Capital structure

Question 1

Financial leverage

Answer 1

• Using debt in capital structure (financial leverage)
• Too much debt increase WACC due to high default risk
• D:E ratio can be used as an indicator of leverage
• Leverage magnifies impact of gains or losses

Question 2

Why use more debt

Answer 2

• Debt riskier than equity and as debt increases it increases financial risk
• It increases return required by ordinary shareholders
• If debt levels increase, cost of debt will increase
• Too much debt, increases WACC
• Loan covenants on secured long term loans may be restrictive in nature

Question 3

Cost of capital

Answer 3

• As DOFL increases, cost of equity will increase although initially there is little change
• Cost of equity higher than cost of debt due to the fact that interest is tax deductible
• Cost of equity is higher than cost of debt also due to the fact that equity carries a higher risk than debt for shareholders
• More debt gets added to capital structure WACC will start to reduce due to equity being more expensive than debt

Question 4

Issue shares to existing shareholders

Answer 4

• Existing shareholders might not have enough funds available to purchase more shares in company
• They might not have appetite to purchase additional shares
• Biggest shareholder holds 45%, if they purchase all new shares issued, gain control

Question 5

Issue shares to existing shareholders

Answer 5

• Dilution of existing shareholders percentage therefore affect existing shareholders negatively
• Private company, not easy to find shareholders
• New shareholders purchase all new shares issued, they influence on management of the company

Question 6

Equity financing to new or existing shareholders

Answer 6

• Equity financing is the most expensive form of financing since shareholders carry more risk
• Equity financing more expensive since dividends are not tax deductible
• Project carries a lot of risk with long pay back period, higher return from shareholders which makes it expensive

Question 7

Using long term debt

Answer 7

• High financial risk and solvency issues
• Lenders require higher interest rate to be compensated for high financial risk
• Debt can have negative impact on target capital structure

Question 8

What to consider when developing a financing plan for a product

Answer 8

• Company wants to keep financial and business risk in a balance
• New project increases business risk reduces financial risk
• Liquidity low, consider positive cash cycle
• Consider D:E to determine FR
• This gives insight to company’s capital structure
• Consider sources of finance in terms of risk, cost and effect
• Consider term of financing
• Match timing of cash flow from investment with financing
• Consider security

Question 9

Financing options

Answer 9

- Match term of financing with project term
🔷Risk, Control and Cost
🔷Capital structure 
-Low debt levels
-Rather issue debt
-High debt rather issue equity
🔷Timing of CF
-Match payments 
-Favour equity financing dividends are flexible than interest

Question 10

Other forms of finance they need to consider

Answer 10

Debt

• Will battle to get it for a startup unless there is a personal guarantee
• Increases risk as it is an overhead for interest
• No dilution by giving equity away

Equity

• Very expensive
• Give away huge amounts

Preference shares
- Don’t have to pay dividends if no profit

Venture/ Private equity
- Bring other values or skills

Founders cash
- Risk to individuals

Ideal to raise cash from founders too early stage for the rest

Question 11

Other forms of finance they need to consider

Answer 11

Debt

• Will battle to get it for a startup unless there is a personal guarantee
• Increases risk as it is an overhead for interest
• No dilution by giving equity away

Equity

• Very expensive
• Give away huge amounts

Preference shares
- Don’t have to pay dividends if no profit

Venture/ Private equity
- Bring other values or skills

Founders cash
- Risk to individuals

Ideal to raise cash from founders too early stage for the rest

Question 12

Recapitalization Options

Answer 12

• Need to consider current debt equity ratio is poor, aim away from debt.
• Debt will therefore be particularly expensive due to additional risk.
• New equity will dilute the shareholding (1), and also with the current low share price, many shares will need to be issued, not the right time to issue (1).
• If the share price recovers, and profitability returns, they will slowly return to a reasonable debt equity ratio through performance.
• This current recapitalisation is unlikely to get them to a 50% debt equity.
• Reject loan outright, as repayment terms and duration are not suitable.
• Information needed and process convertible preference shares.
• The cost of the preference portion is cheaper if there is no deduction for the interest in the near future.
• As the dividends are not taxable, once the company is profitable, then the costs of the instruments will be closer on an after-tax basis.
• The equity conversion if that is where the decision goes, means they will not have to repay the financing which is positive.
• The conversion would however dilute the existing shareholders holdings.
• The nature would be equity either way, and this would therefore improve the debt equity ratio.
• If not converted, the full period is 10 years, therefore much more attractive than the debentures at 5 years.
• Need the expected share price in 5 years, the redemption value, and cost of equity and preference shares.
• We then assess at year 5 whether we would convert or not by calculating the value of each option.
• For the preference shares, this will be 5 years of dividends, and then a redemption at Y10, discounted to Y5 at the cost of preference shares.
• As this is the buyer’s option, they will select the higher of the two values.
• If pref option is higher, then redo the PV at T0, 10 years of dividends, and redemption at Y10, at cost of prefs.
• If equity higher, then split into two pieces, prefs will be just 5 years dividends discounted at cost of prefs.
• Equity will be amount in Y5, discounted back to Y0 at the cost of equity.

Question 13

Relationship between investment decisions and financing decisions

Answer 13

• The reason for this is the pooling of funds principle whereby the investments are considered to be funded from a pool of funds and not a specific source of finance
• Considering the two decisions together, could result in sub optimal decisions made
• When deciding on asset specific finance consider investment and investment decisions together
• Capital budget does not consider specific financing
• Investment decision is discounted at WACC to represent required return of providers of permanent capital. Financing is considered in capital budget but pooing of funds not asset specific
• Financing decisions is discounted after tax cost of debt included in WACC
• Comparing NPC of specific financing to final normal loan will help in deciding source of financing