Capital Structure (12) Flashcards
(23 cards)
What is the cost of Capital?
The rates of return that a company has to offer finance providers to induce them to buy and hold a financial security
What are the two main models for calculating the cost of equity?
Gordon Growth Model
Capital Asset Pricing Model (CAPM)
What is the equation for the Gordon Growth Model?
Ke=(D0(1+g))/P0 + g
where:
D0 = current dividend
P0 = Ex-dividend share price
g = expected annual growth in the dividends
What is irredeemable debt?
A bond that has no maturity date
How do you calculate the Debt Capital cost for irredeemable debt?
K(id)=Interest Payable/Market Value
After tax cost of debt:
K(id) times (1-tax rate)
What method do you use to calculate the debt capital costs for redeemable debt?
The Internal Rate of Return (IRR) method
What is the equation for calculating debt capital costs for a redeemable debt?
check ppt (3) IRR
How do we find Kd once we have tested 2 interest rates and have wrong prices for bonds?
check ppt (3)
What model do you use to estimate a company’s cost of capital who uses a mix of debt and equity?
Weighted Average Cost of Capital (WACC)
What is capital structure about?
Managing or optimising the overall cost of capital and the weighted average cost of capital (WACC)
What does it mean if the return on investment is lower than the WACC?
The company is not creating value
Why is debt generally cheaper?
Lenders require lower rate of return
Debt interest can reduce tax paid
Issuing and transaction costs with raising and servicing debt are less than for equity
What is financial distress?
When obligations to creditors are not met or are met with difficulty
What do high levels of debt suggest?
Financial distress
What is gearing?
Gearing is a measure of how much a company is funded by debt compared to equity
high gearing means more debt
What is Modigliani and Millar (1958)?
A paper which proposed that capital structure has no impact on WACC. Therefore, no optimal capital structure exists
What is Modigliani and Millar (1963)?
A revised version of their previous paper where they now take tax into account. The theory changed to suggest that as you increase gearing you reduce the WACC due to the tax benefit of the debt
What do Trade-off models suggest?
Each firm has a value-maximising optimal capital structure that minimises its overall WACC
What is the effect of increasing debt on WACC and Shareholder wealth?
It decreases WACC as a cheaper source of finance
But it also increases cost of equity as shareholders demand more returns for the risks they face
Draw a graph showing the effect of equity holders demanding higher returns due to debt
check ppt (4)
Draw a graph showing where the optimal gearing ratio is
check ppt (5)
What does the trade of model suggest?
Up to a point gearing will increase shareholder wealth, beyond this point its too risky
What is a Minsky Moment ?
A sudden collapse of asset prices after a long period of growth, sparked by debt or currency pressures
