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FM - Financial Management > Chapter 18 - Capital Structure > Flashcards

Chapter 18 - Capital Structure Flashcards

1
Q

what is operating gearing?

A

a measure of the extent to which a firm’s operating costs are fixed rather than variable as this affects the level of business risk in the firm

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2
Q

What are the operating gearing calculations?

A

Fixed costs / Variable costs

Fixed costs / total costs

% change in EBIT/ % change in rev

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3
Q

At higher levels of gearing what happens to fixed costs?

A

the higher the proportion of fixed costs and the riskier the EBIT

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4
Q

What is financial gearing?

A

a measure of the extent to which debt is used in capital structure

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5
Q

Are preference shares usually debt or equity?

A

debt

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6
Q

What is the calculation for the equity gearing ratio?

A

Debt / Equity

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7
Q

What is the calculation for the capital gearing ratio?

A

Debt / Total capital

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8
Q

What is the calculation for the interest gearing ratio?

A

Debt interest / operating profit before debt interest and tax

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9
Q

What values can be used when calculating financial gearing?

A

the nominal (book) values or market values

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10
Q

If nominal values are used what must be remember to include?

A

include reserves in the value of equity

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11
Q

A company with a higher level of financial gearing will have increased what?

A

variability of returns to shareholders

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12
Q

Increase in gearings represents what?

A

An increase in risk for the equity investor

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13
Q

For ordinary (equity) shares or for preference shares, the total market value is calculated as what?

A

number of shares in issue x ex-dividend share price

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14
Q

what is the calculation for equity nominal value on ordinary (equity) shares?

A

add up the value of any share capital, share premium and equity reserves on the SFP

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15
Q

what is the calculation for equity nominal value on preference shares?

A

add up the value of any share capital and share premium on the SFP

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16
Q

what is the calculation for debt market value for tradeable debt such as companies issued with loan notes?

A

number of loan notes in issue (divide by 100) x ex-interest price per loan note

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17
Q

what is the calculation for debt market value for non- tradeable debt such as companies issued with loan notes?

A

there will be no market value, use the nominal value instead

18
Q

what is the calculation for debt nominal value for trade-able and non-tradeable debt?

A

take figure from the SFP

19
Q

What is the MV of a company equal to?

A

PV of its future cash flows discounted at the WACC

20
Q

If WACC falls what happens to the business value?

A

business value will rise

21
Q

As proportion of debt increases what will happen to the WACC?

A

debt is cheaper source of finance (lower risk and tax relief on interest) so the WACC falls

22
Q

As proportion of equity increases what will happen to the WACC?

A

the equity holders perceive more risk caused by the increase in debt, so the cost of equity rises and WACC rises

23
Q

What is the traditional view based on?

A

a real world observation

24
Q

What are the traditional view conclusions?

A
  • shareholder wealth is affected by changing the levels of gearing
  • there is an optimal gearing ratio at which WACC is minimised and the total value of the company is maximised
  • financial managers have a duty to achieve and maintain
  • we accept that the WACC is probably U shaped for entities generally, we cannot precisely calculate a best gearing level
  • optimum level will differ from one entity to another and can only be found with trial and error
25
Q

What are M&M’s key assumptions?

A
  • a perfect capital market in which there are no information or transaction costs
  • debt is risk free and kd remains constant at all levels of gearing
  • no taxation
26
Q

What is M&M’s no tax theory?

A

in the absence of tax, the two opposing factors cancel out exactly, so the WACC (and business value) is constant at all levels of gearing

27
Q

What is M&M’s no tax theory but with tax?

A

the tax relief on debt interest caused the WACC to fall (and business value to rise) as gearing increases

28
Q

What is the implication of the M&M theory with taxation?

A

the optimum gearing level is 99.9% debt

29
Q

In practice, firms are rarely found with very high levels of gearing. Why is this?

A
  • bankruptcy risk
  • agency costs
  • tax exhaustion
  • the impact on borrowing/debt capacity
  • difference between risk tolerance levels between directors and shareholders
  • restrictions in the articles of association
  • increase in the cost of borrowing as gearing increases
30
Q

What is the pecking-order theory?

A

there is no search for an optimal capital structure through a theorised process

31
Q

In the pecking-order theory it is argued that firms will raise new funds in what ways?

A
  • internally generated funds
  • debt
  • new issue of equity
32
Q

What is the calculation for the dividend valuation model and current WACC?

A

re = (Do(1+g) / Po) +g

33
Q

When would we use the dividend valuation model?

A

to estimate a cost of equity if:
- there is no change in trade
- there is no change in gearing
- funding is not project specific

34
Q

What is the CAPM calculation?

A

E(ri) = Rf + Bi [E(rm) - Rf]

35
Q

Use the CAPM to estimate what?

A

a cost of equity if there is a change in the trade of the business, such as new project in a different business area

36
Q

The beta of the new trade will indicate what?

A

the level of systematic risk exposure, and drive the required return

37
Q

The CAPM uses a beta factor to represent what?

A

the systematic risk levels of the investment

38
Q

What are the 3 types of beta factors?

A

Asset Beta (Ba)
Equity Beta (Be)
Debt Beta (Bd)

39
Q

What is Asset Beta?

A

the beta for an un-geared company. represents the systematic risk of the business type only

40
Q

What is debt beta?

A

Usually 0 unless told otherwise

41
Q

What is equity beta?

A

the beta for a geared company
represents both the business risk and the financial risk (related to gearing levels) of the company

FM - Financial Management (20 decks)

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