Weighted Average Cost of Capital and Gearing Flashcards
How are companies ususally financed?
By both debt and equity
What does WACC represent?
A company’s average cost of long-term finance
What happens if the company’s shares are not listed on the stock market?
The book value of equity will have to be used
When can a company’s existing WACC can be used as the discount rate?
Project is financed by existing pool of funds
Proportion of debt to equity doesn’t change
Project has same business risk as existing operations
Total market value of equity limitation?
If a market price is used, is the market efficient? If the company is unquoted, how has this been estimated?
Cost of equity limitation?
How was the growth rate found? Was this calculated through DVM or CAPM
Pre-tax cost of debt limitation?
Is this likely to be constant over the project life
Corporation tax rate limitation?
Will this be constant over the life of the loan?
What is the marginal cost of capital?
The cost of raising the most recent dollar of finance
Why is WACC more appropriate than MCC?
As the WACC is an average of the cost of equity (which measures business risk) and the cost of deb
Issues with MCC? (project finance)
Project finance may be drawn from the company’s pool of funds and not from a specific source.
Issues with MCC? (cost of debt)
The cost of debt understates the risk of the project and would lead to an overstatement of the project’s NPV
What is a business risk?
The variability in the operating earnings of the company associated with the industry in which it operates
What is a financial risk?
The additional variability in returns as a result of introducing fixed-interest debt into the capital structure
What happens if a company is more highly geared?
The more fixed interest it has to pay regardless of profits, and hence the greater the risk that there will be little or nothing available to distribute as a dividend to shareholders
What does a high fianncial gearing result in?
A company is more vulnerable to poor trading conditions as shareholders require a higher return
What is the decision of a company’s capital structure?
The financing decision
What is the problem with high financial gearing?
High level of financial risk
Increased credit risk
Agency costs
What does a forecast cash flow statement help manage?
Future movements in cash. It sets out the anticipated cash inflows and outflows arising over a particular forecast period and so can provide an early warning of problems.
What happens where the forecast cash flow statement indicates a cash surplus?
Managers have the opportunity to consider whether this surplus should be reinvested
What is a financial distress risk?
The cost of debt rises due to the risk of default on debt payments (i.e. credit risk)
What happens at higher levels of gearing?
The increased financial risk outweighs this benefit and WACC rises.
How can the optimal capital structure only be found?
By trial and error
What happens if a project is optimally geared?
Finance should be raised so as to maintain the existing gearing ratio
What happens if a project is sub-optimally geared?
Raise debt finance so as to increase the gearing ratio towards the optimal level
What happens if a project is supra-optimally geared?
Raise equity finance so as to reduce the gearing ratio back to the optimal level
Once optimal gearing is achieved?
Appraise the project at the existing WACC
Appraise the additional finance
If MCC > WACC?
Finance is not appropriate and should be rejected
