Chapter 12 - Capital structure

Question 1

What is capital structure?

Answer 1

How a company is funded and the proportion of debt to equity

Question 2

What are the disadvantages of debt?

Answer 2

• Financial risk

- Worsens liquidity and risk ratios

Question 3

What are the advantages of debt?

Answer 3

• Cheaper source of finance
• Less impact on EPS
• Quicker and cheaper to issue
• Tax relief
• Signal of confidence

Question 4

What is the formula for operational gearing?

Answer 4

Contribution / PBIT

Question 5

What is the traditional theory?

Answer 5

There is an optimal capital structure. Debt gives a benefit up to this point

Question 6

Why does WACC fall at the start in traditional theory?

Answer 6

Debt is cheaper and equity does not view low debt as higher risk

Question 7

Is company value at its lowest or highest when WACC is at its lowest?

Answer 7

Highest

Question 8

Why is debt cheaper?

Answer 8

• Tax relief

- Lower risk

Question 9

Why does WACC rise past the optimum point in traditional theory?

Answer 9

High debt creates high risk so equity wants high returns

Question 10

What does net operating income theory suggest (M&M without tax)?

Answer 10

The capital structure has no effect on WACC. This is because of the facts that debt is cheaper than equity and that cost of equity rises as gearing does, results in a cancelling effect.

Question 11

What is arbitrage?

Answer 11

If two companies were identical aside from capital structure and had different values then investors could make a risk free gain by selling shares in a company with a higher value and buying from company with a lower value, so market values would move in line with eachother.

Question 12

What does M&M with tax suggest?

Answer 12

WACC falls consistently as gearing rises due to savings from tax relief - a company should use as much debt finance as it can.

Question 13

What are the drawbacks on net operating income theory?

Answer 13

• Assumes a perfect capital market exists in which investors have same information
• No tax or transaction costs
• Debt is risk free

Question 14

What are the drawbacks on M&M with tax?

Answer 14

• Assumes debt is readily available
• Ignores indirect financial distress costs - customers may not want to buy from company with higher gearing as unstable
• At higher levels of debt providers are going to impose restrictive covenants
• Ignores tax exhaustion

Question 15

What is the process for calculating marginal cost of capital?

Answer 15

1. Ungear a proxy company
2. Regear to beta to reflect gearing of project
3. Calculate cost of equity using CAPM

Question 16

What risk does asset beta have attached to it?

Answer 16

Business risk

Question 17

What risk does equity beta have attached to it?

Answer 17

Business and financial risk

Question 18

What is the funding gap?

Answer 18

The inability to raise sufficient finance

Question 19

What is the maturity gap?

Answer 19

The inability of SMEs to raise medium term finance due to inadequate security

Question 20

What are some sources of finance for SMEs?

Answer 20

• Business angels
• Supply-chain finance
• Crowdfunding