Week 3 Everything

Question 1

Capital Structure

Answer 1

The combination of debt and equity used to finance a company’s assets.

Question 2

Total Assets =

Answer 2

Total Liabilities (debt financing)

+

Total Equity (equity financing)

Question 3

Target Capital Structure

Answer 3

The optimal mix of debt, preference shares and ordinary equity with which the company plans to use to finance its investments.

Question 4

Business Risk

Answer 4

The risk associated with a company’s business operations, ignoring any fixed financing effects (i.e. the uncertainty inherent in a company’s earnings or operating income). Business Risk refers to the variability or uncertainty of a company’s operating income.

Question 5

Financial Risk

Answer 5

The additional risk, over and above the basic business risk, that is borne by a company’s shareholders which arises from the manner in which the company’s assets are financed. Financial Risk refers to the variability or uncertainty of a company’s earnings per share (EPS) and the increased risk of bankruptcy when a company uses financial leverage.

Question 6

Operating Income may be affected by:

Answer 6

Sales variability (e.g. changes in sales volume);

Cost variability (e.g. changes in input prices);

Competition from industry rivals
(may affect ability to adjust the selling price to reflect changes in input prices);

Product diversification;

Operating leverage (the extent to which the company’s costs are fixed).

Question 7

Operating leverage

Answer 7

Operating Leverage refers to the presence of fixed operating costs (as opposed to variable operating costs) within a company’s cost structure. A company with relatively high fixed operating costs will experience greater variability in operating income if sales were to change.

Question 8

Operating leverage

Basic profit equation:

Answer 8

Profit = Total revenue – Total costs

Question 9

Profit = Total revenue – Total costs

This can be rewritten as

Answer 9

Profit = (Total revenue – Total VC) – Total FC

Question 10

Contribution margin

Answer 10

Contribution margin is the total revenue minus total variable costs. CM per unit tells how much revenue from each unit can be applied toward FC

Question 11

Degree of operating leverage

Answer 11

Is the ratio of a company’s fixed costs to its variable costs

Question 12

Degree of operating leverage in terms of contribution margin

=

Answer 12

CM/PROFIT

=

(TR-TVC)/PROFIT

=

(P-V)*Q/PROFIT

Question 13

Degree of operating leverage in terms of fixed costs

=

Answer 13

F/PROFIT + 1

Question 14

Degree of operating leverage explained

Answer 14

Measures the extent to which the cost function is comprised of fixed costs. A high degree of operating leverage indicates a high proportion of fixed costs

Question 15

Firms operating at a high degree of operating leverage

Answer 15

face higher risk of loss when sales decrease and enjoy profits that rise more quickly when sales increase

Question 16

Operating leverage of 19.33 can be interpreted as:

Answer 16

The ratio of MM Bikes fixed costs to variable costs

A 10% increase in revenues should yield a 193.3% increase in operating income (10%*19.33)

Conversely, a 10% reduction in revenues will reduce operating income by 193.3%

Question 17

The ratio of MM Bikes fixed costs to variable costs

A 10% increase in revenues should yield a 193.3% increase in operating income (10%*19.33)

Conversely, a 10% reduction in revenues will reduce operating income by 193.3%

IS THIS GOOD OR BAD

Answer 17

Need to compare with industry average and with past history. E.g. If industry average is 10, this means MM Bikes can make more money from incremental revenues than the industry average (i.e. 10% increase in revenues yields 100% increase in operating income for other competitors versus 193.3%). Important to understand cost structure, particularly in competitive markets and volatile markets where there is potential for downturns

Question 18

Fiancial risk is affected by

Answer 18

Financial leverage;

Amount and type of debt obligations;

Changes in interest rates;

Economic cycle.

Question 19

Financial leverage

Answer 19

Financial Leverage refers to the use of fixed-cost sources of finance (rather than variable-cost sources) to finance a portion of a company’s assets.

Question 20

Fixed-cost sources of finance

Answer 20

Debt

Preference shares

Question 21

Variable-cost sources of finance:

Answer 21

Ordinary shares

Question 22

Business Risk versus Financial Risk

Answer 22

Business Risk refers to the relative variability of a company’s operating income or earnings (EBIT). Financial risk refers to the additional variability in earnings available to ordinary shareholders due to financing decisions. It includes the additional risk of bankruptcy that is borne by ordinary shareholders due to the use of financial leverage.

Question 23

the link between business risk and financial risk

Answer 23

23/3/19

Question 24

Capital structure on a balance sheet

Answer 24

23/3/19

Question 25

Importance of capital structure

Answer 25

Cost of capital

Financial leverage

target or optimal capital structure

Question 26

Importance of capital structure

Cost of capital

Answer 26

Since each source of financing has a different cost, the capital structure will affect the overall cost of capital for a company.

Question 27

Importance of capital structure

Financial leverage

Answer 27

Higher financial leverage (in the form of greater debt financing) leads to potentially greater returns to shareholders, but also results in higher financial risks due to the need to make periodic fixed repayments on a regular basis.

Question 28

Importance of capital structure

target or optimal capital structure

Answer 28

Therefore, the target (or optimal) capital structure for a company is the capital structure that minimizes the overall cost of capital for the company, thereby maximizing the market value of the company, which in turn maximizes the overall wealth of its (ordinary) shareholders.

Question 29

DEBT FINANCING

Answer 29

Debt financing involves the substitution of debt for equity in a company’s capital structure which has two important and related effects:

Debt financing increases the returns to (ordinary) shareholders:

However, debt financing also increases the financial risk borne by (ordinary) shareholders:

Question 30

Debt financing increases the returns to (ordinary) shareholders:

Answer 30

Debt financing is typically cheaper than equity financing, which results in relatively more earnings made available for distribution to ordinary shareholders as dividends.
Debt financing is typically cheaper than equity financing

Question 31

However, debt financing also increases the financial risk borne by (ordinary) shareholders:

Answer 31

Debt financing increases the variability of earnings made available for distribution to shareholders, thus resulting in a greater range of returns for ordinary shareholders; and at the same time, debt financing also increases the risk of bankruptcy for a company.

Question 32

Debt financing is typically cheaper than equity financing due to:

Answer 32

Lower interest rates
(debtholders typically require lower returns than ordinary shareholders); and

Tax deductions for interest payments
(the interest payments associated with debt financing are tax deductible).

Question 33

The Effects Of DEBT FINANCING

Answer 33

23/3/19

Question 34

BENEFITS OF DEBT FINANCING

Answer 34

Maintaining ownership and control:

Tax deductions:

Lower interest rates:

Question 35

Maintaining ownership and control:

Answer 35

Unlike equity financing, debt financing does not involve selling claims to ownership of the business to market investors. As such, the owner maintains ownership and control over the business.

Question 36

Tax deductions:

Answer 36

Unlike the dividend payments associated with equity financing, the interest payments associated with debt financing are tax deductible.

Question 37

Lower interest rates:

Answer 37

Since debtholders usually demand lower returns (in the form of lower interest rates) than ordinary shareholders, debt financing is typically cheaper than equity financing.

Question 38

The costs of debt financing include:

Answer 38

Repayment obligations

Risk of bankruptcy

Need for collateral

Question 39

Repayment obligations

Answer 39

With debt financing, need to make periodic fixed repayments to debtholder on a regular basis (c.f. there is no such obligation with equity financing). As such, the business must ensure that it can generate sufficient cash flows to meet the repayments when they fall due or face becoming bankrupt.

Question 40

Risk of bankruptcy:

Answer 40

Debt financing increases the risk of bankruptcy for the business (c.f. there is no such risk of bankruptcy with equity financing). In the event the business becomes bankrupt, the debtholder has priority in claiming the assets of the business before ordinary shareholders.

Question 41

Need for collateral

Answer 41

With debt financing, the business is usually required to pledge some of its assets as collateral in order to protect the debtholder against possible default (c.f. there is no such requirement for collateral with equity financing).

Question 42

Relevance of CAPITAL STRUCTURE

Answer 42

Maximize market value by minimizing cost of capital:

Full utilisation of available funds:

Maximize returns to shareholders

Question 43

Maximize market value by minimizing cost of capital:

Answer 43

A sound capital structure helps to maximize the market value of the company by minimizing the overall cost of capital for the company.

Question 44

Full utilisation of available funds

Answer 44

A good capital structure enables the company to fully utilise its available funds to pursue profitable investment opportunities. In doing so, a good capital structure also protects the company from over-capitalisation and/or under-capitalisation.

Question 45

Maximize returns to shareholders

Answer 45

A sound capital structure enables the company to increase profits, and thus maximize the returns to its shareholders.

Question 46

THEORIES OF Capital Structure

Answer 46

Trade-off Theory
Signalling Theory
Pecking Order Theory

Question 47

Trade-off Theory

Answer 47

Argues that there is a ‘trade-off’ between the tax benefit versus the bankruptcy-related cost associated with debt financing.

Question 48

3 key points of the trade off theory

Answer 48

Since interest is a tax-deductible expense, the government effectively subsidizes part of the cost of debt capital, with more operating income or earnings flowing through to the company’s shareholders.

However, as the company uses greater amounts of debt, the risk of bankruptcy also increases, which results in the company having to pay higher interest rates.

Therefore, the optimal capital structure is the point at which the tax benefit from additional debt exactly offsets the increase in bankruptcy-related cost.

Question 49

TRADE off theory in reality

Answer 49

In reality, however, large companies such as BHP use far less debt financing than Trade-off Theory suggests.

Question 50

TRADE off theory diagram,

Answer 50

23/3/19

Question 51

Signalling Theory

Answer 51

Argues that asymmetric information exists between company management and external investors (i.e. company managers have better information about the company’s future financial prospects than external investors).

Question 52

First two key points of the signalling theory

Answer 52

Due to asymmetric information between company managers and external investors, company management’s choice between debt financing versus equity financing is viewed by market investors as a signal about company management’s perception of the future financial prospects for the company.

External investors expect that companies with bright financial prospects will prefer debt financing over equity financing. Therefore, the decision to use debt financing is viewed as a positive signal by market investors that company managers perceive the company’s future financial prospects to be bright.

Question 53

Next two key points of the signalling theory

Answer 53

Conversely, since external investors expect that only companies with poor financial prospects will prefer equity financing, the decision to use equity financing is viewed as a negative signal by market investors that company managers perceive the company’s future financial prospects to be poor.

This might account for the observation that a company’s share price tends to fal following company management’s decision to use equity financing to raise capital by issuing new equity.

Question 54

signalling theory reserve borrowing capacity

Answer 54

So companies should always maintain a reserve borrowing capacity. In other words, companies should generally use less debt than ‘the optimum debt level’ suggested by Trade-off Theory in order to ensure that further debt capital can be obtained later if required.

Question 55

PECKING ORDER THEORY

Answer 55

Since external investors know that company managers will attempt to issue new equity when they perceive the company’s shares as overpriced, market investors will necessarily discount the price that they are willing to pay for the company’s shares by underpricing the company’s shares. Pecking Order Theory argues that, to avoid this underpricing, company managers prefer to finance investment opportunities using retained earnings, followed by debt financing, and will only choose equity financing as last resort.

Question 56

Hierarchy or order of financing

Answer 56

Use Retained Earnings;
Use Debt financing;
Use Equity financing.