Chapter 10 - Capital structure

Question 1

What is the value of a firm considered to be?

Answer 1

The present value of the future cash-flows discounted at the weighted average cost of capital (WACC)

Question 2

Does a higher or lower WACC lead to a greater value in the firm and wealth of shareholders?

Answer 2

Lower

Question 3

What does the ideal level of gearing result in?

Answer 3

The lowest WACC

Question 4

What is cheaper, debt or equity?

Answer 4

Debt

Question 5

Why is debt cheaper than equity?

Answer 5

• Less risky

- Tax relief is available on debt

Question 6

Why does more debt increase the risk to shareholders?

Answer 6

Interest payments have to be made to the providers of debt finance irrespective of the level of profits generated.

Question 7

What is the name of the risk that arises due to more debt financing?

Answer 7

Financial or Gearing risk

Question 8

If there is a higher risk to shareholders then they will require what?

Answer 8

A higher return

Question 9

Having more debt will tend to increase what?

Answer 9

The cost of equity and hence the WACC

Question 10

Describe the tradition theory of gearing

Answer 10

• Initially the WACC will fall. This is because the benefits of the cheaper debt finance will outweigh the drawback of a rise in the cost of equity.
• Beyond a certain point, however, the drawback of more debt finance will begin to outweigh the benefits of debt finance. If further debt finance is raised beyond this point then the WACC will begin to rise.

Question 11

What is the traditional theory conculsion?

Answer 11

Under the traditional view there is one optimal capital structure point where the WACC is minimised and the value of the firm is maximised.

Question 12

Describe M&M’s theory of gearing with no tax

Answer 12

M and M argued that, in the absence of tax, a company is worth the present value of its future cash flows generated by its assets, irrespective how the earnings are returned to fund lenders i.e. dividend or interest.

Question 13

What is the assumption for tax with M&M’s no tax theory of gearing?

Answer 13

Tax is ignored

Question 14

What is the assumption for markets with M&M’s no tax theory of gearing?

Answer 14

Perfect market

Question 15

What is the assumption for DEBT with M&M’s no tax theory of gearing?

Answer 15

All debt is risk free

Question 16

What is the assumption for INVESTORS with M&M’s no tax theory of gearing?

Answer 16

Investors act rationally

Question 17

What is the conclusion of M&M’s theory of gearing with no tax

Answer 17

• There is no one optional capital structure solution

- WACC is not effected by capital structure

Question 18

Describe M&M’s theory of gearing with tax

Answer 18

Interest on debt is tax deductible therefore there is an advantage to having debt over equity finance

Question 19

What is M&M’s theory of gearing with tax’s ideal gearing level?

Answer 19

99.9%

Question 20

What is the conclusion of M&M’s theory of gearing with tax

Answer 20

Have as much debt as possible until gearing reaches 99.9%

Question 21

What result of high gearing did M&M ignore in relation to bankruptcy?

Answer 21

Increased risk of bankruptcy with high debt

Question 22

What result of high gearing did M&M ignore in relation to Tax exhustion?

Answer 22

Interest payments may exceed the profits

Question 23

What result of high gearing did M&M ignore in relation to borrowing?

Answer 23

There may be restrictions on borrowings in the articles of association

Question 24

What result of high gearing did M&M ignore in relation to cost of borrowing?

Answer 24

Increases in the cost of borrowing as the amount of debt rises

Question 25

What does pecking order theory state?

Answer 25

That a company will prefer retained earnings to any other source of finance.

Question 26

What is the order of preference in raising new funds with pecking order theory?

Answer 26

• Retained earnings
• Debt issue
• Equity issue

Question 27

What can the Risk adjusted cost of equity (or project-specific discount rate) be used to asses?

Answer 27

The risk of a project that is different from the companies usual activities