Topic 7 - Financing and Dividend Decisions Flashcards
What is the effect of leverage on earnings volatility
it magnifies upside gains and downside losses
earnings become riskier with leverage
Describe Capital Structure Theory
Proposition 1 - firm value
Proposition 2 - cost of equity and WACC
The value of the firm is determined by the cash flows to the firm and the risk of the assets
M&M without taxes
Proposition I:
The value of the firm is NOT affected by changes in the capital structure.
The cash flows of the firm do not change; therefore, value doesn’t change.
Proposition II:
Cost of Equity increases as Debt increases.
The WACC of the firm is NOT affected by capital structure.
Case 1 - no taxes examples
also slide 13, 14
Types of Dividends
ordinary, special, share repurchase
Non-cash dividends
Dividend reinvestment plans (DRP)
Instead of cash dividends, shareholders receive new shares often issued at a discount with no brokerage or stamp duty paid
Share Dividends
Instead of cash shareholders receive all or a portion of the dividend in shares – expressed as a percentage (20% share dividend)
Share Splits
Issue of new shares to all shareholders – expressed as a ratio (3:1 share split)
Distinguish between Business and Financial Risk.
Business risk is the equity risk that comes from the nature of the firm’s operating activities.
- Financial risk is the equity risk that comes from the financial policy (capital structure) of the firm.
Explain with examples what financial distress costs are.
Financial distress costs are all the costs associated with going bankrupt and/or avoiding bankruptcy
These costs can be:
- Direct costs such as legal and administrative costs
- Indirect costs such as resources spent on avoiding bankruptcy. These are difficult to measure and estimate and come in the form of lost sales, interrupted operations, loss of valuable employees.
What are the potential advantages to a company’s shareholders if the company increases the proportion of debt in its capital structure?
Advantages:
- Issuing debt instead of more shares avoids dilution of the share price, that is, the company can raise capital by issuing debt without diluting the value of the shares that the existing shareholders already hold.
- Debt is cheaper than equity and therefore the firm’s cost of capital can be minimised (assuming an optimal capital structure is attained). The value of the firm, and therefore shareholder wealth is maximised when the cost of capital for the firm is minimised.
What are the potential disadvantages to a company’s shareholders if the company increases the proportion of debt in its capital structure?
- When the level of debt is too high the firm may not be able to meet the interest payments; therefore, this could lead to a situation of financial distress and/or bankruptcy for the firm.
- Also if the amount of leverage is too great, the equity holders and any potential new investors will require a higher return on their investments in the firm, therefore ultimately increasing the cost of capital for the firm.
What happens to the value of the firm if we introduce debt?
Proprosition 1
If we have no costs or taxes, the value of the firm doesn’t change irrespective of the level of debt introduced in the firm.
VU = VL= EBIT/ra
If no debt ra=re; the cost of capital is the cost of equity
If debt ra=WACC unadjusted
What happens to the cost of equity and cost of capital if we introduce debt?
Proposition II
Cost of capital remains constant irrespective of level of D/E proportion
WACC = ra = E/V x re + D/V x rd
Cost of equity increases as debt increases due to the fact that the firm becomes more risky
re = ra + (ra – rd) x D/E
What is a share repurchase program?
company will buy some of their own stock on the open market
What is a share split?
company increases the number of share but decreases the value of each share
Bonus share issue
payment of dividend in the form of bonus shares
