Module 11 - Capital Structure Flashcards
Cost of equity
ke = (D(1+g) / P ) + g
where P is the ex dividend price
Ex dividend price
price excluding any dividends which are about to be paid
If dividends are ‘about to be paid’ which price is given
Cum-dividend
The relationship between ex and cum dividend price
Ex div price = cum div price - dividend about to be paid
announcement date
the date on which a company announces to its shareholders the upcoming dividend
ex-dividend date
the date from which anyone buying a share is not entitled to recently announced dividend
record date
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
why is the cost of debt lower than the cost of equity:
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
irredeemable debt (kd) formula
l (1-t) / MV
where l - interest payable (coupon rate x nom value)
MV ex-interest price
MV cum interest - interest
cost of redeemable debt
use IRR
what is the redeemable value if debt is redeemed at par
£100
WACC
WACC = %dkd + %eke
which value should be used for calculating the proportions of debt and equity
market values
if using the nominal values for WACC how must the formula be adjusted
WACC = %dkd + %share capke + %retained earnings*ke
if the gearing level of a company is too high:
- high level of risk there will be insufficient cash flows
- returns for shareholders will be very variable
if the gearing level is too low:
- cost of capital may be unnecessarily high
- shareholder’s returns might be reduced
traditional theory of capital structure
- 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
MM-theory without tax
- 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
Assumptions of MM-theory
- 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
MM-theory with tax
- 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
