Chapter 6 Flashcards
What is business risk?
Variability in earnings before interest and tax, comprising systematic business risk (cannot be diversified) and unsystematic business risk
What is financial risk?
Additional variability in earnings after interest and tax as a result of having fixed interest debt in the capital structure
Equity holders take this risk in particular but debt holders also suffer financial risk at higher gearing levels
What is operational gearing? What does this mean in relation to company profits?
The extent to which a firms operating costs are fixed as opposed to variable
Having a high proportion means that the company’s profits are very sensitive to changes in sales volumes and contributes to business risk.
What is financial gearing and what two ways can it be measured?
Extent to which debt is used in the capital structure. Higher financial gearing is associated with high financial risk
Capital terms:
Debt/ equity or debt/debt + equity
Income terms:
EBIT/interest
Why is debt cheaper than equity? 4
Debt general secured
Returns received by debt holders are more certain (interest instead of dividends)
Debt may be redeemable
Debt holders paid before shareholders should business fail.
Interest payments are tax deductible
What happens if gearing increases?
Ke increases due to inc financial risk. This pushes up value of WAAC
Proportion of debt relative to equity in cap structure increases. Since I’d<le this pushes down the value of WAAC
What does the traditional view of cap structure state?
As debt is introduced into cap structure, WAAC will fall because initially the benefit of cheap debt finance more than outweighs any increases in the cost of equity required to compensate equity shareholders for higher financial risk
As gearing continues to increase, equity holders will ask for higher returns and eventually this increase will start to outweigh benefit of cheap debt finance. WAAC will rise
At extreme levels of gearing the cost of debt will also start to rise (as debt holders become worried about the security of their loans) and this will also contribute to increasing WAAC
What does the M&M theory of 1958 state?
Capital markets are perfect
Investors are rational and risk averse
There are no transaction costs
Debt is always risk free
There is no taxation (removes tax benefit of paying interest and means that the total payments to investors will be the same for equivalent companies with and without debt leading to assertion that:
Value of debt + value of equity in geared firm = value of equity in equivalent in geared firm.
Summarise M&Ms initial views?
As debt introduced, equity rises
Without any tax savings on interest payments, the benefit of extra cheap debt is only enough to offset inc cost of equity
Hence WAAC remains unchanged and there is no optimal capital structure
What is the M&M theory of 1963 show?
In the presence of corp tax it is advantageous for firms to issue debt.
Effect of interest being allowable against tax means that geared companies pay less tax. Means geared companies will have more cash to pay out to investors and therefore are worth more
Optimal cap structure is therefore a geared one
Value of debt + value of equity in geared firm = value go equity in equivalent ungeared firm + tax shield on debt where T is corp tax and D is the market value of the geared firms debt.
Means benefits of increasing amounts of debt reduce the WAAC and this is less than offset by increasing returns required by shareholders which push up the WAAC
What 3 real problems were ignored in M&Ms 1963 theory?
Advocating high levels of gearing ignored issues of high levels of gearing:
Bankruptcy costs: at high levels of gearing investors demand higher returns to compensate for the risk the company being unable to pay them back. Also includes liquidation sits, redundancy payments and assets being sold for less than book value
Agency costs: in order to prevent directors acting in the interests of shareholders over lenders, loan covenants will often restrict actions of the directors in high gearing situations. May restrict directors from issuing debt, paying dividends, mergers of new investments
Tax exhaustion: int payments have a tax benefit due to payments being tax deductible. However, once taxable profits are zero, there is no tax benefit from any additional payments
How is CAPM linked to gearing? What formula links them?
Geared company has greater exposure to systematic risk than an inidical ungeared company and will therefore have a higher cost of equity
Beta score of a geared company is greater than the beta score of an identical ungeared company.
Be= ba (1+d(1-t)/ e)
D is mv if debt in company and E is the mv of equity
What do you do if business risk changes? There are 7 steps
If company invests in new project in a different industrial sector, then it is exposed to new business risks
- Locate suitable proxy company (operating in industry area)
- Determine equity bets of the proxy company, gearing and tax rates
- Ungear proxy equity bets to obtain asset beta for new industry sector:
Ba= be/(1+D(1-t)/e)
- Regear the asset beta using our gearing:
Be = ba(1+D(1-t)/e)
- Use CAPM to calculate project specific cost of equity
- Use this cost of equity to calculate a new project specific WAAC (be told the ratio of debt to equity used to calculate this)
- Use this new project specific WAAC to evaluate the new project
What do you do if the capital structure changes? Adjusted present value
If cap structure changes, the existing WAAC can no longer be used due to changes in financial risk
APV approach can be used to address the problem by using the assumptions of 1963:
Calculate base case value of project using Keu (giving value of the project if the company was ungeared) . May need be to calculate Keu using CAPM
Add present value of tax shield (PV of the tax saving interest discounted at the pre tax cost of debt)
Deduct costs of issuing finance to arrive at the APV
IF APV is positive proceed with the project
What is the problem with the APV approach?
Based on assumptions of M&M with tax. That means that issues such as agency costs, bankruptcy costs and tax exhaustion are not reflected in this technique
