Capital Structure

Question 4

Why is there a need for capital structure?

Answer 4

The lower the firm’s cost of capital, the higher the value of the firm, therefore financial managers should determine the capital structure which leads to the lowest cost of capital and which consequently maximize the value of the firm.

Question 5

What is maturity matching?

Answer 5

An optimal strategy to match long term assets with long term finance and short term assets with short term finance.

Question 6

What is the starting point in evaluating the risk profile of a company?

Answer 6

The evaluation of business risk and financial risks

Question 7

What are business risks?

Answer 7

Risk relating to the operating activities of the company such as the nature of the industry.

Question 8

What are financial risks?

Answer 8

Risks primarily influenced by the balance between debt and equity (capital structure). It consists of two parts: interest risk and capital risk. The interest risk is the risk of not being able to cover the fixed interest charges and the capital risk is the risk that on
Inquisition , debt has a preferential claim against the assets.

Question 9

What is gearing or leverage?

Answer 9

Using relatively more debt in the capital structure. It is used to increase the return on shareholder’s fund in exchange for greater financial risk

Question 10

What is the optimal capital structure?

Answer 10

The optimal capital structure is the debt-equity ratio that the company adopts so that it’s weighted average cost of capital (WACC) is at the lowest point.

Question 11

Discuss the M&M approach to optimal capital structure.

Answer 11

M&M argued that there is no optimal capital structure because irrespective of the level of gearing, a firm’s weighted average cost of capital will not change. This occurs because as the company increases its debt (which is cheaper than equity) it is increasing its risk. The equity holder will require compensation for an increase in risk and so the cost of equity will rise and offset the relative benefit of cheaper debts.

Question 12

List the assumptions of M&M approach.

Answer 12

1. Individual can borrow on the same terms as the company can
2. There are no taxes
3. There are no transaction costs
4. There are no costs associated with financial distress
5. The are no agency fees

Question 13

Discuss the M&M approach with tax

Answer 13

Since the interest on debt is deductible for purpose of tax, the value of the geared firm will be higher by the amount of tax saved through the use of debt. The effect is a cost of capital which does decline with increased gearing.
Therefore, initially the interest tax shield give rise to an increase in value, the increase in value declines as expected cost of financial distress and related costs come into play. At a point, marginal benefit from any interest tax shield is exactly offset by the increase in marginal cost. This point is the optimal capital structure. Any further increase in debt will result in the marginal disadvantage being greater than the marginal tax shield.

Question 14

Discuss the downside of the M&M approach with tax

Answer 14

This does not take into account that as debt increases, so the risk of potential financial distress increase. It also ignores the fact that EBIT would fall due to a poorly structured balance sheet. It ignores potential agency costs and it ignores that interest rates are likely to increase at higher level of debts.

Question 15

Explain the trade off theory

Answer 15

Cost of equity and cost of debt will rise as leverage is increased. The companies are seen to trade-off the advantage of debt financing with the costs of taking on increasing level of financial leverage, such as higher interest rates and potential bankruptcy.
Initially the increase in the costs is considered to be slight but as the degree of financial leverage increase, the rate of increase in the costs of equity and debt will also increase. As a result the WACC falls slightly initially then remains reasonably constant for a range of capital structure, and finally increases as the degree of financial risk becomes unacceptable.

Question 16

What are the indirect costs of threat of bankruptcy?

Answer 16

1. Losing customers
2. Losing key employees
3. Bank or lender impose higher interest rate or request loans to be repaid
4. Losing profitable investment opportunities due to limited financing options
5. Divert management time and resources to keep company afloat
6. Competitors aggressive action to reduce company’s ability to compete

Question 17

What is the pecking order theory?

Answer 17

There is no target capital structure, rather finance will be raised according to a preferred hierarchy.
This suggests that financing investment from retained earnings is the most preferred alternatives, as it preserves the existing control of the firm.

Question 17

The strength of a company’s balance sheet can be evaluated by three board categories, what are they?

Answer 17

1. Working capital adequacy
2. Asset performance
3. Capital structure

Question 18

What is the order the funds would be issued according to the pecking theory?

Answer 18

1. Internally generated funds such s retained earnings
2. Debts
3. Convertible debts and preference shares
4. Equity

Question 18

What is a company’s capitalization?

Answer 18

It describe the composition of a company’s permanent or long term capital, which consists of a combination of debt and equity.

Question 19

Discuss the impact of inflation

Answer 19

The higher the rate of inflation, the lower the real after-tax cost of debt. Inflation may therefore impact the optimal capital structure y encouraging a higher degree of financial leverage. This may also increase the level of financial risk.

Question 19

In a company’s capital structure, what does the equity part consist of?

Answer 19

1. Common and preferred stocks

2. Retained earnings

Question 20

When would a company be considered as highly leveraged?

Answer 20

When there is too much debt versus equity.

Question 21

What is the consequence of being highly leveraged?

Answer 21

The company may find its freedom of action restricted by its creditors and or may have its profitability hurt as a result of paying high interest costs.

Question 22

Analysts use three different ratios to assess the financial strength of a company’s capitalization structure, what are they?

Answer 22

1. Debt ratio
2. Debt to equity ratio
3. Capitalization ratio

Question 23

What is capitalization ratio?

Answer 23

Capitalization ratio = total debt/total capitalization
It compares the debt component of a company’s capital structure (the sum of obligations categorized as debt + total shareholders equity) to the equity component. A lower number is indicative of a heathy equity cushion.

Question 24

List the important things to consider when doing a capital structure question.

Answer 24

1. Consider the capital requirement, calculate the amount
2. Consider the options of financing, it is enough to meet the requirement?
3. Make decision by doing simulation calculations.
4. How does it affect statement of financial position and statement of comprehensive income?
5. Calculate the ratios
   - ROA
   - ROE
6. Other qualitative considerations, such as advantage and disadvantages in terms of cost, risk and control.