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Corporate Finance Revision > Capital Structure > Flashcards

Capital Structure Flashcards

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1
Q

What should the directors consider when making the long term financing decision?

A

The relative merits and de-merits of EQUITY and DEBT CAPITAL.

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2
Q

What are the 5 merits and demerits of equity and debt capital?

A
  1. Cost – equity is more expensive to service (and issue) than debt
  2. Control – issuing equity dilutes control of existing shareholders
  3. Risk – shareholders cannot force the company into liquidation
  4. Flexibility – equity does not restrict managerial freedom
  5. Life – equity is permanent but debt is finite and thus carries refinancing risk
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3
Q

What is capital structure?

A

The relative proportions of a company’s equity and debt capital.

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4
Q

What is capital structure also known as?

A

Financial Gearing

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5
Q

What is financial gearing?

A

Financial gearing is the percentage of the market value of a company’s debt capital to it’s total market value.

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6
Q

What is the formula for financial gearing?

A

G = VD ÷ (VD + VE)

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7
Q

Name each component of this forumla and what is it called?

G = VD ÷ (VD + VE)

A

G - Financial gearing
VD - Market value of debt
VE - Market value of equity

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8
Q

What is the financial gearing effect?

A

When an increase in a company’s level of financial gearring will cause an increase in it’s cost of equity.

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9
Q

What is the outcomes of the financial gearing effect?

A
  1. Higher levels of debt mean that relatively small changes in operating profit lead to relatively larger changes in profit attributable to shareholders
  2. Profit attributable to shareholders is therefore more variable / volatile over time
  3. The company is therefore a riskier investment for shareholders
  4. Shareholders thus demand higher returns for this increased risk
  5. The company’s cost of equity rises
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10
Q

What do capital structure theories consider?

A

The nature of the relationship between financial gearing and a company’s WACC (which is inversely related to shareholder wealth).

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11
Q

What are the 5 capital structure theories?

A
  1. Modigilani and Miller’s (M&M) NO TAX theory (1958).
  2. M&M’S WITH TAX theory (1963).
  3. The trade - off theory.
  4. Contemporary theories - pecking order and agency.
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12
Q

What does M&M’s no tax theory suggest? (capital structure theory).

A

As financial gearing (debt) increases, the cost of equity rises due to increased variability of shareholder returns. As well as this, the cost of debt remains constant and the rising cost of equity is exactly offset by the lower effective cost of debt.

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13
Q

What is M&M’S NO TAX Theory mean for the WACC?

A

The WACC is the same at all levels of financial gearing for all companies and thus capital structure is IRRELEVANT to shareholder wealth.

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14
Q

What are the assumptions within M&M’s no tax theory? (slide 8).

A
  1. No tax
  2. Companies and individuals can borrow and lend at a risk free interest rate.
  3. No costs of financial distress as in reality, if a company becomes insolvent 2 things can happen.

Lenders usually lose some of the money lent to the company or
Shareholders usually lose all of the money invested in the company

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15
Q

What does M&M’s WITH tax theory recognise 5 years later?

A

That companies benefit from the tax deductibility of interest payments to lenders (known as a tax shield).

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16
Q

Do all other previous assumptions from NO TAX theory remain with WITH tax theory?

A

YES, in particular that there are no costs of financial distress.

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17
Q

What happens to financial gearing (debt) when it increases within M&M’s WITH TAX theory?

A

The cost of equity rises due to increased variability of shareholder returns but does so at a slower rate than in a world with no tax as shareholders benefit from the tax shield

The post-tax cost of debt remains constant

The rising cost of equity is more than offset by the lower effective post-tax cost of debt

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18
Q

What happens to the WACC when financial gearing increases within M&M’s WITH Tax theory? (slide 10)

A

The WACC of all companies falls as financial gearing increases so capital structure is relevant to shareholder wealth

19
Q

What is a market value of a geared company?

A

It’s ungeared market value + the value of its tax shield.

20
Q

What is the formula to work out the market value of a company when geared?

A

Vg = Vug + VDTC

21
Q

What is the formula and what does each component mean?

Vg =  Vug + VDTC
A

Calculation to find out when the market value of a company when geared.

Vg	= Market value of company when geared
Vug	= Market value of company when ungeared
VD	= Market value of company’s debt
TC	= Corporation tax rate
22
Q

What is the forumla for when a company has a lower WACC when it is geared than when it is ungeared?

A

Kg = Kug ( 1 - (VDTC ÷ Vg))

23
Q

What does this forumla try to calculate and what does each component mean?

Kg = Kug ( 1 - (VDTC ÷ Vg))

A

It tries to calculate the WACC of a company when geared.

Kg	= WACC  of company when geared
Kug	= WACC of company when ungeared (its KE)
VD	= Market value of debt
TC	= Corporation tax rate
Vg	= Market value of company when geared
24
Q

What does M&M’s WITH TAX theory indicate?

A

That companies should be highly geared.

25
Q

What are the 4 reasons very few companies are highly geared in reality? (M&M’s with tax theory).

A
  1. Costs of financial distress – high gearing leaves company vulnerable to unforeseen adverse events.
  2. Debt capacity constraints – insufficient unencumbered and/or unsuitable assets to use as security.
  3. Tax exhaustion – insufficient taxable profits to obtain tax relief.
  4. Restrictive covenants on debt – become more onerous as gearing rises to high levels and restrict managerial freedom
26
Q

What does the trade of theory suggest and what does it mean for shareholder wealth?

A

Each company has an ‘optimal’ level of financial gearing where its WACC is minimised and its market value / shareholder wealth are maximised. Hence it’s capital structure is relevant to shareholder wealth.

27
Q

What is stage 1 of the trade off theory?

A

When a company is f1rom an ungeared position to the optimal level of financial gearing.

28
Q

What happens in stage 1 of the trade off theory?

A
  1. The cost of equity rises slowly
  2. The post-tax cost of debt remains constant
  3. The lower effective cost of debt more than offsets the slowly rising cost of equity
29
Q

Why does the cost of equity rise slowly in stage 1 of trade off theory? (2 reasons)

A
  1. Increased variability of shareholder returns; and

2. Shareholder perception of negligible insolvency risk

30
Q

What happens to the WACC at stage 1 of trade off theory?

A

WACC falls to a minimal level which maximises shareholder wealth and market value

31
Q

What is stage 2 of the trade off theory?

A

When a company is above the optimal level of financial gearing

32
Q

What happens in stage 2 of the trade off theory?

A
  1. The cost of equity rises more quickly.
  2. The post-tax cost of debt remains constant
  3. The lower effective cost of debt is more than offset by the accelerating cost of equity
33
Q

Why does the cost of equity rise slowly in stage 2 of trade off theory? (2 reasons)

A
  1. Increased variability of shareholder returns;

2. Shareholders perception of rising insolvency risk

34
Q

What happens to the WACC at stage 2 of trade off theory?

A

WACC starts to rise from its minimal level which reduces shareholder wealth & market value

35
Q

What is stage 3 of the trade off theory?

A

When a company is at high levels of financial gearing.

36
Q

What happens in stage 3 of the trade off theory?

A
  1. The cost of equity rises rapidly

2. Lenders also start to perceive default risk so demand a higher return and the cost of debt also starts to rise

37
Q

Why does the cost of equity rise slowly in stage 3 of trade off theory? (2 reasons)

A
  1. Increased variability of shareholder returns

2. Shareholder perception of high levels of insolvency risk

38
Q

What happens to the WACC at stage 3 of trade off theory?

A

WACC rises sharply which leads to a large fall in shareholder wealth and market value

39
Q

How is a company’s optimal level of financial gearing affected? (Trade off theory)

A

Affected by the sectors in which it operates as this determines its business (systematic and unsystematic) risk.

40
Q

What’s the difference within business risk when considering a companies optimal level of financial gearing? (Trade off theory)

A

Companies with low levels of business risk have higher optimal levels of financial gearing whereas

Companies with high levels of business risk have lower optimal levels of financial gearing

41
Q

What 3 things do companies do as the result of not being able to calculate the optimal level using the theory? (Trade off theory).

A
  1. Benchmark against their industry group
  2. Set a target range of financial gearing
  3. Try to keep financial gearing within this range
42
Q

What is the percking order theory? (Contemporary capital structure). (Myers 1984).

A

Managers will opt for the finance that is easiest and cheapest to source / issue first even though it may not be the cheapest to service or most appropriate in the long-term such as retained profits and short-term finance.

43
Q

What is the agency theory? (jensen 1986) (Contemporary capital structure).

A

When shareholders require an optimal capital structure to minimise the cost of capital per the trade off theory.

44
Q

Why do directors keep financial gearing below the optimal level? (agency theory)

A

Increased risk of insolvency and loss of office and reduced managerial freedoms from restrictive covenants.

Corporate Finance Revision (10 decks)

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