Ch.6 - Capital structure and assessing financing options

Question 1

What is operating and financial risk/gearing?

Answer 1

Operating gearing = Fixed costs/Variable costs
or
Operating gearing = Fixed costs/Total costs

Financial gearing = Debt/Equity
or
Financial gearing = Debt/(Debt + Equity)

• in practice, preference shares are treated as debt

Question 2

What is the no-tax theory of Modigliani and Miller (M&M)?

Answer 2

• based on the premise of perfect capital market (no transaction costs, no individual dominates the market, full information efficiency, all investors are rational and risk-averse, no taxes)
• as investors are rational, Ke is directly linked to the level of gearing -> as gearing increases, Ke increases in direct proportion which exactly offsets the benefit of cheaper finance
  => WACC remains UNCHANGED

Conclusion = WACC is unaffected by changes in gearing and therefore gearing is irrelevant

Question 3

What is the with-tax theory of Modigliani and Miller (M&M)?

Answer 3

• as no-tax theory apart from:
  a) debt is tax deductible so Kd is lower than before
  b) increase in Ke does not offset the benefit of the cheaper debt finance
  c) therefore WACC falls as gearing increases

Conclusion = WACC decreases with increasing gearing levels. Optimal capital structure is therefore 99.9% gearing.

Question 4

What are problems with high levels of gearing?

Answer 4

• increased bankruptcy risk
• tax exhaustion (tax shield on debt may not be enough is profits are not enough to cover interest costs)
• agency costs (directors may be more risk-averse than shareholders as their livelihood depends on the company remaining solvent)

Question 5

What are practical issues influencing levels of gearing?

Answer 5

• cost of raising finance
• asset quality (for use as security)
• loan covenants
• availability of other sources of finance
• levels of other risks (operational and industry risk)`

Question 6

What is the impact of gearing on beta factors?

Answer 6

Asset beta = reflects only systematic business risk
Equity beta = reflects asset beta adjusted for level of gearing

b(e) = b(a) * [1 + (D*(1-T)/E)]

Question 7

How to choose the appropriate beta for appraising project?

Answer 7

If the best beta available is from a geared company:

• find appropriate equity beta
• degear it to obtain asset beta (at that company’s gearing levels)
• gear it at own gearing levels

Question 8

How to calculate adjusted present value of the project (APV) when gearing levels have changes?

Answer 8

APV = base case NPV (discount @ Ke as if no gearing) + PV of the tax shield

*PV of tax shield = interest payments @ 17% discounted at Kd

Question 9

What are parts of business plan?

Answer 9

• front sheet
• contents page
• executive summary
• history and background
• mission and objectives
• products or services
• market information
• key business information
• financial information
• summary action plan
• appendices