Capital Structure

Question 1

What is business risk?

Answer 1

Risk that operating profit will be different from expected due to systematic influence on the company’s business

Question 2

What is financial risk?

Answer 2

• Risk that profit available to shareholders will vary from the expected due to the need to make interest payments.
• Risk of liquidation due to high gearing
• Bankruptcy risk

Question 3

What is the impact of debt on cost of capital?

Answer 3

Debt provided perceive that debt has a lower risk than equity.

• Interest has to be paid out before dividends can be paid.
• Debt providers are repaid the principal before shareholder receive any repayment of capital.
• Debt holders accept a lower rate of return than ordinary shareholders.

Issuing and transaction costs are generally less for debt than for ordinary shares.

Debt interest is tax deductible and so a £1 of interest costs £1

Question 4

What is gearing?

Answer 4

Gearing refers to the introduction of debt into the capital structure of the company.
Debt included interest bearing borrowings.

Question 5

Gearing (leverage)

Answer 5

• Financial risk the risk of the return to the ordinary shareholder being different from expected due to the level of debt in the capital structure of the company.
• As gearing increase, financial risk increase.
• As financial risk increase, shareholders’ risk increases.

Question 6

Implications of “high” gearing - volatility of profits/ dividends

Answer 6

• higher gearing= high interest payments
• changes in interest rate will have significant impact on profit after tax
• dividends will be at risk if interest rates rise
• Shareholders will bear greater financial risk

Question 7

Implications of “high” gearing - bankruptcy

Answer 7

• Increased possibility of bankruptcy
• Company goes into liquidation
• Shareholders lose their investment
• Need for short-term cash

Question 8

Value of Company

Answer 8

VC= cashflow/WACC
VC= MVe + MVd

Question 9

Modigiliani and Miller (no tax)

Answer 9

• In a perfect capital market, the market value of the company is not affected by its capital structure.
• It is the value of the assets that are important not the structure of the equity/liabilities

Question 10

Assumptions of M&M

Answer 10

• no taxation
• perfect capital markets
• perfect information available to all
• no transaction costs
• no financial/liquidation costs
• individuals can borrow as cheaply as companies

Question 11

Modigiliani and Miller (with tax)

Answer 11

No taxation

• invalid
• revised proposition

M&M With tax
Vg = Vu + TL

Vg -value of a geared company
Vu- value of ungeared company
T- corporation tax rate
L- value of borrowings
TL- the present value of the “tax shield”

Question 12

M&M with tax- implication

Answer 12

• Under this model the gearing which produces the lowest WACC is 100%
• At 100% gearing, lenders are actually equity providers
• Lenders would perceive higher risk and demand higher return
• Unlikely to hold in practice

Question 13

M&M capital structure theory- no tax

Answer 13

• The value of a company remains the same irrespective of the mix of debt and equity in its capital structure
• An “optimal” capital structure does not exist
• The market value depends on the company’s performance and its business risk

Question 14

M&M capital structure theory- no tax

Answer 14

• Tax deductibility of interest payments acknowledged
• WACC decreases as gearing increases
• Optimal capital structure is 100% debt
• As this does not happen in practice there must be other factors that counteract the tax advantage (bankruptcy costs, agency costs, tax exhaustion)

Question 15

Traditional view

Answer 15

At modest levels of gearing equity holders will not require additional return therefore the WACC will decrease as cheaper debt is added

As gearing is increased both equity and debt holders require a higher return and WACC starts to increase again

There is an optimal level

Question 16

Other capital structure considerations

Answer 16

Agency costs

Signalling effect
-issue of debt implies confidence about future cashflow

Clientele effect

• existing client are happy with existing capital structure
• change could cause some to sell/ buy

Industry norm

Question 17

“Pecking Order” for finance

Answer 17

Retained profit
-positive share price reaction

Capital markets

• Debt: slight negative share price reaction
• Equity: higher negative share price reaction

Based on empirical observations of share price movements and managerial behaviour