Capital Structure Flashcards

Flashcards about Capital Structure concepts, including definitions, calculations, and theories.

What does 'capital structure' refer to?

The mix of debt and equity (usually long-term) used by a company to finance its overall operations and growth.

What is 'gearing' or 'leverage'?

The mixture of debt finance relative to equity finance that a company uses to finance its business operations. It indicates how much debt is being used.

List three gearing ratios that assess financial risk.

Debt/Equity ratio (D/E), Capital gearing (D/(D+E)), and Income Gearing.

What is the preferred method for determining values in gearing ratios when assessing financial risk and why?

Market values are preferred to book values because they better reflect the current financial standing.

Return on Equity (KE) Formula

Dividend payments / (Market) Value of equity VE

Return on Debt (KD) Formula (ignore tax)

Interest payments / (Market) Value of debt VD

What is the formula for Weighted Average Cost of Capital (WACC)?

K0 = (VE × KE) + (VD × KD) / (VE + VD)

When calculating WACC, what are the four steps?

1. Calculate the cost of debt. 2. Calculate the cost of equity. 3. Determine the market value of debt and equity. 4. Calculate the WACC using market weightings.

How is the cost of debt calculated?

Cost of Debt = Interest rate * (1 – Tax rate) / Market price of bond

How is the cost of equity calculated?

Cost of Equity = CAPM = Rf + B * Rmrp

What is the formula for calculating the market value of ordinary shares?

Market value of ordinary shares = Nominal value × Number of shares

According to Miller and Modigliani I, what affects the firm value?

Miller and Modigliani I: no OCS is found

According to Miller and Modigliani II, what affects the firm value?

Miller and Modigliani II: OCS is 100% debt

Why do market imperfections suggest an optimal capital structure (OCS) exists?

Miller and Modigliani I: no OCS is found

What is the key assumption in the Miller and Modigliani (1958) model regarding capital markets?

Capital markets are assumed to be perfect.

According to Miller and Modigliani (1958), what happens to the cost of equity as gearing increases?

The cost of equity increases as gearing increases.

What is the formula for calculating the cost of equity of a geared firm (using debt) according to MM1958?

KE g = KE ug + (KE ug −KD) VD / VE

According to the MM (1958) model, what primarily determines the value of a company?

Value depends on investments, NOT financing.

How did Modigliani and Miller adjust their model in 1963 and what was the implication?

They adjusted their model to reflect the tax deductibility of interest payments, implying an optimal capital structure does exist, with as much debt as possible.

How is the total market value of a geared company (V0g) calculated in the MM(1963) model?

V0g = VEug + VBT

In the context of capital structure, what does 'tax shield' refer to?

Tax efficiency implies that gearing up by replacing equity with debt gives benefit of a tax shield, increasing the value of company

What should companies balance to achieve an optimal capital structure when considering market imperfections?

Companies have to balance the tax efficiency of debt with the risk of bankruptcy.

What are some of the other capital structure approaches?

Agency theory and capital structure, The pecking theory of financing, and The market timing approach

According to Agency theory and capital structure, what do debt suppliers often impose on loan agreements?

In order to try to avoid this situation we find that debt suppliers often impose very restrictive conditions (or covenants) on loan agreements that constrain management’s freedom of action.

What is the first rule of the 'pecking order theory'?

Finance the company as much as possible through the use of retained earnings.

What is the second rule of the 'pecking order theory'?

If external finance has to be used, issue debt until debt capacity is reached and only then, if +NPV projects still remain to be financed, issue equity.

What does the market timing approach suggest about raising equity?

It’s a good time to raise equity, when the company’s share is relatively high.

What does the market timing approach suggest about raising debt?

And it’s a good time to raise debt when the share price is relatively low.