Chp 6: Capital Structure

Question 1

What does the CAPM calculation give?

Answer 1

The cost of equity

Question 2

How do you calculate the cost of a preferecne share?

Answer 2

Kpref = D0/P0

D0=dividend rate; P0=market value

Question 3

What would be the impact on the WACC if gearing increased?

Answer 3

Shares become more risky so the Ke will rise

More debt finance is used and the Kd is lower than the cost of equity

Question 4

What impact does a fall in the WACC have on shareholders?

Answer 4

Benefits shareholders

Present value of cash flows will be higher if discounted at a lower rate.

In an efficient market, this implies that the market value of debt + equity will rise as the WACC falls

Question 5

Explain the traditional view of gearing

Answer 5

As gearing increases, Kd remains unchanged up to a point before increasing as interest cover falls

Ke rises as gearing increases as the financial risk increaes

The WACC falls initially as the proportion of debt capital increases before rising as the Ke becomes more significant

Optimum gearign is when WACC is at it’s lowest point

Question 6

What is the net operating income theory of gearing (Modigliani and Miller)?

Without tax

Two propositions and three assumptions

Answer 6

Propositions
1. The total market value of a company is independent of it’s capital structure - MV depends on a companys future income and the risk attached to this, which is unaffected by the capital structure as the WACC is unaffected (point 2)
2. The cost of equity increases proportionately with the gearing ratio - Debt finance transfers risk to shareholders and causes a proportionate rise in Ke. Therefore WACC remains constant.

Assumptions
1. A perfect capital market exists, in which investors have the same information
2. There are no tax or transaction fees
3. Debt is risk free and fully available

Total MV of a company = Value fo debt + value of equity

Question 7

What is arbitrage?

Answer 7

If a low geared company is worth less than a high geared company then MM propose shareholders will take on personal debt to buy shares in the undervalued company. Which would drive up the value of the low geared company until they are equal.

Question 8

How does MM theory of gearing change with tax being involved?

Answer 8

Taxation reduces the cost of debt capital by multiplying it by (1-t).

Therefore, as gearing rises, the WACC will fall constantly up to a gearing of 100%

This still assumes there are no financial distress costs

Question 9

What are the four factors that can influence capital structure in the real world?

Answer 9

1. Debt Capacity - the maximum amount of debt that a company can support or obtain. Based on the assets they can use as securities and the availability of finance in the market
2. Debt Covenants - can restrict borrowing behaviour
3. Cost of debt - MM assumes Kd remains the same. However, lenders are likely to want a higher return for borrowers already in debt
4. Tax Exhaustion - As gearing increases, there will be a point in which interest repayments reduce taxable profit to zero, thereby negating the tax benefit of debt.

Question 10

What are four practical considerations that influence debt levels (and therefore gearing)?

Answer 10

1. Life cycle - New, growing businesses find it difficult to forecats cash flows with certainty so high debt is unwise.
2. Operational Gearing - High fixed costs mean cash flow is volatile so high gearign is unwise.
3. Stability of revenue - If revenue is not stable, then high gearing is unwise
4. Security - If unable to offer security then debt will be expensive and difficult to obtain