Capital Structure Flashcards
What is business risk?
Risk that operating profit will be different from expected due to systematic influences (economic profit) on the company’s business sector - the business environment between 2 businesses is the same
What is financial risk?
Risk that profit available to shareholders (distributable profit) will vary from the expected due to the need to make interest payments. Risk of liquidation due to high gearing and bankruptcy risk.
What do debt providers perceive?
They perceive that debt has a lower risk than equity. Interest has to be paid out before dividends can be paid.
When are debt providers repaid?
debt providers are repaid the principal before shareholders receive any repayment of capital. Debt holder accept a lower rate of return than ordinary shareholders.
What are issuing and transaction costs?
Issuing and transaction costs are generallyl less for debt than for ordinary shares. Debt interest is tax deductible and so a £1 of interest costs £1 x (1-tax rate).
What is cost of debt capital?
cost of debt capital to company is less than the return required by the debt holder due to this ‘tax shield’ - debt finance is cheaper than equity finance.
What is gearing and how is it calculated?
gearing refers to the introduction of debt into the capital structure of the company.
Gearing is calculated as debt to equity - if you had 50 million debt and 50 million equity the gearing ratio would be 100% because 50/50 = 1 x 100 = 100%
How is leverage calculated?
as debt divided by total capital (equity + debt) - if you had 50m debt and 50m equity, leverage would be 50/100 = 50%
What does debt include?
debt includes interest bearing borrowings, current borrowings may be included in the gearing calculation if they are persistent.
What is the financial risk of gearing?
financial risk is the risk of the return to the ordinary shareholder being different from expected due to the level of debt in the capital structure of the company.
As financial risk increases, shareholder risk increases the shareholder demand a higher return.
What happens when gearing increases?
financial risk increases, the nature of the industry is an important factor in determining a suitable level of gearing.
Why does volatility of profits/dividends occur when there is high gearing?
high gearing leads to high interest, changes in interest rates will have a significant impact on profit after tax, dividends will be at risk if interest rates rise, shareholders will bear greater risk - financial risk.
Why does bankruptcy occur when there is high gearing?
increases possibility, company goes into liquidation, shareholders lose their investment.
Why does need for short term cash occur when there is high gearing?
there is a change of focus.
When does the value of a company change and how is it worked out?
changes under different debt scenarios or capital structure scenarios.
Value of company = cash flow/WACC (technically cashflow/r-g but assume g = 0)
Value of company = MVe + MVd
What is the Modigliani-miller-theorem (no tax)?
in a perfect capital market, the market value of the company is not affected by its capital structure. It is the value of the assets that are important, not the structure of the equity/liabilities or how you paid for them.
value of company = cash flow/WACC
WACC = D/D+E x Kd + E/D+E x Ke
What are the assumptions of the MM theory?
- no taxation
- perfect capital market
- perfect information available to all
- no transaction costs
- no financial/liquidation costs - assumes if company goes into bankruptcy you will be able to get a fair value on all your assets
- individuals can borrow as cheaply as companies
What is the Modigliani-Miller theorem (with tax)?
This 1963 model with tax makes it invalid but there is a revised proposition,
Vg = Vu + TL
- Vg = value of geared company
- Vu = value of ungeared company
- T = corporation tax rate
- L = value of borrowings
- TL = the present value of the ‘tax shield’
How do you pay for your assets?
how you pay for your asset can increase the value of your company, which is the value of the asset.
e.g. borrowing 4bn the company is worth 1bn more than ours, even though assets are the same because they keep a continuous tax shell, they pay interest on their borrowing. To maximise value you borrow as much as possible.
What is the value of company and WACC under the MM with tax?
value of company = cashflow/WACC
WACC = D/D+E x Kd x (1-T) + E/D+E x Ke
What is the implication of the MM theorem with tax?
Under this model, the gearing which produces the lowest WACC is 100%, At 100% gearing, lenders are actually equity providers. Lenders would perceive higher risk and demand higher return, this is unlikely to hold in practice.
How does the MM 1958 theorem with no tax influence company value?
the value of the company remains the same irrespective of the mix of debt and equity in its capital structure.
An optimal structure does not exist (min cost of capital is optimal). The market value depends on the company’s performance and its business risk.
How does the MM 1963 theorem with tax influences company value?
Tax deductibility of interest payment acknowledged, WACC decreases as gearing increases, optimal capital structure is 100% debt - need to have equity.
As this does not happen in practice there must be other factors that counteract the tax advantage - bankruptcy costs, agency costs.
Conflict between debt holders and management - they are more risk taking, tax exhaustion.
What is the traditional view of gearing?
At modest levels of gearing equity holder will not require additional return therefore the WACC will decrease as cheaper debt is added.
Once debt pasts 60-75% of asset value its costs will go up massively, there is a fixed rate to a certain point.
As gearing is increased both equity and debt holders require a higher return and WACC starts to increase again - there is an optimal level.
As debt increases, equity goes down, but debt is far cheaper than equity, the remaining equity becomes more expensive as you have more debt, must ask for higher returns.
