chapter 6

Question 1

Business risk

Answer 1

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

Question 2

Financial Risk

Answer 2

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

Question 3

Operating gearing

Answer 3

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

Question 4

Financial gearing

Answer 4

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

Question 5

Gearing - measured in capital terms

Answer 5

debt/equity or debt/debt+equity

Question 6

Gearing - income terms

Answer 6

EBIT/Interest

Question 7

Two impacts of gearing increasing

Answer 7

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

Question 8

What is the traditional view of gearing

Answer 8

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

Question 9

MVE + MVD =

Answer 9

Earnings (1-T)//WACC

Question 10

MM 1958

Answer 10

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

Question 11

Implications of MM 1958

Answer 11

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

Question 12

MM 1963

Answer 12

In the presence of corporation tax, advantageous to issue debt

Question 13

MM 1963 Value of geared firm

Answer 13

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

Question 14

Implications of MM1963

Answer 14

WACC falls as gearing increases
optimal gearing 100% debt

Question 15

Problems associated with high levels of gearing

Answer 15

Bankruptcy costs
Agency Costs
Tax exhaustion

Question 16

Bankruptcy costs

Answer 16

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

Question 17

M&M with bankruptcy costs

Answer 17

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

Question 18

Direct costs of bankruptcy

Answer 18

• 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

Question 19

Indirect costs of bankruptcy

Answer 19

Relate to problems of operating company under severe financial distress

Question 20

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

Answer 20

• 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

Question 21

Loan covenants - restrictions on issuing new debt

Answer 21

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

Question 22

Loan covenants - restrictions on dividends

Answer 22

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

Question 23

Loan covenants - restrictions on merger activity

Answer 23

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

Question 24

Loan covenants - restrictions on investment policy

Answer 24

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

Question 25

Tax exhaustion

Answer 25

at certain level of gearing, may have no taxable income left to offset interest charges against.

Question 26

Capital structure and business risk

Answer 26

Gearing adds financial risk on top of business risk, therefore higher business risk lower gearing

Question 27

Capital structure and bankruptcy

Answer 27

Bankruptcy costs have higher change of being incurred at higher levels of gearing

Question 28

Capital structure and quality of assets

Answer 28

lenders want security, firms with more tangible assets can often borrow more

Question 29

Capital structure and availability of other sources of finance

Answer 29

Small firms may be limited in terms of external finance so are forced to use equity

Question 30

Capital structure and cost of raising finance

Answer 30

Retained earnings - zero
Loan finance - Cheap compared to equity
Equity - expensive

Question 31

Capital structure and tax rate

Answer 31

Higher tax rate higher tax relief on interest

Question 32

Gearing tends to be a lower factor if business risk is

Answer 32

Higher

Question 33

Gearing tends to be a lower factor if bankruptcy risk is

Answer 33

Higher

Question 34

Gearing tends to be lower if tax exhaustion on

Answer 34

low taxable profits

Question 35

Gearing tends to be lower If assets are mainly

Answer 35

intangibles

Question 36

Gearing tends to be lower if access to debt finance is

Answer 36

Litte

Question 37

Gearing tends to be lower if tax rates are

Answer 37

low

Question 38

Signalling effect

Answer 38

Raising debt could signal confidence to investors, as the directors are signalling they are confident about the future to commit to interest paymments

Question 39

Clientele effect

Answer 39

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.

Question 40

APV Steps

Answer 40

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

Question 41

Issues with APV

Answer 41

Based upon M&M with tax, agency costs, financial distress not reflected

Question 42

Geared companies will have … 𝝱

Answer 42

Higher
as financial risk applies systematically and cannot be diversified

Question 43

Cash forecasts provide early warning of liquidity problems by estimating

Answer 43

How much cash is required
when it is required
how long it is required for
whether it will be available