Capital structure policy Flashcards
What is capital structure?
A firm can raise funds by issuing both debt and equity securities - this mix is known as the capital structure
What is the cost of equity?
The return, the Equity investors require on their investment in the firm
what is ordinary equity?
Equity without priority for dividends, or in bankruptcy
what are preference shares?
Equity with dividend priority over ordinary shares, normally with fixed dividend rate, sometimes without voting rights
what is the cost of debt?
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.
What is the systematic risk of the equity?
Risk that cannot be diversified away
What is the risk free rate used for?
Frequently is used as a proxy: returns on short-term government bonds
What is does WACC stand for?
Weighted average cost of capital
What is the weighted average cost of capital?
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
What is the WACC simplified?
The rate that a company is expected to pay to finance all of it’s security holders and commitments to finance it’s assets
What markets should you go to for early-stage financing?
Private equity and venture capital markets
What do venture capital funds do?
They provide financing for new, often high-risk, ventures
What are the stages of financing?
- Seed money
- Start-up
- Later stage capital
- Growth capital
- Replacement capital
- Buyout financing
What is seed money?
A small amount of financing needed to prove a concept or develop a project (Not included in calculations)
What is start-up money?
Financing for firms that started within the past year. Funds are likely to pay for marketing and product development expenditures
What is later-stage capital?
Additional money to begin sales and manufacturing after a firm has spent its start-up funds.
What is growth capital?
Funds earmarked for a firm to enable it to reach its potential and achieve successful growth
What is replacement capital?
Financing for a company to buy out other investors to the firm
What is buyout financing?
Money provided for managers and outside investors to acquire a fully functioning firm
How does an IPO work?
- 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
How does financial leverage effect ROE?
Financial leverage affects ROE by magnifying the return on equity when the Return on assets (ROA) is higher than the cost of debt.
How does an increase in net income from financial leverage effect ROE?
An increase in Net Income from financial leverage increases ROE through ROA
Why is interest special regarding taxation?
Interest is tax deductible and therefore lowers the effective cost of debt
How are debt holders effected by firm performance?
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
What do higher debt ratios lead to?
Higher debt ratios lead to greater risk and higher required interest rates (to compensate for the additional risk)
In event of default, what is the order of payments?
In the event of default, debt holders get paid first, followed by the preference shareholders, and then the holders of common equity
What is the relationship between debt and risk?
Debt has a positive relationship with risk and higher return on equity
How do changes in the capital structure affect shareholders?
Changes in the capital structure benefit the shareholders if and only if the value of the firm increases
What does the optimal capital structure aim to achieve?
- Maximise firm value
- Lowest possible WACC
What does the effect of financial leverage depend on?
Depends largely on the companies EBIT
- When EBIT is relatively high, leverage is beneficial
What is the impact of leverage on shareholders?
- 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
Why is capital structure an important question?
Because the impact that financial leverage has on both expected return to shareholders and the riskiness of the equity
What is homemade leverage?
The use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed