question 26

How does market interpret equity issues?

Answer 26

As an indication that managers believe that equity is currently overvalued and hence are trying to achieve high proceeds while they can