Capital Structure and Assessing Finance Options

Question 1

What two things happen as gearing increases?

Answer 1

• Reduced WACC as debt is cheaper than equity.

- An increased risk faced by the shareholders which increases required return and in turn the Ke.

Question 2

What is the traditional theory?(gearing)

Answer 2

-There is an optimal gearing level which is found via trial and error.

Question 3

What is the MM theory (without tax)?

Answer 3

WACC is unaffected by gearing changes so it doesn’t matter how project are financed.

Question 4

What is the MM theory (with tax)?

Answer 4

The more debt the better. The benefit arises from the tax relief gained on the interest - the “tax shield”.

Question 5

What 3 issues are there with the assumptions in the M&M/Real world view?

Answer 5

• No bankruptcy risk.
• No tax exhaustion.
• Agency costs.

Question 6

What is “Asset Beta”?

Answer 6

The beta appropriate to a company that is ungeared.

Question 7

What is “Equity Beta”?

Answer 7

The (higher) beta, adjusted to reflect the extra risk of gearing.

Question 8

Equity beta=

Answer 8

Asset beta x 1 + D(1-T)/E

Question 9

If Co A is considering an activity that Co B does, how do you calculate risk adjusted WACC?

Answer 9

1. Degear the Be of company B (using B’s D:E ratio) to find Ba.
2. Regear this Ba for company A (using A’s D:E ratio)
3. Use this Be in the CAPM formula to find ke for company A.
4. Calculate kd and then WACC as usual for company A.

Question 10

When a new project finance significantly changes the gearing level and therefore the WACC how do you know whether to accept?

Answer 10

1. Discount the project using ke rather than WACC.
2. Discount the tax sheild on the new debt finance (less any issue cost) at the pre-tax cost of debt.
3. If the total APV is positive, do the project.

Question 11

What is likely to be included in a business plan?

Answer 11

• Exec summary.
• History/background.
• Mission statement/objectives.
• Products.
• Markets.
• Operations.
• Financial info.
• Summary action plan.

Question 12

What answering finance questions what makes up the “FAT PRICE” acronym.

Answer 12

Financial risk
Analysis and discussion
Theory
Practical gearing
Ratios
Industry averages
Conclusion
Easy marks

Question 13

What should you discuss in relation to “Financial risk”?

Answer 13

More debt=more risk.

Question 14

What should you discuss in relation to “Analysis and discussion”?

Answer 14

Use numbers where possible.

Question 15

What should you discuss in relation to “Theory”?

Answer 15

If a question asks for theory specifically, then apply the different theories to the scenario.

Question 16

What should you discuss in relation to “Practical gearing”?

Answer 16

Consider the company’s current level of gearing.

Question 17

What should you discuss in relation to “Ratios”?

Answer 17

Interest cover and gearing.

Question 18

What should you discuss in relation to “Industry averages”?

Answer 18

Use, if given.

Question 19

What should you discuss in relation to “Conclusion”?

Answer 19

Give a reasoned recommendation.

Question 20

What should you discuss in relation to “Easy marks”?

Answer 20

Think about the chapter 4 checklist.

Question 21

How do you re-gear equity beta with addition of tax?

Answer 21

Beta x (1+(0.83D/E))

Question 22

How do you re-gear equity beta with no changes in tax?

Answer 22

Beta x (1+(D/E))

Question 23

How do you degear Beta?

Answer 23

B * equity/(equity+debt*0.83)

Question 24

How do you calculate the base case NPV for an APV question?

Answer 24

The investment cash flows are discounted at the ungeared cost of equity, assuming the corporate debt is risk free (and has a beta of zero).

Question 25

How do you calculate APV?

Answer 25

Base case NPV + Tax relief on debt interest - issue costs of new debt and equity

Question 26

How do you calculate the tax relief on debt interest?

Answer 26

PV of the total tax savings discounted at the gross cost of debt.

Question 27

When is the statement “The NPV value of a project will be reflected in an equivilant increase in the company’s share price.” true? 3 factors.

Answer 27

1. The financing used does not create a significant change in gearing.
2. The project is small relative to the size of the company.
3. The project risk is the same as the company’s average operating risk.

Question 28

What is the main problem with APV?

Answer 28

The estimation of the various financing side effects and the discount rates used to appraise them.

Question 29

Is actual share price is likely to be equal to the theoretical ex-rights price?

Answer 29

Depends on the market’s reaction to the rights issue eg, whether it is fully taken up, and whether the proceeds are invested in positive net present value projects. If we were told the net present value of the projects this could be incorporated in the theoretical ex-rights price giving a more realistic estimate of the actual share price post rights issue.

Question 30

What are 4 exit routes for an MBO?

Answer 30

• Selling the company to a third party.
• A secondary MBO.
• Floating on the stock exchange.
• Liquidation (if unsuccessful).

Question 31

Explain the portfolio effect.

Answer 31

A portfolio is a combination of investments. Many investors attempt to reduce their risks by holding a portfolio. The idea is that by investing in different securities they are ‘not putting all of their eggs in one basket’. It is better to spread investment risks.

Question 32

When calculating the gearing % do you need to adjust the MV of debt for tax?

Answer 32

No, just (Long Term Debt/Capital)