Capital Structure

Question 1

Operating gearing formula

Answer 1

Fixed costs/Total costs

Question 2

Financial gearing formula

Answer 2

Debt/Debt + Equity

Question 3

What happens to WACC at low levels of gearing

Answer 3

Equity investors don’t see a change in risk
Cheaper debt is incorporated, WACC falls

Question 4

What happens to WACC at high levels of gearing

Answer 4

Equity investors see volatility of returns as debt interest is paid first
Increased equity risk increases Ke WACC rises

Question 5

What did M&M argue in no tax theory

Answer 5

Ke directly linked to increase in gearing
As gearing increases so does Ke
WACC unchanged

Question 6

What did M&M argue in with tax theory

Answer 6

Debt interest is tax deductible so Kd is lower than before
Increase in Ke does not offset benefit of cheaper debt finance
WACC falls as gearing increases
99.9% gearing optimal

Question 7

Problems with high level of gearing

Answer 7

Increased bankruptcy risk
Tax shield may not be achieved as there are high interest costs
Directors may be more risk averse than shareholders