Chapter 6 - Financing: Capital structure

Question 1

How does a company maximise shareholder wealth?

Answer 1

Minimise its WACC, since a lower cost of capital will maximise NPVs and the value of a company

Question 2

As an entity increases its gearing, what two things happens to the cost of capital?

Answer 2

1. Debt is cheaper source of finance than equity so the WACC falls by introducing more debt
2. Equity holders perceive more risk caused by the increase in debt, so the cost of equity rises and hence WACC rises

Question 3

What is the traditional view of gearing?

Answer 3

Shareholder wealth is affected by changing the level of gearing
Optimal gearing ratio at which WACC is minimised and the total value of the company is maximised
Financial managers have a duty to achieve and maintain this ratio
While we accept that the WACC is probably U shaped for entities generally, we cannot precisely calculate a best gearing level
The optimum level will differ from one entity to another and can only be found by trial and error

Question 4

What is the key assumptions of Mordigliani and Miller’s (M & M’s) gearing theories?

Answer 4

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

Question 5

What is M & M’s no tax theory?

Answer 5

Absence of tax, the opposing factors cancel out exactly, so the WACC is constant at all levels of gearing

Question 6

What is M & M’s with tax theory?

Answer 6

Effect of tax is taken into account, the tax relief on debt interest causes the WACC to fall as gearing increases.

Question 7

What considerations should companies consider when determining their capital structures in the real world?

Answer 7

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

Question 8

What are some additional considerations for groups of companies?

Answer 8

Country risk - risk lower if an entity borrows funds in the country where it generates its net income
Type of finance provided by the parent
Tax issues - Maximise borrowings in regimes with the highest tax rate
Transfer pricing
Thin capitalisation rules - aims to stop companies from getting excessive tax relief on interest if they have entered into a borrowing with a related party that exceeds the amount a third party lender would be prepared to lend.