Module 12 - Financial Theory Part 2

Question 1

What are the three types of efficiency?

Answer 1

1. Pricing efficiency - prices move in a rational way.
2. Operational Efficiency - stock market carries out proceedings at low cost.
3. Allocation efficiency - the companies performing best are allocated resources.

Question 2

What is the cost of capital?

Answer 2

The amount a company must provide in order to persuade investors to part with their money.

Cost of equity = (D(1+g)/P)+g

Question 3

Why is debt finance cheaper for a company to obtain that equity?

Answer 3

1. Fewer bank/legal/ insurance fees
2. Debt is usually backed by security (e.g building)
3. In the event of liquidation debt must be paid first (more security my investors).
4. Interest tax is deductible where are dividends are not.

Question 4

What is gearing and what are the effects of it?

Answer 4

Gearing = Debt/ Equity

Increased gearing results in increased variability and therefore increased risks.

Question 5

What are the traditionalists views on gearing?

Answer 5

As gearing increases, risk increases therefore investors want greater return and lenders want a higher level of interest.

Question 6

Describe MM model with tax in relation to WACC

Answer 6

As gearing increases, the WACC will decrease as the higher proportion of debt capital means there is a greater level of taxable benefit.

Question 7

What is the cost of equity with tax under the MM?

Answer 7

On the tax sheet!