Chapter 6

Question 1

How should a company maximise shareholder wealth?

Answer 1

Minimise WACC

Question 2

Traditional view on gearing conclusion

Answer 2

Shareholder wealth is affected by changing the level of gearing
Optimal gearing ratio at which WACC is minimised
Finance managers have a duty to acheive and maintain this ratio
Optimum leve will differ from one entity to another

Question 3

M & M’s key assumptions

Answer 3

Exists a perfect capital market in which there are no information costs or transaction costs
Debt is risk free and Kd remains constant at all levels of gearing
Investors are indifferent between personal and corporate gearing
Investors and companies can borrow at same rate

Question 4

M & M’s with tax theory

Answer 4

Tax relief on debt and interest causes WACC to fall
Optimum gearing level is 99.9% of debt

Question 5

Main practical considerations when determining capital structure in the real world

Answer 5

Debt capacity
Existing debt covenants
Increasing costs of debt finance as gearing rises
Tax exhaustion
Views of other stakeholders

Question 6

Additional considerations when structuring the debt/equity profile of group companies

Answer 6

Country risk
Type of finance provided by the parent
Tax issues
Transfer pricing
Thin capitalisation rules