Capital Stucture Decision Flashcards
(11 cards)
Define relative valuation and PE ration
Relative valuation assesses a stock’s price by comparing financial multiples to peers, the overall market typically used in sectors with many comparable firms
Define the cost of capital
required return, discount rate, and cost of capital all refer to the minimum return needed to justify an investment (postive NPV)
This rate compensates investors for the use of their capital.
It includes both the cost of debt and the cost of equity.The cost of equity is always higher than the cost of debt due to higher risk faced by shareholders
Explain why the Wacc is important
Companies calculate WACC to measure performance and how it affects shareholders.
WACC is used to help decide if an investment is a worthwile undertaking.
Regulators like Ofgem and Oftel use WACC to decide what a fair profit is for certain industries.
For example, in 2011, Ofgem set the WACC for gas companies at 7.6%, which was different from what the companies expected (8.8%)
Define the Wacc
The Weighted Average Cost of Capital (WACC) is the firm’s overall cost of capital, the minimum return needed to justify an investment. calculated as the weighted average of the costs of debt and equity,
The WACC refers to the cost of financing based on the capital structure.
A firm’s value is maximized when its WACC is minimized.
The optimal (or target) capital structure is the mix of debt and equity that results in the lowest possible WACC.
formula for WACC/calculate firms overal cost of capital
WACC = Ke * E / (E+D) + Kd * D/(E+D) * (1-T)
where t = corp tax rate
Ke/d = cost of equity and debt
E/D value of equity and debt, e/e+d etc is the weight of the debt/equity of the capital structure
Define capital structure
Capital structure is the way a company finances its operations by using a mix of debt and equity.
In simple terms, it’s how a company gets the money it needs — either by borrowing (debt ) or by raising it from investors (equity)
formula for value of firm using wacc
-Perpretual vash flow,
V = C / Wacc
-Growing cash flow
V = C / Wacc - G, g is cash flow growth rate
The value of the firm is calculated by estimating its future cash flows and then discounting these using the cost of capital.
Define leverage
Leverage refers to how much debt a company uses compared to its total capital. Leverage shows how much the company relies on borrowing (debt) rather than equity.
-Higher debt levels means higher financial leverage and greater financial risk.
Higher leverage in a company’s capital structure reduces net income, due to interest costs however can boost earnings per share by limiting new equity;, it also increases the volatility of income, raising financial risk for shareholders
Define business and financial risks in terms of risks assosiated with leverage/cap structure decision
Financial risk refers to risk arises from the use of debt (leverage) in the capital structure, increasing profit volatility because of interest payments, this risk is taken on by some of shareholds.
Business risks refers to the overall variation in profits due to the company’s operations, affecting both equity and debt holders regardless.
Why does financial risk increase with more debt/leverage, how does it affect shareholders?
Debt has priority over equity for cash flow and liquidation payments.
Interest on debt must be paid before any dividends to shareholders.
More debt means higher chance the company can’t pay dividends, increasing financial risk.
Define interest rate tax shewidl, formula for PV of tax sheild and calculating value of leveerd and unleveted firm
Interest Tax Shield: The tax saving a company gets from deducting interest payments.
InterestTaxShield (annually)=InterestPayment×TaxRate
-PV tax sheild = D (debt value) * tax rate
-value of Unlevered Firm: EBIT *(1-t) / unlevered Cost of capital
or FCF / r (cost of capita)
-value of levered Firm: Vl = Vu + (D * T) (PVofTaxShield)
