Captial Structure

Question 1

Why might the share price after rights not be TERP?

Answer 1

1. Investors may have different expectations of the company now
2. Rights not fully taken up
3. Stock market conditions
4. Market could be using different valuation methods e.g. earnings multiple
5. Market may not be efficient

Question 2

Pros of rights issues

Answer 2

1. Reduces gearing
2. Flexibility on paying dividends
3. Non taxable for shareholders unlike dividends

Question 3

Cons of rights issues

Answer 3

1. Dilutes current shareholders holding if rights not fully taken up
2. Riskier than debt > higher cost of capital
3. Issue costs could be high
4. May cause earnings per share to fall
5. Reduces gearing
6. Shareholder reaction could be bad
7. Difficult to use if company not listed

Question 4

Advantages of convertible debt

Answer 4

1. Lower interest rate
2. Attractive to investors interested in buying shares in the future
3. Short term gearing, could reduce WACC
4. Relatively cheap way to issue shares
5. Fewer covenants than bank loans normally
6. Doesn’t dilute shareholder value initially but could do when converted

Question 5

The forms of market efficiency?

Answer 5

1. Weak - market has complete information about past events only
2. Semi strong - market has all information available to the public
3. Strong - market has all information that exists, suggesting insider trading.

Question 6

What are the considerations for dividend policy?

Answer 6

1. MM = pattern of earnings is irrelevant over time
2. Pecking order theory = retained earnings are the cheapest source of finance, which dividends often use up
3. Resolution of uncertainty = people prefer dividends now
4. Signalling = a stable or increasing dividend could show investor confidence
5. Clientele = some shareholders may prefer a dividend others a capital gain
6. Tax = some people may prefer capital gain or dividend depending on their tax affairs
7. Transaction costs of manufacturing dividends (MM) by selling shares = therefore dividend is preferable
8. Reduction in agency problems = paying out as dividends easy resource available for projects, so will have to justify each project

Question 7

What is the formula for MM I?

Answer 7

Value geared = Value ungeared

Question 8

What is the formula for MM II?

Answer 8

Value geared = Value ungeared + Value of tax shield - Bankruptcy costs

Question 9

What are the main restrictions on loan covenants?

Answer 9

1. Restriction on issuing new debt
2. Restriction on issuing new shares
3. Restriction on merger activity
4. Restriction on investment policy
5. Restriction on dividends
6. Financial covenants (gearing, interest cover)

Question 10

What are the restrictions to debt?

Answer 10

1. Bankruptcy costs
2. Agency costs
3. Tax exhaustion

Question 11

Elements of a business plan?

Answer 11

• Executive summary
• History
• Mission statement
• Product/services
• Market information
• Resources employed (e.g. CVs, premises)
• Ratios
• Sensitivity analysis
• Forecasts
• Cash flows
• Action plan
• Appendices

Question 12

Financing question format?

Answer 12

FAT PRICE

1. Financial risk
2. Analysis and discussion
3. Theory (MM I, II)
4. Practical gearing
5. Ratios
6. Industry averages
7. Conclusion
8. Easy marks

Question 13

Assumptions of WACC?

Answer 13

1. Historic proportions of debt to equity haven’t changed
2. The operations and the risk associated with the company haven’t changed (business risk - unlevered firm)
3. The financing isn’t project specific.

Question 14

What could affect the actual share value after a rights issue?

Answer 14

1. Market’s reaction
2. Will they take up the rights?
3. Is there a positive NPV project that could be added into the value?