Ch6 Capital structure and assessing financing options

Question 1

Define operating gearing

Answer 1

Measure of the extent to which the firm’s operting costs are fixed rather than variable:

Fixed costs / variable costs
OR
Fixed costs / total costs

Question 2

Define financial gearing

Answer 2

Measure of the extent to which debt is used in the capital structure:

Debt / equity
OR
Debt / debt + equity

Question 3

Outline the traditional view of gearing

Answer 3

At low levels of gearing:

1. Equity holders see risk as relitively unchanged
2. As debt is incorporated, WACC falls

At higher levels of gearing:

1. Equity holders see increased volatility in returns (as debt abd pref shares are paid first)
2. Ke starts to rise, increasing the WACC

At very high levels of gearing

1. Bankrupsy risk worrries equity and debt holders
2. Ke and Kd rise, so the WACC rises further

Question 4

Outline the Modigliani and Miller 1958 view of gearing

Answer 4

There is a perfect capital market

1. As investors are rational, Ke is directly linked to the increase in gearing
2. As gearing increases, Ke increases in direct proportion
3. The increase in Ke directly offsets the benefit of cheaper debt finance
4. Therefore the WACC remains unchanged

Conclusion: gearing is irrelevant as WACC is completely unchanged by it

Question 5

Outline the Modigliani and Miller 1963 view of gearing

Answer 5

Starts the same as MM 1958, but now with tax, so:

1. As debt is tax deductible, Kd is lower then before
2. The increase in Ke does not offset the benefit of cheaper debt finance
3. therefore WACC falls as gearning increases

Conclusion: optimal level of gearning is 99.9%

Question 6

List the three practical problems with high levels of gearing

Answer 6

1. Increased bankrupsy risk
2. Tax exhaustion (do they have profits to actually use the debt relief?)
3. Agency costs (a director is more risk averse as job relies on company remaining solvent).

Question 7

Formula for equity beta (Be)

Answer 7

Be = Ba (1+ (D(1-T)/E))

Question 8

APV definition and formular

Answer 8

Adjusted Present Value

1. Find the base NPV by using the dicoutn rate without any gearing
2. Add the PV of the tax shield from using debt finance, discounted at the pre tax cost of debt (i.e. the interest rate)