S2 - capital structure Flashcards
what is capital structure
Equity = higher risk, high returns are demanded
Debt = lower risk so cheaper to acquire
managing or optimising the overall cost of capital, the weighted cost of capital or WACC that a company has to be the most beneficial it can be for the company
Since WACC is often also the starting point for determining a hurdle rate for investment appraisal this is an important figure affecting nit only current operations, but all future investments
If the return on investment is lower than the WACC, the company is not creating value
what is the concept of an optimal capital structure
WACC calculation suggests a possible optimal structure
Debt is cheaper, it would suggest that you just take on more debt
Debt is cheaper
lenders require a lower rate of return than ordinary shareholders in exchange for some kind of security or collateral
Debt interest can be offset against pre tax profits before the calculation of the corporation tax bill - reduce tax paid
Issuing and transaction costs associated with raising and servicing debt are generally less than for ordinary shares
what is gearing
theoretically just increase the gearing level
And overall cost of financing the company should reduce
But this increases risk of the company becoming financially distressed which increases costs
what are corporate financial distress costs
financial distress is where obligations to creditors are not met or are met with difficulty
what is Modigliani and Millar 1958
a seminal paper which Franco Modigliani won the Nobel prize for economics for in 1985 and was part of Millar’s consideration for his 1990 joint win
Argued in 1958 that a companies capital structure has
No impact on the WACC and therefore no optimal capital structure exists
argued that a company’s value depends purely on business risk
Proposed that the total market value of any company is independent of its capital structure
Often heavily criticised for the assumptions on which is based on
what is Modigliani and milar 1963
revised their paper to take tax into account
Tax has a measurable benefit on using debt in particular to finance an entity
Debt is tax deductible and can be offset against profit
Theory dramatically changed
As you increase the gearing, you will reduce the WACC due to the tax benefit of debt
In turn will increase the overall value of the company
what is the application of Modigliani and milar
private equity groups are seen as the main practical utiliser
Buy all the shares of a company and take them private and off the publicly traded exchanges
So completely control the cost of equity
Allows them to leverage the company to levels which would be unacceptable to shareholders if it was publicly owned
what are trade off models
accept that in perfect capital markets, the firms market value is independent of its capital structure
They argue that market imperfections do exist and are impossible to ignore
shareholder wealth is affecters by market reactions to gearing both through share price movements and WACC changes
Increasing debt has a twofold impact on WACC and shareholder wealth
It decreases WACC as a cheaper source of income but it increases the cost of equity as shareholders demand more returns for the risks they are taking
what are trade off model conclusions
indicates that up to a point, gearing will increase shareholder wealth
Beyond this point it starts to become too risky
As the impact of the increase in Ke starts to outweigh the impact of the extra debt
The WACC rises
Share price and shareholder wealth falls
So we can attain an optimal capital structure
what is capital structure in practice
seminal survey
Scott and Johnson surveyed 212 CFOs of Fortune 1000 companies
what is gearing practice
extreme positions tend to be avoided
All equity - you lose the benefit go low cost debt
Highly geared - financial risk likely to increase Ke and Kd
Compromise must be reached by managers
A company can borrow up to a reasonable level
How equity shareholders react to levels of debt can be very much dependent on market sentiment
Market sentiment allows us to have record high levels of indebtedness of UK companies
what is market sentiment - minsky
investor sentiment in credit markets can be an important driver of economic fluctuations
He stated that stability leads to instability
High aggregate demand and profits raise confidence and expectations which in turn increases risk taking
A minsky movement - sudden collapse of asset prices after a long period of growth sparked by debt or currency pressure
