FI 11 Capital Structure Flashcards
Define optimal capital structure
The % mix of debt and equity that minimizes the overall cost of capital
Two factors that influence optimal capital structure
- amount of debt available to an entity and its related costs
- the change in cost of debt and equity as debt is added
Define financial leverage. What does a greater financial leverage indicate?
The proportion of debt in relation to the proportion of equity that has been used to finance a company. The greater the leverage, the higher the proportion of debt.
+/- about being highly leveraged
+ if business is profitable, higher returns for shareholders as debt payments are fixed
- more risky as company may not be able to repay it’s obligations
Two factors that amount of debt depends upon
- nature of company’s operations and its assets
- level of probability that entity will suffer financial distress
Two factors that influence amount of debt a company can attract
- level of volatility of operating cash flows. higher = less debt because this needs to be paid even when cash is scarce.
- amount and type of assets owned. more assets = higher debt as likely they will be used for collateral.
What do companies strive for in terms of debt/equity mix?
max debt as it is always cheaper than equity. however, this increases chance of financial distress and bankruptcy.
Tax considerations - interest
Interest paid on debt is tax deductible, on dividends it is not
Define financial risk for equity investors
The decrease in amounts paid out to shareholders when debt is added, as debt must be repaid before net income to shareholders
M&M proposition formula and when can it be used
Re = Ru + D/E(Ru – Rd)(1 – T)
where
Re is the cost of equity Ru is the cost of equity when the entity is unlevered (no debt) Rd is the entity's cost of debt D/E is the existing debt-to-equity ratio for the company based on market values, not book values.
Only be used when prob of distress is and its related costs are low
M&M proposition 1 formula and assumptions
VL = Vu + TD
where
VL is the value of the levered firm Vu is the value of the firm in the unlevered state (all equity-financed) T is the corporate tax rate D is the amount of borrowed debt
assuming no new investments made and any debt issued is used to buy back equity
As interest is tax deductible, what is the tax benefit that companies achieve when adding debt?
the income tax rate x the interst charge (T x i x D). Value of company increases by PV of future amounts of tax benefits to be received.
Tax benefit / discount rate = (T × i × D) / i = TD
