Week 9

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).

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.

Question 6

Business Risk explained

Answer 6

photo in favourites 21/9/18

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

Financial Risk explained

Answer 8

photo in favourites 21/9/18

Question 9

Financial leverage

Answer 9

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 10

Fixed-cost sources of finance:

Answer 10

Debt

Preference shares

Question 11

Variable-cost sources of finance:

Answer 11

Ordinary shares

Question 12

Business Risk versus Financial Risk

Answer 12

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.
Includes the additional risk of bankruptcy that is borne by ordinary shareholders due to the use of financial leverage.

Question 13

the link between business risk and financial risk

Answer 13

photo in favourites 21/9/18

Question 14

Capital structure on the balance sheet

Answer 14

photo in favourites 21/9/18

Question 15

Importance of capital structure

Answer 15

Cost of capital

Financial leverage

Target capital structure

Question 16

Cost of capital

Answer 16

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

Question 17

Financial Leverage importance

Answer 17

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 18

Target capital structure

Answer 18

Target capital structure

Question 19

DEBT FINANCING

Answer 19

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

(1) Debt financing increases the returns to (ordinary) shareholders
(2) However, debt financing also increases the financial risk borne by (ordinary) shareholders

Question 20

(1) Debt financing increases the returns to (ordinary) shareholders

Answer 20

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

Question 21

Debt financing is typically cheaper than equity financing due to:

Answer 21

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

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

Question 22

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

Answer 22

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 23

The Effects Of DEBT FINANCING

Answer 23

photo in favourites 21/9/18

Question 24

BENEFITS OF DEBT FINANCING

Answer 24

Maintaining ownership and control:

Tax deductions

Lower interest rates

Question 25

Maintaining ownership and control:

Answer 25

• 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 26

Tax deductions

Answer 26

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

Question 27

Lower interest rates

Answer 27

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 28

COSTS OF DEBT FINANCING

Answer 28

Repayment obligations

Risk of bankruptcy

Need for collateral

Question 29

Repayment obligations

Answer 29

• 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 30

Risk of bankruptcy

Answer 30

• Debt financing increases the risk of bankruptcy for the business (c.f. there is nosuch 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 31

Need for collateral

Answer 31

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 32

Relevance of CAPITAL STRUCTURE

Answer 32

Maximize market value by minimizing cost of capital

Full utilisation of available funds

Maximize returns to shareholders

Question 33

Maximize market value by minimizing cost of capital

Answer 33

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

Question 34

Full utilisation of available funds

Answer 34

• 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 35

Maximize returns to shareholders

Answer 35

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

Question 36

THEORIES OF Capital Structure

Answer 36

1. Trade-off Theory
2. Signalling Theory
3. Pecking Order Theory

Question 37

1. Trade-off Theory

Answer 37

• Trade-off between the tax benefit versus the bankruptcy-related cost associated with debt financing.

Question 38

Key points of the trade off theory

Answer 38

(i) 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.
(ii) 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.
(iii) 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 39

TRADE-OFF THEORY graphs

Answer 39

photo in favourites 21/9/18

Question 40

Signalling Theory

Answer 40

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 41

Key points of signalling theory

Answer 41

(i) 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.

(ii) 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 42

Key points of signalling theory 2

Answer 42

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

Question 43

Signalling theory reserve borrowing theory

Answer 43

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 44

PECKING ORDER THEORY

Answer 44

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 45

Hierarchy or order of financing:

pecking order theory

Answer 45

(1st) : Use Retained Earnings;
(2nd) : Use Debt financing;
(3rd) : Use Equity financing.