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Year 1 - Accounting and Finance > fiance lecture 9 - capital structure > Flashcards

fiance lecture 9 - capital structure Flashcards

1
Q

iwhat is business risk

A

risk operating profit will be different from expected duee to systematic influences on company’s business sector

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1
Q

two types of risk

A

business financial

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2
Q

what is financial risk

A

risk profit avaiable to SH will vary from expected dur to need to make interest payments

(distributable)

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3
Q

why may there be a risk of liquidation

A

high gearing

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4
Q

financial risk can lead to whta risk

A

bankruptcy

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5
Q

if we have a company operating in the same exact way but capital structure is different what risk will be the same and what risk will bediffernt

A

business - same

financial - different

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6
Q

the market has bad year and both companies make 2milly profit but one company got 8m interest to pay what happens

A

incur huge loss of 6mm

if can’t find cash call in loan and company go bankruptch

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7
Q

if copany goes bankrupt what do shareholders recieve

A

0

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8
Q

what happens if compnay goes into bankruptcy

A

miss out on profit company wiped out

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9
Q

profits avaialble to sh from redistributbable profit x and poitentialy due to what

A

varies

interest payments

and small fluctuations in business risk

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10
Q

if company not able to pay for interest what happnes

2 things

A

bankrupt + liquidate company

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11
Q

if i have 0 debt i have

A

0 financial risk

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12
Q

total risk =

A

business + fianncial risk

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13
Q

why would SH of a company w debt ask for a higher ROR than sh of comp w 100% equity

A

got more risk

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14
Q

return to investors =

A

cost to company

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15
Q

as soon as you introduced debt into a company what happens to bsuniess risk and fiancial risk

A

business risk - same

finacnial risk - increases

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16
Q

when you look at risk to equity holders you should thnk aboutt the

A

underlying risk to assets of company

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17
Q

if company has debt there is financial risk which is bore by

A

SH

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18
Q

IMPACT OF DEBT ON COST OF CAPITAL

A
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19
Q

If company gets a change in operating profit likely debt holders recieve .. and what would they recieve if it was in final year

A

coupon repayment b4 sh recieve dividend payment

principal repayment but SH recieve capital return

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20
Q

debt us a safer form of cpaital from whos POV and why

A

debt holder

get padi b4 SH

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21
Q

Issuing and transaction csots for debt genreally x than ordinary sahres

A

lower

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22
Q

it is slighty cheeaper for comany to raise

A

debt

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23
Q

debt interest is tax deductible so and expand

A

£1 of interst costs £ x 1-tax rate

so cost of debt capital to company is less than return required by debt holder due to tax shield

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24
Q

to sum why is debt finance cheaper than equity - 3 things

A

lower risk

lower issuing cost

tax shield

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25
Q

we may think if a company wants to max its profits it shte same as min costs and so shoudlahve as much debt as possible but we musnt forget

A

we may bring cost down by bringin debt into capital structure but this can have knock on effect on cost of equity becasue the more debt

the grater the bankruptcy risk

therfore required hihger ror

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26
Q

Gearing

A

ratio of debt in capital structure sometimes debt to equity sometimes det + equity

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27
Q

ungeared

A

no debt in captial struture

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28
Q

what does debt include

A

interest , bearing borrowings , lt debt , st debt anything payinginterest on borrowings

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29
Q

finacnial risk of return to ordinary share holders being different than expected due to

A

level of debt in caital structure of a company

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30
Q

debt magnifies the volatitly of the

A

operating profit

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31
Q

gearinf increases what risk

A

financial risk

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32
Q

what is important in identifying a suitable level of gearing

A

nature of industry

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33
Q

why does financial risk increase SH risk

A

they are residual claimant so finacial risk inreases SH risk

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34
Q

implication of high gearing - 3 things

A

volatility of profit/dividends

bankruptcy

need for ST cash

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35
Q

volatility of profit/dividedns

A

hgih gearing = high interest payments/finance charges

change in IR have significant impact profit after tax so more vulnerable to change and residual profit is waht SH care about

dividend ar risk if increase IR

SH bear greater risk if bearing risk ask for hgiher return q

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36
Q

bankruptcy

-whats the risk
- who may call in debt if compayn cant and waht is consequencw
- - effect of bankrutpcy on sh company…

A

risk of no cash left in company to pay debt holders and got principla/interst payments falling due

creditors amy call in debt if company cant pay em company goes into liquidation and then SH loose investment

any form of bankruptcy wipes out SH

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37
Q

LIQUIDITAION IS NTO THE SAME AS

A

ADMINISTRATION

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38
Q

What is adminisatration

A

tryna keep comp going for beenfit of employees and creditors so SH got nuttin to do w this

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39
Q

need for st cash - 4 things

what do company need cash for anf how much

can st cash intro change and how

what is the effect of this change

A

comp need enough cash to finance incestments

can cahnge priority of comp

so bringin in st cash becomes priority to avoid bankruotcy

so may not be able to make LT investments which wasintially your LT plan

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40
Q

value of a company

A
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41
Q

what you gain in debt you loose in

A

equity

overall effect is they offset each other so value of company should remain the same

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42
Q

value of company formula

A

cash flow(operating)/wacc

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43
Q

technically what is teh formula but waht do we assume

A

cash flow/r-g

g=0

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44
Q

to value the company all we need to do is

A

get overall operating cashflow

avaiabel to sh and debt holder then divided required ROR forboth debt and equit holders

WACC for both debt holdrs and equity holders ?

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45
Q

value of company other formula =

A

MVe + MV d

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46
Q

modigliani theory no tax

A

in a perfect capital market the market value of company not affected by capital structure

i.e so how we pay for the our 50m portolio shouldt affect value of assets

point is - it is teh value fo teh asets we care about not the structure of equity/liabilities

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47
Q

assumptions of modigliani theory no tax

-how is capital markets - how is the info available
- is ther liquidation costs
- how can idnfiduals borrow

A

oerfect caotal amrekts - so all stkh kow whats going on

perfect and complete info is avaiable to all

0 transaction costs

no financial liquidation csots

individuals can borrow as cheaoly as companies - so can create own leverage ratio

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48
Q

explain the graph with ke highest wacc straigh horizontal and kd straight

y axis - cost of capital

x axis - gearing

A

straight wacc line indicates that cashflow is fixed regardless of geariing

wacc is avg between kd and ke

wacc must be cost of equity because of some intersection, and at this intersection point debt must be 0

and if thats the ke then kd should be lower as debt is cheaper than cost of equity

cause at this point WACC becomes cost of equity ~

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49
Q

what is the other graph in modigliani and milller theory

A

y axis - value of copm

x axis - gearing D/E
straight line = kd

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50
Q

Graph 2 - what is not affectd by capital structure

A

assets of the company that count and mkt value of comp not affected by capital structure

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51
Q

graph 2 explain graph

A

at point x company got 0 debt so value of comp/asset = value of equity

add more debt as you move to the right hand side but youve still got the same amount of assets

total value fo debt and equity the same regardless of gearing ratio or debt in capital structure
as we increasse gearing we have more debt but its a 1 for 1 charge - £1 more of debt = £1 less of equity so cancel each other out

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52
Q

company value =

A

cash flow/WACC

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53
Q

Cash flow doesnt

A

change

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54
Q

as cash flow doesnt chane and value of copany stas he same then mathematically waht will happen to WACC

A

WACC is same

as value of company is not afffected by gearing

WACC mut also be a straight line

55
Q

graph 1 and det must be cheaper than equity and casue we know kd will be consistent over differnt levles what do we draw

A

a straigth line

56
Q

graph 1 what does vertical distance drom kd to WACC give us

A

Ke w no debt

so can put kd ahywhere but below intersection

57
Q

graph 1 why is cost of debt a flat line

A

we got perfect ingot and cuz no bankruptcy cost no reason for debt to be expensive at diff levels of gearing

58
Q

ke is an upward sloping line but we areen’t suprised why

A

more debt mroe financial risk therefore the bigger the risk and the higher total risk thsis increaes risk for SH meaning a higher ror so ke higher

59
Q

when does waac become a straight avg calculation

A

we halfway through

50 50 point

60
Q

at mid way point how should debt and equity be in relation to the other distancce wise

A

same dsitance cuz its an avg of the 2 points

61
Q

the full ke line =

A

cost of equity

and so can apply this to other percentages

62
Q

look at how to draw the graph

A
63
Q

modigliani w tax

*differentiate between all the diff theoeries w learnt on a sheet at the end

A
64
Q

modigliani w tax

A

tax exists and is signficantly cheaper than Ke - tax shield /paymetns being deductible so

so no tax theory is irrelevant and incorrect

65
Q

modigliani no tax - if you’ve got debt in your company what is happenieng to cf and why

A

increase

when you get income this is taxed
and apparently interest payments are tax deductible

so tax billl faced by company with no dent will be higher than bill faced by copmany with debt in capital structure

66
Q

the assumption in which we said comp value remains the same - why was that an assumption

A

cf stays the same

67
Q

the assumption in which we said company value remains the same becasue cf stays he same isnt right when you introduce

A

taxes

68
Q

why is the assumption copmany vaue reamins the same as cf stays the same not right when we introduce taxes

A

after tax cf are higher whe you have debts as opposed to when you don’t have debts

69
Q

after tax cf to equity holders may be lower but what eles shoudl ew consider

A

the cashflow to debt holders

70
Q

so if we aggregate all cashflow received by capital providers including debt and shareholders , because of tax shield for the debtt then what happens to aftertax cf for a company was a whole

A

will increasse when you intro/add debt to your capital structure

71
Q

debt is cheaper cuz of

A

tax shield

72
Q

what was modigliansis revised proposition

A

yes debt affects capital structure and in a radical way

73
Q

expand on modiglianis revised propostion

valof company thats geared …

A

value of a company that’s geared and has got debt element in capital structure is = to the value of the company that’s ungeared w/o debt +value of tax shield

tax shield is simply = NPV of all the improvement to cf as a result of having a tax shield for interest payment cause of debt

74
Q

what is the value fo ungeared company in symbol terms + transalte

A

Vg = Vu + TL

value of a geared company = value of an ungeared company(net assets) + corporation tax rate*value of borrowings(assume stay consistent forever)

TL = PV of tax shield

75
Q

do example of VG = VU + TL

A
76
Q

sum up modiglani and dem tings der

A

tax adds value and matters

77
Q

what is graph 1 of the (with tax theory)

A

y axis - cost of capital %
x axis - gearing D/E

Ke - upward sloping line
WACC - downward sloping line

straight line kd(1-t)

78
Q

what is graph 2 of with tax theory

A

value of a company - y axis

gearing D/E - x axis

line touchnig above 0 and going up horizontally

79
Q

what does graph 2 of the with tax theory show

use exmaplar numbers

A

we have value of copany at 10bn with no debt as soon as we intro debt value of copmany increases cuz of tax shield

as you increase debt tax shield increases also

80
Q

how mch is the ta shield

A

25%

81
Q

what does a tax shield fo 25% mean

A

for every £1 you add 25% added value to the company

82
Q

WACC w tax formula

A

D/D+E *Kd *(1-t) +

E/D+E *Ke

83
Q

when we do 1-t what do we deal wirh

A

tax in the WACC not teh cashflow

84
Q

aftertax cashflow inr eality is better and improved casue of

A

taxshield as we pay less tax

85
Q

t/f our operating cf (Cash b4 we pay taxes) stays the same

A

t

86
Q

why does operating cf stay the asme

A

got nothign to do w tax bill or the amount we pay , its operaitng progit whihc is b4 company pays tax

87
Q

why is the WACC w tax lower

A

we deal w tax in WACC formula and incoroporate the beenfit of tax shield

88
Q

casue we deal w tax in WACC by reducing WACC the operating cf that appear in company valution remains the ….

A

same regardless of leverage we have

89
Q

if valu of company increeases and the cashflows are constant and the numebrator is contant mathematically what happesn to teh WACC

A

It goes down

90
Q

a rising value must be assocauted with a

A

decreasing WACC

91
Q

why must a rising value be associated w a decreasing WACC

A

we still have Ke increasing as gearing increases but we have a lower cost of debt due to tax shield

92
Q

why should kd be lower on these graphs than previous ones (and lower than ke)

A

cheaper and less riskier

but now w intro of tax shield the already cheaper cheaper Kd is cheaper

(+ this explains the reduction in the weighted average cost of capital)

93
Q

as we add more debt, equity which gets more expensive it is replaced w what

and also what does this replacement of more expensive equity by cheaper debt casue and therefore

A

cheaper debt

overall WACC to reduce in value

therfore we see a decline in WACC as we increase gearing of amount of debt

94
Q

so to sum why is WACC downward slopign

A

debt more cheaper than equity

cause of tax shield as you add more debt ou are giving up £1 of equity
to gain £1 of debt
replacing mroe expensive equity w cheaper debt

95
Q

conclude on the whole WACC debt matter

A

the more debt we have the WACC will always go down and if we add extra unit of det WACC will go down and comp value will increase

96
Q

whats the issue/implicaito of mm theorem w tax

A

if adding debt increases company value then should fund company w 100% debt

as in order to max value of a copany you should max value of tax shield by adding as mcuh debt as possible - so entire capital should be debt

97
Q

once you get to 100% gearing what does this mean

A

no equity to take residual risk for debt holders

debtholders take all residual risk

98
Q

since debt holders takign all risk what do lenders do

A

demand higher risk premium

as taking equity risk also

99
Q

as lenders take on all the equity what hhappens to kd line

A

it no longer applies

as once you get close to gearing ratio debt holders effectively become sh

so kd shoots up to csot of equity

100
Q

what dod debt holders demand as a resuklt of a company capitla structure being 100% debt

A

bear entire risk so they would charge you a higher rate

effectively become sh

101
Q

why cant a company be funded on 100% gearing

A

every copany must have an equity bassis then choose ho mcuh debt its gonna have

102
Q

do summary of MM theorem w tax

A

gearing whihc produces wacc is 100%

at 100% gearing lenders are actually equity providers

lenders would percieve highe rrisk and demand hihgher return

unlikely to hold in practice

103
Q

summary of 1856 theory no tax

A

value of copmany remains same irrespective of mix of debt and equity in its capital structure

an oprimal capital dont exist

mkt value depends on copmanys perfomrnce and business risk

104
Q

summary of 1963 with tax

A

tax dedctibliiity of interest paments acknowledged

WACC decreases as gearing increasses

optimal capital structure 100% debt

as this dont happen in practice there must be other factos counteractin tax advantage e.g bankruptcy costs , agency costs tax echaustion

105
Q

what si tax exhaustion

A

as incerase debt interest oaymens increase but poin

bruh just look on teh mondy pls

106
Q

what is traditional viewe

A

at modest levels of gearing equity mostly wont rewuire addditoiinal retun threfore the WACC will reduce as cheaper debt is added

as gearing is increased both equity and debt holders require a hgiher returna dn WACC increases

there is an optimal value

107
Q

what is relationship between financial risk and and ror/cost of equity

A

positive

108
Q

lenders work on a loan to value ratio what does this men

A

x% of alue of assets you have , we gonna charge you a 5-10% interest rate so fixed to a certain point

once you go beyond prespecififed loan to value ratio either stop lending your moeny or cahrge a higher rate of interst

109
Q

at low levels of gearing we see expensive equity being replaced by cheaper debt ehich does waht to WACC

A

Reduce it

110
Q

as we keep increasing gearing at some point ke becomes so high and kd becomes more expensive that replacing it with waht will increase what

A

debt

will increase WACC

111
Q

SUM UP DEBT AND WACC PLS - LOL I DUNNO HWO MAN TIMES IVE WRITTENT HIS

A

more debt reduces WACC up till a certain point ater tha it increases WACC

so there is an optimal lelve

112
Q

how does the trad graph llook

A

y axis - cost of capital

x axis - gearing D/E

ke curve upward slop

WACC - slight U bucket shape

kd straight then rises

otimal oint is wheer WACC is at the minimum

113
Q

outoine the KE on teh trad view graph

A

@ earlier stages of gearing as we add mroe debt carrying risk but not signfificant to SH so they ask for sligjtly higher rate hence ke increaseut not too stepp

later at higher levels of leverage SH tend to start facing bankruptcy cost of inaicla risk that they dramatically increases ROR

114
Q

explain d on graph

A

till we get to x (dotted line from minimum point)

bank charges same flat rate but as soon as you pass prepsec threshold bank will say we dont liek tha so we not gone lend you/be charged at a highe rinterest rate

so significant increase in cost of debt once company moves beyonf prespecified loan to value ratio

115
Q

explain WACC

A

U shaped cuz if got to have amimium

if we minimise our disocunt rats which is weighted ACC then we must be maxing value of firm

as cf/wacc if min discount rate and cf constant we’ll be maing val of company

so point x is optimal value - as it gives us mini wieghted ACC

116
Q

minimum weighted WACC gives us

A

max val of copmany

117
Q

in the trad view of WACC explain why wacc falls then rises

A

intially fall due to benefit of having greater amount of cheaper debt outweighs increased cost of equity ( as a result of greater risk

continues to fall till reaches optimal value

ater x as you add more debt equity becomes so expensive benwfits of having cheaer amount of debt outweigh no longer outweighs the increase in Ke so WACC tend to go up beyonf this point

118
Q

what is the trad view each 2 - check this on moodle because the line doesnt actually have a label

A

y axis return %

x axis debt/equity

bucket u shape but more narroe

draw dot from the middle down - optimal should be the line going down

left side - impetus to add debt

right side oimpetus to decrease sebtr

119
Q

what are the notes on impetus to add de bt

A

ereduced cost of eebt

tax rlief on debt

120
Q

what are the notes on impetus to decrease dbt

A

financial distress/bankruptcy cost

agency costs

121
Q

the trad approach whihc is a combo of oth series say

A

benefits to adding debt from an unleverged positoin up to optimal point ass Kd lower than Ke + we get a tax shield so adv of having debt lead to decrease in weighted avg cost of capital

122
Q

what are the negatives of adding debt past optimal poitn

A

there are finaical disress and bankrupty costs and other costs(e.g. advisors, legal fees

in real world if got to sell all assets throguh bankruptcy probably won’t get afair value

123
Q

when managermt under water w debt they not incentivised to do the right thing - what do they do instead

A

crazy thinkgs not in line w interest of SH or stkh of company

124
Q

in right hand zone impetus to add debt how do you add value

and so if you to far right …..

A

decreasing debt

if you tot eh far right and you reduce debt youre reducin your WACC but if jkeep adding debt you increase WACC which reduces aue of cop

125
Q

keyy point from trad view graph 2

A

Min possible WACC leads to max possible value

if on extreme of left add debt if on right reducce debt to REDUCE WACC

126
Q

trad view graph 3

A

y axis - firms value
x axis - debt/equity

curve touches y axis and tehn springs over in an inveerse U shape

from teh middle draw dotted line to get to optimal

127
Q

what does trad view graph 3 show

A

increae val of firm up to optimal point by adding and benefitting from debt and cheaper tax shield

if push leverage beyond optimal valu wew destroting value as WACC increases

128
Q

summary of trad view (3)

A

optimal capital structure corresponds to min possible weighted avg cost of capital

if managment want to maximise SH value and wealth - val of fim which corresponds to min WACC must target optimal debt to equity ratio whicch gives minimal WACC which increases max val of firm

129
Q

what are the 4 capital structure considerations

A

agency costs

signalling effect

clientele effect

industry norms

130
Q

what are agency costs

A

principal agent problem

managment w debt overhang may take freater risk

deep in debt all earnings from projec go to existing debt holder leaving v little incentive for management or SH to do teh right thing

so maangment may take excesiveky riky prokects w high return in teh case they think project succcesful and so oncce they pay debt hlders there’s chacne suttin left for sh

but if project fails and is unsuccesful they don’t got much to loose as most of loss bore by debt holders

131
Q

sum agency cost

A

too much debt can ipact company value if managment engage in excessivley risky projects as they feel like got nothing to loose as majority of risk bore by debt holders

132
Q

signallign effect

A

issuing debt implies confidence about future to cashflow

as you wont isssue debt if you not confident if you can easily make interst payments

otherwise you’d be walking straight into bankruptcy

confident in companies ability to pay financial obligation

133
Q

clientele effect

A

existing client sahppy w existing capital structure

so change can cause some to sell/buy if large scale can impact company valuation

134
Q

industry norms

A

caopital structure depnds on teh type of copnay and industry

e.g norm for utility industry if got 80-90% leverage

whereas retail having this kind of thing will be percieved as a bad finacial situation you put yourself in

Year 1 - Accounting and Finance (49 decks)

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