Lecture 9-Cost of Capital & Capital Structure Flashcards

Question

How can the WACC be used as a discount rate?

Answer 1

It can use the WACC as the discount rate in project appraisals – providing the new projects are of the same risk class as existing projects The moment it starts to invest in projects with different risks (safer or riskier), it needs to use a different discount rate Remember: The discount rate must always reflect the risk of the project being considered

Answer 2

greater the value of (conventional) projects and hence the greater the value of the firm Since companies want to maximise their value, they will want to minimise their WACC

Answer 3

-The returns on debt and equity are not constant -As debt levels change the risks for equity holders and debt holders change At each new debt level we should re-calculate a new r_e and r_d

Answer 4

Business risk The risk associated with doing a particular kind of activity Determined by industry factors, competition, pricing volatility, market power, etc. Financial risk Additional risk to shareholders because of the existence of debt

Answer 5

In 1958 they first proposed their now famous theory of capital structure

Answer 6

No taxes Perfect information No transaction costs No cost of bankruptcy or financial distress No cost in monitoring debt Investors can borrow at same rates as companies No costs involved in raising capital Firms can be grouped into “homogeneous risk classes”, firms in the same class offer the same return

Answer 7

The value of the firm is independent of its capital structure

Answer 8

is where a firm cannot, either now, or in the near future, meet its financial obligations A firm in financial distress faces lots of additional costs - known as the costs of financial distress and bankruptcy As debt increases, the probability of distress increases, and the costs become greater At some point these additional costs begin to outweigh the tax shield advantages of the extra debt

Answer 9

Direct costs Lawyers fees, court fees, late payment penalties, etc. Indirect Costs These can continue long after the immediate danger of financial difficulty/default has passed ``` Examples include; Lost customers Higher operating costs Higher financial costs Extra staffing costs Reduced investment, R&D spending ```

Answer 10

- Theory that says capital structure is based on a trade-off between tax savings and costs of financial distress That is, companies will increase their debt until the additional costs of financial distress start to outweigh the additional tax savings Trade-off theory once again implies there is an optimum level of gearing for a company

Answer 11

-WACC varies with gearing meaning there is an optimal capital structure

Answer 12

The risk of financial distress varies from company to company It depends on things such as: - The ability to generate cash - The volatility of the firms income stream - The proportion of fixed to variable costs - The liquidity of the firm’s assets Investors are therefore willing to tolerate higher gearing levels in some industries than in others

Answer 13

An alternative view of capital structure is that there is no “optimal” or target gearing level Firms simply “prefer” retained earnings in preference to debt, and debt in preference to equity for reasons of: Ease of raising each source of funds Returns offered on each source of funds Issuing costs associated with each source Pecking order implies firms with high profits will use less debt, i.e. have low gearing

Answer 14

No matter the construction of the capital structure for the company, if the overall risk fo the firms is the same, then the returns must be the same -Doesn't matter if you invest in a mix of equity and debt, or just debt the returns will be the same

Answer 15

The value of the firm is the discounted sum of the future cash flows The cash flows depend on the projects, assets, employees, management, etc. – not funding Imagine a single investor holding all debt and equity of a firm – they receive all firm income Switching between debt and equity will not result in any extra income for the investor hence it can’t add any value to the their total investment

Answer 16

If M&M theory is true and WACC is constant i.e. Issuing more debt will not change the WACC Issuing new shares will not change the WACC Then every time you increase the proportion of debt, the cost of equity increases, i.e. Imagine a single investor holding all debt and equity of a firm – they receive all firm income Thus we don’t need to worry about how a project is funded when deciding which projects to do i.e. Financing decisions can be and should be made separately from investment decisions

Answer 17

-The required rate of return on the equity of the firm increases in proportion to its debt-equity ratio

Answer 18

-The “no tax” assumption of M&M is very unrealistic Firms are allowed to deduct interest from their profits before they work out their tax liability - Interest payments thus create a tax shield - This saves money and hence adds value

Answer 19

-Companies pay less in tax because interest is tax deductible

Answer 20

Required rate of return They expect this return or they will not hold the debt The company must pay 〖 𝑟〗_𝑑 to the debt-holders But it recoups part of the cost in tax savings

Answer 21

A tax shield is a reduction in taxable income for an individual or corporation achieved through claiming allowable deductions such as mortgage interest

Answer 22

- Increasing gearing always reduces the WACC and hence increases the value of the firm - Optimal capital structure is all debt

Answer 23

-we always have enough profits to pay interest But as the level of debt increase: Probability of having sufficient profits to capture all the tax benefits decreases As the risk of the tax shield increases, we should discount it at a higher rate, reducing its value In the extreme case, high debt -Thus implies tax shield is overvalued