fiance lecture 9 - capital structure Flashcards
iwhat is business risk
risk operating profit will be different from expected duee to systematic influences on company’s business sector
two types of risk
business financial
what is financial risk
risk profit avaiable to SH will vary from expected dur to need to make interest payments
(distributable)
why may there be a risk of liquidation
high gearing
financial risk can lead to whta risk
bankruptcy
if we have a company operating in the same exact way but capital structure is different what risk will be the same and what risk will bediffernt
business - same
financial - different
the market has bad year and both companies make 2milly profit but one company got 8m interest to pay what happens
incur huge loss of 6mm
if can’t find cash call in loan and company go bankruptch
if copany goes bankrupt what do shareholders recieve
0
what happens if compnay goes into bankruptcy
miss out on profit company wiped out
profits avaialble to sh from redistributbable profit x and poitentialy due to what
varies
interest payments
and small fluctuations in business risk
if company not able to pay for interest what happnes
2 things
bankrupt + liquidate company
if i have 0 debt i have
0 financial risk
total risk =
business + fianncial risk
why would SH of a company w debt ask for a higher ROR than sh of comp w 100% equity
got more risk
return to investors =
cost to company
as soon as you introduced debt into a company what happens to bsuniess risk and fiancial risk
business risk - same
finacnial risk - increases
when you look at risk to equity holders you should thnk aboutt the
underlying risk to assets of company
if company has debt there is financial risk which is bore by
SH
IMPACT OF DEBT ON COST OF CAPITAL
If company gets a change in operating profit likely debt holders recieve .. and what would they recieve if it was in final year
coupon repayment b4 sh recieve dividend payment
principal repayment but SH recieve capital return
debt us a safer form of cpaital from whos POV and why
debt holder
get padi b4 SH
Issuing and transaction csots for debt genreally x than ordinary sahres
lower
it is slighty cheeaper for comany to raise
debt
debt interest is tax deductible so and expand
£1 of interst costs £ x 1-tax rate
so cost of debt capital to company is less than return required by debt holder due to tax shield
to sum why is debt finance cheaper than equity - 3 things
lower risk
lower issuing cost
tax shield
we may think if a company wants to max its profits it shte same as min costs and so shoudlahve as much debt as possible but we musnt forget
we may bring cost down by bringin debt into capital structure but this can have knock on effect on cost of equity becasue the more debt
the grater the bankruptcy risk
therfore required hihger ror
Gearing
ratio of debt in capital structure sometimes debt to equity sometimes det + equity
ungeared
no debt in captial struture
what does debt include
interest , bearing borrowings , lt debt , st debt anything payinginterest on borrowings
finacnial risk of return to ordinary share holders being different than expected due to
level of debt in caital structure of a company
debt magnifies the volatitly of the
operating profit
gearinf increases what risk
financial risk
what is important in identifying a suitable level of gearing
nature of industry
why does financial risk increase SH risk
they are residual claimant so finacial risk inreases SH risk
implication of high gearing - 3 things
volatility of profit/dividends
bankruptcy
need for ST cash
volatility of profit/dividedns
hgih gearing = high interest payments/finance charges
change in IR have significant impact profit after tax so more vulnerable to change and residual profit is waht SH care about
dividend ar risk if increase IR
SH bear greater risk if bearing risk ask for hgiher return q
bankruptcy
-whats the risk
- who may call in debt if compayn cant and waht is consequencw
- - effect of bankrutpcy on sh company…
risk of no cash left in company to pay debt holders and got principla/interst payments falling due
creditors amy call in debt if company cant pay em company goes into liquidation and then SH loose investment
any form of bankruptcy wipes out SH
LIQUIDITAION IS NTO THE SAME AS
ADMINISTRATION
What is adminisatration
tryna keep comp going for beenfit of employees and creditors so SH got nuttin to do w this
need for st cash - 4 things
what do company need cash for anf how much
can st cash intro change and how
what is the effect of this change
comp need enough cash to finance incestments
can cahnge priority of comp
so bringin in st cash becomes priority to avoid bankruotcy
so may not be able to make LT investments which wasintially your LT plan
value of a company
what you gain in debt you loose in
equity
overall effect is they offset each other so value of company should remain the same
value of company formula
cash flow(operating)/wacc
technically what is teh formula but waht do we assume
cash flow/r-g
g=0
to value the company all we need to do is
get overall operating cashflow
avaiabel to sh and debt holder then divided required ROR forboth debt and equit holders
WACC for both debt holdrs and equity holders ?
value of company other formula =
MVe + MV d
modigliani theory no tax
in a perfect capital market the market value of company not affected by capital structure
i.e so how we pay for the our 50m portolio shouldt affect value of assets
point is - it is teh value fo teh asets we care about not the structure of equity/liabilities
assumptions of modigliani theory no tax
-how is capital markets - how is the info available
- is ther liquidation costs
- how can idnfiduals borrow
oerfect caotal amrekts - so all stkh kow whats going on
perfect and complete info is avaiable to all
0 transaction costs
no financial liquidation csots
individuals can borrow as cheaoly as companies - so can create own leverage ratio
explain the graph with ke highest wacc straigh horizontal and kd straight
y axis - cost of capital
x axis - gearing
straight wacc line indicates that cashflow is fixed regardless of geariing
wacc is avg between kd and ke
wacc must be cost of equity because of some intersection, and at this intersection point debt must be 0
and if thats the ke then kd should be lower as debt is cheaper than cost of equity
cause at this point WACC becomes cost of equity ~
what is the other graph in modigliani and milller theory
y axis - value of copm
x axis - gearing D/E
straight line = kd
Graph 2 - what is not affectd by capital structure
assets of the company that count and mkt value of comp not affected by capital structure
graph 2 explain graph
at point x company got 0 debt so value of comp/asset = value of equity
add more debt as you move to the right hand side but youve still got the same amount of assets
total value fo debt and equity the same regardless of gearing ratio or debt in capital structure
as we increasse gearing we have more debt but its a 1 for 1 charge - £1 more of debt = £1 less of equity so cancel each other out
company value =
cash flow/WACC
Cash flow doesnt
change
as cash flow doesnt chane and value of copany stas he same then mathematically waht will happen to WACC
WACC is same
as value of company is not afffected by gearing
WACC mut also be a straight line
graph 1 and det must be cheaper than equity and casue we know kd will be consistent over differnt levles what do we draw
a straigth line
graph 1 what does vertical distance drom kd to WACC give us
Ke w no debt
so can put kd ahywhere but below intersection
graph 1 why is cost of debt a flat line
we got perfect ingot and cuz no bankruptcy cost no reason for debt to be expensive at diff levels of gearing
ke is an upward sloping line but we areen’t suprised why
more debt mroe financial risk therefore the bigger the risk and the higher total risk thsis increaes risk for SH meaning a higher ror so ke higher
when does waac become a straight avg calculation
we halfway through
50 50 point
at mid way point how should debt and equity be in relation to the other distancce wise
same dsitance cuz its an avg of the 2 points
the full ke line =
cost of equity
and so can apply this to other percentages
look at how to draw the graph
modigliani w tax
*differentiate between all the diff theoeries w learnt on a sheet at the end
modigliani w tax
tax exists and is signficantly cheaper than Ke - tax shield /paymetns being deductible so
so no tax theory is irrelevant and incorrect
modigliani no tax - if you’ve got debt in your company what is happenieng to cf and why
increase
when you get income this is taxed
and apparently interest payments are tax deductible
so tax billl faced by company with no dent will be higher than bill faced by copmany with debt in capital structure
the assumption in which we said comp value remains the same - why was that an assumption
cf stays the same
the assumption in which we said company value remains the same becasue cf stays he same isnt right when you introduce
taxes
why is the assumption copmany vaue reamins the same as cf stays the same not right when we introduce taxes
after tax cf are higher whe you have debts as opposed to when you don’t have debts
after tax cf to equity holders may be lower but what eles shoudl ew consider
the cashflow to debt holders
so if we aggregate all cashflow received by capital providers including debt and shareholders , because of tax shield for the debtt then what happens to aftertax cf for a company was a whole
will increasse when you intro/add debt to your capital structure
debt is cheaper cuz of
tax shield
what was modigliansis revised proposition
yes debt affects capital structure and in a radical way
expand on modiglianis revised propostion
valof company thats geared …
value of a company that’s geared and has got debt element in capital structure is = to the value of the company that’s ungeared w/o debt +value of tax shield
tax shield is simply = NPV of all the improvement to cf as a result of having a tax shield for interest payment cause of debt
what is the value fo ungeared company in symbol terms + transalte
Vg = Vu + TL
value of a geared company = value of an ungeared company(net assets) + corporation tax rate*value of borrowings(assume stay consistent forever)
TL = PV of tax shield
do example of VG = VU + TL
sum up modiglani and dem tings der
tax adds value and matters
what is graph 1 of the (with tax theory)
y axis - cost of capital %
x axis - gearing D/E
Ke - upward sloping line
WACC - downward sloping line
straight line kd(1-t)
what is graph 2 of with tax theory
value of a company - y axis
gearing D/E - x axis
line touchnig above 0 and going up horizontally
what does graph 2 of the with tax theory show
use exmaplar numbers
we have value of copany at 10bn with no debt as soon as we intro debt value of copmany increases cuz of tax shield
as you increase debt tax shield increases also
how mch is the ta shield
25%
what does a tax shield fo 25% mean
for every £1 you add 25% added value to the company
WACC w tax formula
D/D+E *Kd *(1-t) +
E/D+E *Ke
when we do 1-t what do we deal wirh
tax in the WACC not teh cashflow
aftertax cashflow inr eality is better and improved casue of
taxshield as we pay less tax
t/f our operating cf (Cash b4 we pay taxes) stays the same
t
why does operating cf stay the asme
got nothign to do w tax bill or the amount we pay , its operaitng progit whihc is b4 company pays tax
why is the WACC w tax lower
we deal w tax in WACC formula and incoroporate the beenfit of tax shield
casue we deal w tax in WACC by reducing WACC the operating cf that appear in company valution remains the ….
same regardless of leverage we have
if valu of company increeases and the cashflows are constant and the numebrator is contant mathematically what happesn to teh WACC
It goes down
a rising value must be assocauted with a
decreasing WACC
why must a rising value be associated w a decreasing WACC
we still have Ke increasing as gearing increases but we have a lower cost of debt due to tax shield
why should kd be lower on these graphs than previous ones (and lower than ke)
cheaper and less riskier
but now w intro of tax shield the already cheaper cheaper Kd is cheaper
(+ this explains the reduction in the weighted average cost of capital)
as we add more debt, equity which gets more expensive it is replaced w what
and also what does this replacement of more expensive equity by cheaper debt casue and therefore
cheaper debt
overall WACC to reduce in value
therfore we see a decline in WACC as we increase gearing of amount of debt
so to sum why is WACC downward slopign
debt more cheaper than equity
cause of tax shield as you add more debt ou are giving up £1 of equity
to gain £1 of debt
replacing mroe expensive equity w cheaper debt
conclude on the whole WACC debt matter
the more debt we have the WACC will always go down and if we add extra unit of det WACC will go down and comp value will increase
whats the issue/implicaito of mm theorem w tax
if adding debt increases company value then should fund company w 100% debt
as in order to max value of a copany you should max value of tax shield by adding as mcuh debt as possible - so entire capital should be debt
once you get to 100% gearing what does this mean
no equity to take residual risk for debt holders
debtholders take all residual risk
since debt holders takign all risk what do lenders do
demand higher risk premium
as taking equity risk also
as lenders take on all the equity what hhappens to kd line
it no longer applies
as once you get close to gearing ratio debt holders effectively become sh
so kd shoots up to csot of equity
what dod debt holders demand as a resuklt of a company capitla structure being 100% debt
bear entire risk so they would charge you a higher rate
effectively become sh
why cant a company be funded on 100% gearing
every copany must have an equity bassis then choose ho mcuh debt its gonna have
do summary of MM theorem w tax
gearing whihc produces wacc is 100%
at 100% gearing lenders are actually equity providers
lenders would percieve highe rrisk and demand hihgher return
unlikely to hold in practice
summary of 1856 theory no tax
value of copmany remains same irrespective of mix of debt and equity in its capital structure
an oprimal capital dont exist
mkt value depends on copmanys perfomrnce and business risk
summary of 1963 with tax
tax dedctibliiity of interest paments acknowledged
WACC decreases as gearing increasses
optimal capital structure 100% debt
as this dont happen in practice there must be other factos counteractin tax advantage e.g bankruptcy costs , agency costs tax echaustion
what si tax exhaustion
as incerase debt interest oaymens increase but poin
bruh just look on teh mondy pls
what is traditional viewe
at modest levels of gearing equity mostly wont rewuire addditoiinal retun threfore the WACC will reduce as cheaper debt is added
as gearing is increased both equity and debt holders require a hgiher returna dn WACC increases
there is an optimal value
what is relationship between financial risk and and ror/cost of equity
positive
lenders work on a loan to value ratio what does this men
x% of alue of assets you have , we gonna charge you a 5-10% interest rate so fixed to a certain point
once you go beyond prespecififed loan to value ratio either stop lending your moeny or cahrge a higher rate of interst
at low levels of gearing we see expensive equity being replaced by cheaper debt ehich does waht to WACC
Reduce it
as we keep increasing gearing at some point ke becomes so high and kd becomes more expensive that replacing it with waht will increase what
debt
will increase WACC
SUM UP DEBT AND WACC PLS - LOL I DUNNO HWO MAN TIMES IVE WRITTENT HIS
more debt reduces WACC up till a certain point ater tha it increases WACC
so there is an optimal lelve
how does the trad graph llook
y axis - cost of capital
x axis - gearing D/E
ke curve upward slop
WACC - slight U bucket shape
kd straight then rises
otimal oint is wheer WACC is at the minimum
outoine the KE on teh trad view graph
@ earlier stages of gearing as we add mroe debt carrying risk but not signfificant to SH so they ask for sligjtly higher rate hence ke increaseut not too stepp
later at higher levels of leverage SH tend to start facing bankruptcy cost of inaicla risk that they dramatically increases ROR
explain d on graph
till we get to x (dotted line from minimum point)
bank charges same flat rate but as soon as you pass prepsec threshold bank will say we dont liek tha so we not gone lend you/be charged at a highe rinterest rate
so significant increase in cost of debt once company moves beyonf prespecified loan to value ratio
explain WACC
U shaped cuz if got to have amimium
if we minimise our disocunt rats which is weighted ACC then we must be maxing value of firm
as cf/wacc if min discount rate and cf constant we’ll be maing val of company
so point x is optimal value - as it gives us mini wieghted ACC
minimum weighted WACC gives us
max val of copmany
in the trad view of WACC explain why wacc falls then rises
intially fall due to benefit of having greater amount of cheaper debt outweighs increased cost of equity ( as a result of greater risk
continues to fall till reaches optimal value
ater x as you add more debt equity becomes so expensive benwfits of having cheaer amount of debt outweigh no longer outweighs the increase in Ke so WACC tend to go up beyonf this point
what is the trad view each 2 - check this on moodle because the line doesnt actually have a label
y axis return %
x axis debt/equity
bucket u shape but more narroe
draw dot from the middle down - optimal should be the line going down
left side - impetus to add debt
right side oimpetus to decrease sebtr
what are the notes on impetus to add de bt
ereduced cost of eebt
tax rlief on debt
what are the notes on impetus to decrease dbt
financial distress/bankruptcy cost
agency costs
the trad approach whihc is a combo of oth series say
benefits to adding debt from an unleverged positoin up to optimal point ass Kd lower than Ke + we get a tax shield so adv of having debt lead to decrease in weighted avg cost of capital
what are the negatives of adding debt past optimal poitn
there are finaical disress and bankrupty costs and other costs(e.g. advisors, legal fees
in real world if got to sell all assets throguh bankruptcy probably won’t get afair value
when managermt under water w debt they not incentivised to do the right thing - what do they do instead
crazy thinkgs not in line w interest of SH or stkh of company
in right hand zone impetus to add debt how do you add value
and so if you to far right …..
decreasing debt
if you tot eh far right and you reduce debt youre reducin your WACC but if jkeep adding debt you increase WACC which reduces aue of cop
keyy point from trad view graph 2
Min possible WACC leads to max possible value
if on extreme of left add debt if on right reducce debt to REDUCE WACC
trad view graph 3
y axis - firms value
x axis - debt/equity
curve touches y axis and tehn springs over in an inveerse U shape
from teh middle draw dotted line to get to optimal
what does trad view graph 3 show
increae val of firm up to optimal point by adding and benefitting from debt and cheaper tax shield
if push leverage beyond optimal valu wew destroting value as WACC increases
summary of trad view (3)
optimal capital structure corresponds to min possible weighted avg cost of capital
if managment want to maximise SH value and wealth - val of fim which corresponds to min WACC must target optimal debt to equity ratio whicch gives minimal WACC which increases max val of firm
what are the 4 capital structure considerations
agency costs
signalling effect
clientele effect
industry norms
what are agency costs
principal agent problem
managment w debt overhang may take freater risk
deep in debt all earnings from projec go to existing debt holder leaving v little incentive for management or SH to do teh right thing
so maangment may take excesiveky riky prokects w high return in teh case they think project succcesful and so oncce they pay debt hlders there’s chacne suttin left for sh
but if project fails and is unsuccesful they don’t got much to loose as most of loss bore by debt holders
sum agency cost
too much debt can ipact company value if managment engage in excessivley risky projects as they feel like got nothing to loose as majority of risk bore by debt holders
signallign effect
issuing debt implies confidence about future to cashflow
as you wont isssue debt if you not confident if you can easily make interst payments
otherwise you’d be walking straight into bankruptcy
confident in companies ability to pay financial obligation
clientele effect
existing client sahppy w existing capital structure
so change can cause some to sell/buy if large scale can impact company valuation
industry norms
caopital structure depnds on teh type of copnay and industry
e.g norm for utility industry if got 80-90% leverage
whereas retail having this kind of thing will be percieved as a bad finacial situation you put yourself in
