Chapter 6: Corporate Finance Flashcards
List the six main issues that will determine the type of finance that a company chooses to raise.
Six main issues that affect the type of finance raised
- the company’s size and location
- the company’s existing capital structure
- the relative cost (both in terms of arranging finance, and the ongoing cost in interest or dividends)
- the capital structure of competitors
- tax consequences
- market demand for particular types of security.
Give two equations (one for returns and one for beta) that help determine what the likely impact of gearing will be on a company’s systematic risk.
Two equations for determining impact of gearing
R equity = R assets + D/E * (R assets - R debt)
β equity = β assets + D/E * (β assets - β debt)
β assets is often referred to as the ‘ungeared’ equity beta.
A company is entirely equity financed and has a cost of equity of 12% pa. Its market capitalisation is £1bn and it raises £500m of new capital in the form of debt with a gross redemption yield of 6%.
Determine the likely cost of equity for the company after the issue and the company’s beta.
You may assume that the risk-free return is 4% pa and the equity risk premium is 6% pa.
Likely cost of equity
The cost of equity is given by:
R equity = R assets + D/E * (R assets - R debt)
R equity = 12% + 500m/1 000m * (12% - 6%) = 15%
Likely impact on beta
Currently the (ungeared) beta is given by:
R equity = Rf + β equity (ungeared) * (R market - Rf)
12% = 4% + β equity (ungeared) * (10% - 4%)
β equity (ungeared) = 1.333
The beta of the debt is given by:
6% = 4% + β debt * (10% - 4%)
β debt = 0.333
So
β equity (geared) = β assets + D/E * (β assets - β debt)
where:
β assets = β equity (ungeared)
β equity (geared) = 1.333 + 500/1 000 * (1.333 - 0.333)
State a formula for the weighted average cost of capital (WACC), and calculate its value in the circumstances of the previous flashcard assuming a corporation tax rate of 20%.
The WACC is given by:
WACC = D/(D+E) * R debt (net) + E/(D+E)* R equity
where:
R debt (net) is the cost of debt for the company, allowing for the corporation tax rebate
R debt (net) = R debt (gross) * (1 - T)
Using the ungeared situation in the previous flashcard, the company has only equity finance and therefore its WACC is 12%.
After raising debt, and allowing for the tax efficiency of debt, the WACC is:
= 500 / (500 + 1 000) * 6% (1 - 20%) + 1 000 / (500 + 1 000) * 15%
= 11.6%
Outline the impact of the amount of debt that a company has in the real world.
Real-world impact: level of gearing
Medium to low levels of gearing have no impact at all on a company’s cost of either debt capital or equity capital.
Above medium gearing levels, the costs of debt and equity rise more sharply than predicted in theory.
The result is that WACC initially falls when a company introduces debt into its capital structure, but at a certain level of gearing the WACC begins to rise again.
This leads to an ‘optimal’ gearing structure which minimises the company’s WACC.
State a formula that can be used to determine the ‘relative advantage’ of debt and equity. The formula incorporates both corporation taxes and personal taxes that shareholders and bondholders pay on receipt of dividends and interest.
Explain what conclusions can be drawn when using this formula, and what drawbacks exist when using the formula in the real world.
Relative advantage:
Relative advantage = (1 - tl)/{(1 - te)*(1 - tc)}
where:
tl: loan interest is taxed at rate tl
te: equity returns are taxed at an effective rate te
tc: equity returns are taxed at an effective rate tc
If the relative advantage is greater than one, then it is more efficient for the company to pay interest rather than dividends, and so the company should issue debt rather than equity.
Drawbacks
1. shareholders can reinvest profits rather than having them paid as dividends, which defers the tax and possibly avoids it altogether (allowances)
- different investors have different tax rates
- there are other ways of reducing taxes (eg pension contributions or accelerated capital allowances on certain investments).
List nine costs of financial distress.
(#CCCCF ROOM)
Costs of financial distress (#CCCCF ROOM)
Bankruptcy costs – direct
1. Court, legal and administrative fees
Bankruptcy costs – indirect
2. Costs of attracting and retaining staff, customers, suppliers
3. extra Costs of management
4. Firesale of assets by senior lenders attracts poor prices
Costs of financial distress without full bankruptcy
5. resolving Conflicts of interest
6. undertaking Risky ventures
7. failing to exploit Opportunities
8. Overpayment of dividends
9. Massaging of financial reports.
Explain the ‘trade-off’ theory of capital structure.
Trade-off theory of capital structure
On the one hand, companies can benefit from higher gearing, and the introduction of low-cost debt into the capital structure.
Corporation taxes are reduced, and shareholder returns can be increased.
On the other hand there are costs when a company gets close to financial distress.
The chances of financial distress increase with higher gearing.
Describe Modigliani & Miller’s (M&M) dividend irrelevance proposition, including the assumptions on which it is based.
M&M’s dividend irrelevance proposition
The market valuation of a company is unaffected by dividend policy.
M&M argued that, since an investor’s desire for additional cash could be satisfied by selling part of an existing investment holding, investors will not pay a higher price for shares of firms with high payouts.
Assumptions:
1. a perfect world (no market imperfections)
2. no taxes
3. no transaction costs.
State the more traditional view on dividend policy.
State a view that incorporates tax paid by investors.
Traditional view on dividend policy:
Shareholders value dividends more highly than retained earnings and so an increase in dividends will increase the market value of the company.
This is because cash dividends are certain, whereas retained earnings are not certain to increase the share price and give capital gains.
However, it is necessary to consider how a company’s dividend policy affects its operations (ie does it need to retain earnings to maintain its asset base?)
Tax angle:
Alternatively, higher dividends incur income tax (in addition to corporation tax) and therefore will reduce the value of a firm. This latter point only holds in a tax system where dividends are taxed twice, and not in an imputation system for example.
List nine practical issues that affect a company’s choice of dividend level.
Practical considerations that affect the dividend level
- target dividend payout ratios
- trends in long-run, sustainable earnings
- administrative and processing costs
- impact of changes in dividends on shareholders (who prefer stable dividends for planning purposes)
- wish to avoid future reductions in dividends
- the information content of dividend policy
- restrictive covenants on debt
- statutory restrictions
- whether the policy will be accepted by the shareholders.
List five alternatives to cash dividends.
Alternatives to cash dividends
- bonus issues (some free shares, nominal value stays the same; also called a scrip issue)
- share splits (each share splits into several shares, nominal value reduces)
- share repurchases (‘buybacks’)
- scrip dividends / scrips in lieu (similar to a very small scrip issue)
- dividend reinvestment plans.
It can be argued that bonus issues, scrip issues and share splits are not alternatives to a cash dividend, but in fact are methods of keeping the share price down within an acceptable range.
List the two aspects that will determine the levels of stock (inventory) that a company chooses to hold.
Levels of stock (inventory)
- the opportunity cost of holding cash balances
- the transaction cost of realising investments.
Outline four types of shares that a company can issue.
Four types of shares
- common stock / ordinary shares
– a ‘standard’ share entitled to dividends and rights to vote on company matters - preference shares
– a hybrid between bonds and equity, these pay a regular, known preference dividend and rank above common stock in the case of a wind-up but typically do not have voting rights - non-voting shares
– entitled to dividends but not to votes - founder or management shares
– shares with additional voting or control rights.
List five key services that a company might receive from a bank with which it has good relations.
Five key services from a bank
- credit assessments (of other parties the company may deal with)
- assistance with overseas transactions
- custodian services
- investment dealing (especially money market instruments)
- provision of loans and lines of credit.
