Chapter 7 - Capital Structure

Question 1

Matching

Answer 1

• Duration
• Currency
• Pattern of cash flows

Question 2

Conditions for use of WACC

Answer 2

Requires risks of future investments to be identical to existing business:

• Business risk - industry
• Financial risk - gearing/capital structure
• Size (of investment)

Question 3

Portfolio Theory

Answer 3

• Start with undiversified investments
• Diversify to eliminate unsystematic risk
• Then only susceptible to systemic risk
• Use B factor in CAPM to give investors required return

Question 4

WACC and Gearing Theories

Answer 4

Traditional Theory

• Debt makes sense up to a point (since cheaper)
• Eventually risks incraese and WACC starts to rise
• There is an optimum WACC

Modigliani + Miller (no tax)

• As debt increases, benefits exactly offset by increase in k_e (higher risk)
• WACC not affected by gearing (remains constant)

Modigliani + Miller (with tax)

• Added benefit of k_d - WACC falls as debt (gearing) increases

M+M Assumptions

• debt always risk free (same interest rate regardless of gearing)
• perfect market - perfect info.