Capital Structure (2) Flashcards
What if debt is lower than WACC?
Shareholders will benefit since market value depends on its cost of capital
The lower the company’s WACC?
The higher the NPV of its future cash flows and therefore the higher its market value
Traditional theory of gearing?
Debt brings benefits up to a certain level of gearing
What is the optimal level in traditional gearing?
Where WACC is at its lowest
Issue with traditional theory?
Fails to consider the impact of tax on the cost of debt finance
How is the total market value of M&M determined?
Through the total earnings of the company and the level of risk attached to those earnings.
Tax relief on debt interest is ignored
How is total market value computed?
Discounting the total earnings at a rate that is appropriate level of of business risk
What does M&M conclude?
Capital structure of a company has no effect on its overall value or WACC
Similarity with M&M and traditional theory?
Debt is cheaper than equity and that use of high levels of debt makes equity riskier so cost of gearing rises
When WACC remains constant in M&M?
Debt and equity offset each other
What is an arbitage?
When purchase and sale of a security takes place simultaneously in different markets
Aim of arbitage?
To make risk free profit through the exploitation of any price difference between the markets
M&M assumptions
Perfect capital market exists
No tax or transaction costs
Debt is riskfree
What is the tax shield?
The savings arising from tax relief on debt interest
When tax shield is taken into account in M&M?
Debt brings an extra benefit
What should be done when tax is included in M&M?
Company should use as much debt finance as it can
WACC continues to fall as gearing rises
Disadvantages of M&M with tax?
Direct financial distress
Indirect financial distress
Agency costs
M&M disadvantage with higher levels of gearing
Higher levels of gearing means company is unable to meet interest payments. And shareholders and debt providers would want greater compensation
M&M disadvantage with stakeholders and gearing
Customers may not buy from financially unstable company
Suppliers won’t want to supply an unstable firm
M&M disadvantage with agency costs?
Providers of debt finance likely to impose restrictive covenants, such as restriction of future dividends
M&M disadvantage for when companies increase their gearing?
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
Pecking order theory ranking?
- Use internal funds available
- Use debt
- Convertible debt
- Preference shares
- issue new equity
Issue costs and pecking order theory?
Zero if retained cash is used
issue costs of debt lower than equity
What does investor preference for safer securities mean?
Debt has guaranteed income and priority on liquidation
Why do debt issues have a better signalling effect than equity issues?
The market will interpret debt issues as a sign of confidence
How does market interpret equity issues?
As an indication that managers believe that equity is currently overvalued and hence are trying to achieve high proceeds while they can
