Chapter 12 - Capital structure Flashcards
What is capital structure?
How a company is funded and the proportion of debt to equity
What are the disadvantages of debt?
- Financial risk
- Worsens liquidity and risk ratios
What are the advantages of debt?
- Cheaper source of finance
- Less impact on EPS
- Quicker and cheaper to issue
- Tax relief
- Signal of confidence
What is the formula for operational gearing?
Contribution / PBIT
What is the traditional theory?
There is an optimal capital structure. Debt gives a benefit up to this point
Why does WACC fall at the start in traditional theory?
Debt is cheaper and equity does not view low debt as higher risk
Is company value at its lowest or highest when WACC is at its lowest?
Highest
Why is debt cheaper?
- Tax relief
- Lower risk
Why does WACC rise past the optimum point in traditional theory?
High debt creates high risk so equity wants high returns
What does net operating income theory suggest (M&M without tax)?
The capital structure has no effect on WACC. This is because of the facts that debt is cheaper than equity and that cost of equity rises as gearing does, results in a cancelling effect.
What is arbitrage?
If two companies were identical aside from capital structure and had different values then investors could make a risk free gain by selling shares in a company with a higher value and buying from company with a lower value, so market values would move in line with eachother.
What does M&M with tax suggest?
WACC falls consistently as gearing rises due to savings from tax relief - a company should use as much debt finance as it can.
What are the drawbacks on net operating income theory?
- Assumes a perfect capital market exists in which investors have same information
- No tax or transaction costs
- Debt is risk free
What are the drawbacks on M&M with tax?
- Assumes debt is readily available
- Ignores indirect financial distress costs - customers may not want to buy from company with higher gearing as unstable
- At higher levels of debt providers are going to impose restrictive covenants
- Ignores tax exhaustion
What is the process for calculating marginal cost of capital?
- Ungear a proxy company
- Regear to beta to reflect gearing of project
- Calculate cost of equity using CAPM
