chapter 6 Flashcards

1
Q

Business risk

A

the variability in earnings before interest and tax associated with the industrial sector in which a firm operates

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2
Q

Financial Risk

A

Additional variability in returns as a result of having fixed interest debt in the capital structure

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3
Q

Operating gearing

A

Extent to which operating costs are fixed, high operating gearing firms have high fixed costa low variable costs and high contribution, so sensitive to change in sales volume

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4
Q

Financial gearing

A

extent to which debt is used in the capital structure - measured in capital terms (debt/equity or debt/debt+equity) or income terms (EBIT/Interest

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5
Q

Gearing - measured in capital terms

A

debt/equity or debt/debt+equity

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6
Q

Gearing - income terms

A

EBIT/Interest

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7
Q

Two impacts of gearing increasing

A

Ke increases as financial risk increases
Debt proportion increases relative to equity, as Kd<ke WACC down

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8
Q

What is the traditional view of gearing

A

When debt introduced, WACC will fall as cheaper debt outweighs increased KE
as debt increases, KE increases and this will outweigh cheap debt, WACC will rise
extreme levels, kd will also start to rise, WACC increases further

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9
Q

MVE + MVD =

A

Earnings (1-T)//WACC

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10
Q

MM 1958

A

No corporation tax, no advantage to issue debt
Value of an un-geared firm = value of geared firm

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11
Q

Implications of MM 1958

A
  • WACC is constraint regardless of gearing
  • no optimal level of gearing (benefit cheap debt offset by ke)
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12
Q

MM 1963

A

In the presence of corporation tax, advantageous to issue debt

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13
Q

MM 1963 Value of geared firm

A

= value of unguarded firm + D*T
where D is mv of debt, T is tax

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14
Q

Implications of MM1963

A

WACC falls as gearing increases
optimal gearing 100% debt

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15
Q

Problems associated with high levels of gearing

A

Bankruptcy costs
Agency Costs
Tax exhaustion

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16
Q

Bankruptcy costs

A

As take on more debt, risk of insolvency increases, investors concerned and sell holdings, so value of securities fall.

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17
Q

M&M with bankruptcy costs

A

MV = Value if all equity + value of tax shield - bankruptcy costs

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18
Q

Direct costs of bankruptcy

A
  • Assets realise less than economy value as sold at less than GC value when liquidated
  • GC value > winding up value, loss borne by debt holders
  • As compensation, investors want higher rate of return
19
Q

Indirect costs of bankruptcy

A

Relate to problems of operating company under severe financial distress

20
Q

Agency problems - managers act in interest of shareholder and increase indirect cost of bankruptcy through

A
  • paying large cash dividends (at expense of debt holders)
  • hide financial state by cutting back on research, maintenance - improve this year at expense of next year
  • May negotiate a loan for safe investment project and use funds for more risky investment
  • Arrange further loans increasing risk
21
Q

Loan covenants - restrictions on issuing new debt

A

prevent issuing new debt with superior claim on assets unless existing debt is upgraded to same priority, or minimum asset backing maintained

22
Q

Loan covenants - restrictions on dividends

A

Dividend growth usually required to be linked to earnings growth, repurchase of shares often also restricted

23
Q

Loan covenants - restrictions on merger activity

A

May be prohibited unless post-merger asset backing maintained at minimum prescribed level

24
Q

Loan covenants - restrictions on investment policy

A

restrict investments in other companies, restrict disposal of assets, requirements for maintaining assets - hard to monitor

25
Tax exhaustion
at certain level of gearing, may have no taxable income left to offset interest charges against.
26
Capital structure and business risk
Gearing adds financial risk on top of business risk, therefore higher business risk lower gearing
27
Capital structure and bankruptcy
Bankruptcy costs have higher change of being incurred at higher levels of gearing
28
Capital structure and quality of assets
lenders want security, firms with more tangible assets can often borrow more
29
Capital structure and availability of other sources of finance
Small firms may be limited in terms of external finance so are forced to use equity
30
Capital structure and cost of raising finance
Retained earnings - zero Loan finance - Cheap compared to equity Equity - expensive
31
Capital structure and tax rate
Higher tax rate higher tax relief on interest
32
Gearing tends to be a lower factor if business risk is
Higher
33
Gearing tends to be a lower factor if bankruptcy risk is
Higher
34
Gearing tends to be lower if tax exhaustion on
low taxable profits
35
Gearing tends to be lower If assets are mainly
intangibles
36
Gearing tends to be lower if access to debt finance is
Litte
37
Gearing tends to be lower if tax rates are
low
38
Signalling effect
Raising debt could signal confidence to investors, as the directors are signalling they are confident about the future to commit to interest paymments
39
Clientele effect
Particular shareholders may be satisfied with existing level of gearing, if this changes, they may sell shares. new investors may be happier with new gearing and buy if gearing changes.
40
APV Steps
1. Give base case value using ke (unguarded) 2. Establish PV tax shield - appropriate discount is pre tax cost of debt 3. Adjust for the costs of issuing
41
Issues with APV
Based upon M&M with tax, agency costs, financial distress not reflected
42
Geared companies will have ... 𝝱
Higher as financial risk applies systematically and cannot be diversified
43
Cash forecasts provide early warning of liquidity problems by estimating
How much cash is required when it is required how long it is required for whether it will be available