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PPF > Lecture 9-Cost of Capital & Capital Structure > Flashcards

Lecture 9-Cost of Capital & Capital Structure Flashcards

1
Q

What are the providers of capital?

A
  • depends on the rate of return investors require, to be willing to provide capital in the first place
  • The return investors will demand will depend on the risk they are exposed to:

Ordinary shareholders – Highest Risk, Highest Return

Preference shareholders – Medium Risk, Medium Return

Bondholders – Lowest Risk, Lowest Return

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2
Q

What to use as a provider of capital?

A

On average, of all new funds used each year:
~50% comes from retained earnings

~35% comes from debt

~15% comes from equity

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3
Q

What are retained earnings?

A

is the amount of net income left over for the business after it has paid out dividends to its shareholders

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4
Q

What are the advantages of retained earnings?

A
  • No dilution of ownership i.e. ownership decrease when a new equity is introduced
  • No issuing costs
  • No nee to explain how the funds will be used.
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5
Q

What are the disadvantages of retained earnings?

A
  • Uncertain may not be enough
  • Managers may think that it is ‘free’ capital its not as shareholders are foregoing dividends
  • Equity holders will expect the same return on retained earnings, as on the rest of their investment
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6
Q

What are the advantages of debt for the company?

A
  • Cheaper than equity due to lower issuing costs, lower rate of return
  • Fixed payments, don’t change irrespective of profits, easy to plan
  • No loss of control (bondholders have no votes)
  • Tax advantages
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7
Q

What are the advantages of debt for the investors?

A
  • Low risk

- Guaranteed income each year (From coupon)

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8
Q

What are the disadvantages of debt for the company?

A

Has to be repaid

Usually involves regular cash flows which can’t be avoided

Non-payment can force the company into liquidation

Too much debt is considered harmful

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9
Q

What are the disadvantages of debt for the investors?

A

Because they are low risk they only offer a low return

Limited upside, do not share in any abnormal returns

No voting rights

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10
Q

What is equity?

A

-degree of ownership in any asset after subtracting all debts associated with that asset.

Equity represents the shareholders’ stake in the company.

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11
Q

What are the advantages of equity for company?

A
  • No principal sum to be repaid

- Dividends are optional

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12
Q

What are the advantages of equity for investors?

A
  • Can make very high returns
  • Voting rights give some control over company
  • Potential for dividends
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13
Q

What are the disadvantages of equity for the company?

A

Have to offer a higher return

Relatively high issuing costs

No tax advantages

Dilution of control of the company

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14
Q

What are the disadvantages for investors of equity?

A

Potential for big losses

No guarantee to any cash flows

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15
Q

What is gearing?

A
  • Gearing refers to the amount of debt a company has.

- A highly geared company is one with a high level of debt

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16
Q

What are the two types of gearing?

A
  • Capital gearing

- Income gearing

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17
Q

What is capital gearing?

A

Focuses on how much of the firm’s capital is in the form of debt

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18
Q

What is income gearing?

A

Focuses on how much of the firm’s income is used to pay off interest charges associated with that debt

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19
Q

What is the Weighted average cost of capital (WACC)?

A
  • If the firm has more than one source of capital then we need to know what average return the company has to make in order to keep everybody happy
  • This is the discount rate we use to find the NPV
20
Q

Non-traded securities

A

If the bonds or shares are not traded then we won’t be able to observe prices or calculate betas

But we can estimate the rates of return by finding similar bonds or shares that are traded and use the returns on those as a “best guess”

As always, by similar we mean the securities would be in the same risk class, i.e. expose the holder to the same level of risk

21
Q

Bank Loans in the WACC

A

We could include bank loans as a separate source of funds

Not traded so can’t observe market value

But unless chances of default are high, market value ~ book value

22
Q

How can you estimate the return on bank loans?

A

Looking at market rate for equivalent loans, or
Assume its the same as for the firm’s bonds, or
Calculate as interest paid/outstanding loans

23
Q

What is the right discount rate?

A

The required returns to debt, equity, etc. were dependent on the risk
This depends to a large extent on what the firm is doing

WACC thus represents the average return needed, for the current given level of risk

Even if a new project is to funded entirely by debt
Still use the WACC as discount rate and not 𝒓_𝒅

24
Q

Who uses WACC

A

Today ~80% of firms use it but often in arbitrary ways, e.g.

Guesses for cost of equity instead of using the CAPM or DGM

Coupon rates for required return on debt instead of the YTM

Target Debt/Equity ratios or book values rather than proportions based on current market values

25
Q

How can the WACC be used as a discount rate?

A

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

26
Q

What is a good WACC?

A

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

27
Q

Why shouldnt the WACC just consist of debt?

A

-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

28
Q

Other ways to view risk?

A

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

29
Q

Who are Modigliani & Miller (M & M)

A

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

30
Q

What were the key assumptions of the M&M model?

A

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

31
Q

The first proposition of the M & M model?

A

The value of the firm is independent of its capital structure

32
Q

What is financial distress?

A

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

33
Q

What are the costs of financial distress?

A

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
34
Q

What is the trade-off theory

A
  • 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

35
Q

What does the trade-off theory say in relation to WACC?

A

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

36
Q

How does risk vary from company to company?

A

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

37
Q

What is pecking order theory?

A

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

38
Q

M & M theory I

A

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

39
Q

Alternative explanation of M & M

A

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

40
Q

M & M theory proposition II

A

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

41
Q

What does the formula for the second proposition of M & M mean?

A

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

42
Q

Tax in relation to M & M

A

-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
43
Q

What is tax in relation to interest?

A

-Companies pay less in tax because interest is tax deductible

44
Q

What is the true cost of debt?

A

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

45
Q

What is a tax shield?

A

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

46
Q

M &M modified assumption that allow for corporation tax

A
  • Increasing gearing always reduces the WACC and hence increases the value of the firm
  • Optimal capital structure is all debt
47
Q

What does an uncertain tax shield assume?

A

-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

PPF (9 decks)

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