Module 6: Capital Structure And Management Flashcards
What are the three roles of the Australian Securities and Investments
Commission?
As the corporate regulator, it is responsible for ensuring that company directors and officers carry
out their duties honestly, diligently and in the best interests of their company.
As the markets regulator, it assesses how effectively authorised financial markets are complying
with their legal obligations to operate fair, orderly and transparent markets.
As the financial services regulator, it licenses and monitors financial services businesses to ensure
that they operate efficiently, honestly and fairly. These businesses typically deal in superannuation,
managed funds, shares and company securities, derivatives, and insurance
What are the advantages to a company of using debt finance?
Debt is a cheaper form of finance than shares partly because, unlike preferred shares, debt interest
is tax deductible in most tax regimes.
Debt should be more attractive to investors because it will be secured against the assets of the
company.
Debt holders rank above shareholders in the event of a liquidation.
Issue costs should be lower for debt than for shares.
With debt finance there is usually no change in regards to who controls the company. However, if
the debt is convertible (from debt to equity), the structure of control will change over time as
conversion rights are exercised.
There is no immediate dilution in earnings and dividends per share.
Debt acts as a discipline on management as careful management of working capital and cash flow is needed.
How do you calculate the leverage and interest cover ratios.
The leverage (gearing) ratio indicates the extent to which the business is reliant on debt financing
versus equity to fund the assets of the business. Total liabilities divided by Total equity x 100
Like gearing, interest cover is a measure of financial risk which is designed to show the risks in terms of profit rather than in terms of capital values. = Profit before interest and tax divided by interest payable
What does dividend policy refer to?
Dividend policy refers to the choice that financial managers make between retaining a
proportion of earnings for reinvestment as opposed to distributing earnings in the form of
dividends.
Name two different theories of dividend policy.
TRADITIONAL VIEW
The ‘traditional’ view of dividend policy focuses on the effects on share price. The price of a share
depends upon the mix of dividends, given shareholders’ required rate of return, and growth. If other
factors are held constant, an increased dividend payout, as a result of growth in earnings, will lead to a
higher share price. Therefore, shareholders’ expectations of the future dividend pattern influence the share price.
IRRELEVANCY THEORY (MODIGLIANI AND MILLER)
In contrast to the traditional view, Modigliani and Miller (MM) proposed that in a tax-free world with
perfect information, no transaction costs and no personal tax, shareholders are indifferent between dividends and capital gains. A shareholder will be prepared to sacrifice dividends now in order to
invest in projects that will allow it to pay higher dividends in the future. MM believed that the value of
a company is determined solely by the ‘earning power’ of its assets and investments, rather than its
dividend policy. It is the success of the projects undertaken by the firm that influence its share price,
rather than the dividends it chooses to distribute from those projects.
What is the residual theory of dividends?
This recognises that the issue is whether a company should pay out its earnings as dividends when it
has profitable investment opportunities available.
The ‘residual’ theory of dividend policy can be summarised as follows:
If a company can identify projects with positive NPVs, it should invest in them.
Only when these investment opportunities are exhausted should dividends be paid.
