Capital structure policy

Question 1

What is capital structure?

Answer 1

A firm can raise funds by issuing both debt and equity securities - this mix is known as the capital structure

Question 2

What is the cost of equity?

Answer 2

The return, the Equity investors require on their investment in the firm

Question 3

what is ordinary equity?

Answer 3

Equity without priority for dividends, or in bankruptcy

Question 4

what are preference shares?

Answer 4

Equity with dividend priority over ordinary shares, normally with fixed dividend rate, sometimes without voting rights

Question 5

what is the cost of debt?

Answer 5

The return that lenders require on the firms debt here they are obligated to pay some kind of interest. This could be made up of borrowing from banks or issuing corporate bonds.

Question 6

What is the systematic risk of the equity?

Answer 6

Risk that cannot be diversified away

Question 7

What is the risk free rate used for?

Answer 7

Frequently is used as a proxy: returns on short-term government bonds

Question 8

What is does WACC stand for?

Answer 8

Weighted average cost of capital

Question 9

What is the weighted average cost of capital?

Answer 9

The WACC is the costs of capital for the firm as a whole and it can be interpreted as the required return on the overall firm. The overall return on assets

Question 10

What is the WACC simplified?

Answer 10

The rate that a company is expected to pay to finance all of it’s security holders and commitments to finance it’s assets

Question 11

What markets should you go to for early-stage financing?

Answer 11

Private equity and venture capital markets

Question 12

What do venture capital funds do?

Answer 12

They provide financing for new, often high-risk, ventures

Question 13

What are the stages of financing?

Answer 13

• Seed money
• Start-up
• Later stage capital
• Growth capital
• Replacement capital
• Buyout financing

Question 14

What is seed money?

Answer 14

A small amount of financing needed to prove a concept or develop a project (Not included in calculations)

Question 15

What is start-up money?

Answer 15

Financing for firms that started within the past year. Funds are likely to pay for marketing and product development expenditures

Question 16

What is later-stage capital?

Answer 16

Additional money to begin sales and manufacturing after a firm has spent its start-up funds.

Question 17

What is growth capital?

Answer 17

Funds earmarked for a firm to enable it to reach its potential and achieve successful growth

Question 18

What is replacement capital?

Answer 18

Financing for a company to buy out other investors to the firm

Question 19

What is buyout financing?

Answer 19

Money provided for managers and outside investors to acquire a fully functioning firm

Question 20

How does an IPO work?

Answer 20

• Goes public and is listed on an exchange
• Select a bank to provide underwriting and to advise on the IPO
• Due diligence and regulatory filings

Question 21

How does financial leverage effect ROE?

Answer 21

Financial leverage affects ROE by magnifying the return on equity when the Return on assets (ROA) is higher than the cost of debt.

Question 22

How does an increase in net income from financial leverage effect ROE?

Answer 22

An increase in Net Income from financial leverage increases ROE through ROA

Question 23

Why is interest special regarding taxation?

Answer 23

Interest is tax deductible and therefore lowers the effective cost of debt

Question 24

How are debt holders effected by firm performance?

Answer 24

Debt holders are limited to a fixed return regardless of performance whereas stockholders do not have to share profits if the business does exceptionally well

Question 25

What do higher debt ratios lead to?

Answer 25

Higher debt ratios lead to greater risk and higher required interest rates (to compensate for the additional risk)

Question 26

In event of default, what is the order of payments?

Answer 26

In the event of default, debt holders get paid first, followed by the preference shareholders, and then the holders of common equity

Question 27

What is the relationship between debt and risk?

Answer 27

Debt has a positive relationship with risk and higher return on equity

Question 28

How do changes in the capital structure affect shareholders?

Answer 28

Changes in the capital structure benefit the shareholders if and only if the value of the firm increases

Question 29

What does the optimal capital structure aim to achieve?

Answer 29

• Maximise firm value
• Lowest possible WACC

Question 30

What does the effect of financial leverage depend on?

Answer 30

Depends largely on the companies EBIT
- When EBIT is relatively high, leverage is beneficial

Question 31

What is the impact of leverage on shareholders?

Answer 31

• Magnifies returns to shareholders relative to the no leverage case
• Shareholders are more exposed to risk because EPS and ROE are much more sensitive to changes in EBIT

Question 32

Why is capital structure an important question?

Answer 32

Because the impact that financial leverage has on both expected return to shareholders and the riskiness of the equity

Question 33

What is homemade leverage?

Answer 33

The use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed