Module 11 - Capital Structure

Question 1

Cost of equity

Answer 1

ke = (D(1+g) / P ) + g

where P is the ex dividend price

Question 2

Ex dividend price

Answer 2

price excluding any dividends which are about to be paid

Question 3

If dividends are ‘about to be paid’ which price is given

Answer 3

Cum-dividend

Question 4

The relationship between ex and cum dividend price

Answer 4

Ex div price = cum div price - dividend about to be paid

Question 5

announcement date

Answer 5

the date on which a company announces to its shareholders the upcoming dividend

Question 6

ex-dividend date

Answer 6

the date from which anyone buying a share is not entitled to recently announced dividend

Question 7

record date

Answer 7

when the payment is made it will be made to all shareholders on the company register at the record date - ex dividend date usually two business days before the record date

Question 8

why is the cost of debt lower than the cost of equity:

Answer 8

debt finance is cheaper for a company to obtain because:

• cost of raising debt finance is lower
• annual return required to attract investors in the form of debt is lower
• cost of interest is tax-deductible

Question 9

irredeemable debt (kd) formula

Answer 9

l (1-t) / MV

where l - interest payable (coupon rate x nom value)

Question 10

MV ex-interest price

Answer 10

MV cum interest - interest

Question 11

cost of redeemable debt

Answer 11

use IRR

Question 12

what is the redeemable value if debt is redeemed at par

Answer 12

£100

Question 13

WACC

Answer 13

WACC = %dkd + %eke

Question 14

which value should be used for calculating the proportions of debt and equity

Answer 14

market values

Question 15

if using the nominal values for WACC how must the formula be adjusted

Answer 15

WACC = %dkd + %share capke + %retained earnings*ke

Question 16

if the gearing level of a company is too high:

Answer 16

• high level of risk there will be insufficient cash flows

- returns for shareholders will be very variable

Question 17

if the gearing level is too low:

Answer 17

• cost of capital may be unnecessarily high

- shareholder’s returns might be reduced

Question 18

traditional theory of capital structure

Answer 18

• WACC varies with the level of gearing
• optimum level of gearing for each company in which the cost of capital will be minimised
• addition of low levels of debt reduces WACC
• if gearing too high the shareholders demand a higher rate of return and the cost of debt increases -> WACC increases

Question 19

MM-theory without tax

Answer 19

• under a restrictive set of assumptions gearing would have no effect on the cost of capital or company value
• agrees that debt is cheaper than equity
• reduction in cost of capital because of the rise in debt is matched by a rise in the cost of equity which compensates shareholders for increased risk

Question 20

Assumptions of MM-theory

Answer 20

• capital markets are perfect
• no taxation
• no transaction costs
• individuals can borrow at the same rate as firms
• home made gearing has the same risks as corporate gearing

Question 21

MM-theory with tax

Answer 21

• cost of debt financing is even lower due to tax deduction
• WACC declines as more debt is added
• ## WACC lowest when capital is almost entirely debt