F3 - 6. Capital Structure

Question 1

What are 3 matching considerations that must be made when raising new finance?

Answer 1

1. Duration
2. Currency
3. Risk of cash flows

Question 2

What are 3 issue costs associated with new finance?

Answer 2

1. Arrangement fees
2. Underwriting fees
3. Advisers fees

Question 3

What are 3 on going costs of finance?

Answer 3

1. Dividends paid
2. Interest paid
3. Cost of supplying information to finance providers

Question 4

What are 4 key considerations when deciding whether to provide capital?

Answer 4

1. Impact on gearing
2. Impact on control
3. Impact on EPS
4. State of the marketq

Question 5

What is thin capitalisation?

Answer 5

Groups using intragroup loans to generate interest deductions in excess of the group’s actual third party interest expense

Question 6

What are the generally followed thin capitalisation rules?

Answer 6

Interest is only tax deducible on the part of a loan that a 3rd party would be willing to lend

Question 7

What can WACC be used for?

Answer 7

The hurdle rate for appraising projects (e.g higher return than WACC is worth doing)

Question 8

What are the 4 conditions for using WACC to appraise a new project?

Answer 8

1. New project has the same business risk
2. No change in long term capital structure of company
3. Relatively small project
4. Not project specific finance

Question 9

As exposure to systematic risk increases, what happens to cost of equity?

Answer 9

Increases

Question 10

In which is there higher risk to shareholder returns - in a geared or ungeared company?

Answer 10

Higher risk in a geared company

Question 11

What is the inequality relationship between a geared and ungeared risk beta?

Answer 11

Beg > Beu

Question 12

What are the steps to determine the WACC of a company entering a new sector?

Answer 12

1. Ungear typical market Beg
2. Take Beu and regear with company gearing
3. Use CAPM to calculate specific cost of equity
4. Enter keg into WACC equation

Question 13

What are the 2 conflicting results of increasing the level of debt?

Answer 13

1. WACC decreases as debt is cheaper than equity
2. WACC increases as shareholder risk increases so cost of equity goes up

Question 14

What is the traditional theory of the effect of increasing levels of debt on WACC and value?

Answer 14

Adding debt :
- Initially decreases WACC as debt is cheaper
- Cost of equity increases and WACC starts to rise
- Eventually even the cost of debt rises as lenders see high gearing
> so there is an OPTIMUM gearing for lowest WACC and highest value

Question 15

What is Modigliani and Miller’s (no tax) theory of the effect of increasing levels of debt on WACC and value?

Answer 15

As debt increases, benefit of cheaper debt exactly offsets cost of equity increase so WACC is constant, and valuation is not impacted by gearing

Question 16

What are M&M’s 4 assumptions in their debt:WACC theories?

Answer 16

1. Debt is always risk free (so cost of debt is at risk free rate)
2. Perfect markets (information + no transaction costs)
3. Individuals and companies borrow at the same rate
4. Investors are indifferent between personal and corporate gearing

Question 17

How is the value of a geared company calculated?

Answer 17

Value ungeared + Value of ‘tax shield’ (pv of tax savings of interest)

Question 18

What are 4 reasons that, practically speaking, a company would not gear up?

Answer 18

1. Lenders wont lend if too high due to payment commitments
2. If lenders do lend, it ma be at increasing interest rates
3. Existing covenants may cap gearing
4. Shareholders may be concerned by financial risk of increased gearing