Lecture 2 - Capital structure basic concepts

Question 1

2 choices to raise long term capital for new investments

Answer 1

Issue new shares (equity)
Borrow funds through financial institutions

Question 2

Capital structure

Answer 2

Refers to the mix of equity and debt making up a company’s long term capital

Question 3

Ordinary shares

Answer 3

Refers to equity that has no special preference in either dividends or bankruptcy

Question 4

Called up share capital

Answer 4

Par or nominal value of share multiplied by number of issued shares

Question 5

Additional paid in capital

Answer 5

Directly contributed capital in excess of par value

Question 6

Treasury shares

Answer 6

The shares the company has bought back from the market

Question 7

Earnings per share =

Answer 7

Net income/ shares outstanding

Question 8

Key features of debt compared to equity

Answer 8

Debt is not an ownership interest
Interest on debt is an expense, dividends are return of capital
Debt is a liability and unpaid creditors can force a liquidation to claim assets of the firm

Question 9

Preference shares

Answer 9

Equity shares with a preference over ordinary shares in terms of dividends or bankruptcy

Question 10

MM proposition I

Answer 10

Vl = Vu

Value of levered firm is the same as the value of the unlevered firm because individuals can undo the effects of leverage through homemade leverage

Question 11

MM proposition II

Answer 11

Rs = R0 + B/S (R0-Rb)

The cost of equity rises with leverage because the risk to equity uses with leverage

Question 12

What do the MM propositions without taxes assume?

Answer 12

No taxes
No transaction costs
Individuals and companies borrow at the same rate

Question 13

Difference between unlevered and levered firm

Answer 13

Unlevered is financed through equity
Levered is financed through equity and debt

Question 14

Financial leverage and risk

Answer 14

Leveraged equity has greater risk. Do it should have a greater return as compensation
Meaning the expected return on equity is positively related to leverage as the risk to equity holders increases with leverage

Question 15

Define components for MM II
Rs = R0 + B/S(R0 - Rb)

Answer 15

Rs = Cost of equity capital
R0 = Cost of unlevered equity capital
Rb = Cost of debt capital
B/S = Debt equity ratio

Question 16

WACC

Answer 16

WACC is a weighted average of its cost of debt and it’s cost of equity
The weight applied to debt is the proportion of debt in capital structure

Question 17

Why is capital structure irrelevant in MM models?

Answer 17

Through homemade leverage, individuals can either duplicate or undo the effects of corporate leverage so it has no effect on them
Firms overall cost of capital is constant because even though debt is generally cheaper, as more debt is added, the risk to equity rises and cost of equity capital rises as a result