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CFS C4TX: Capital Structure (additional considerations (b. some factors…
CFS C4TX: Capital Structure
introduction
a. debt finance is cheaper and riskier (for the company)
what do we mean by 'gearing'?
operating gearing: refers to the extent to which the firm's total costs are fixed
financial gearing: is the focus of this chapter and concerns the proportion of debt in the capital structure
capital gearing: focuses on the extent to which a firm's total capital is in the form of debt
income gearing: is concerned with the proportion of the annual income stream (that is, the pre-interest profits) which is devoted to the prior claims of debt holders, in other words, what proportion of profits is taken by interest charges
the effect of gearing
a. expected returns and standards deviation of Harby plc
b business risk and financial risk
business risk is the variability of the firm's operating income, that is, the income before interest
financial risk is the additional variability in returns to shareholders and the increased probability of insolvency that arises because the financial structure contains debt
the value of the firm and the cost of capital
does the cost of capital (WACC) decrease with higher debt levels?
scenario 1:the cost of equity capital remains at 20 per cent
if shareholders remain content with a 20 per cent return, the WACC decreases
scenario 2: the cost of equity capital rises due to the increased financial risk to exactly offset the effect of the lower cost of debt
in this case the WACC and the firm's value remain constant
scenario 3: the cost of equity capital rises, but this does not completely offset all the benefits of the lower cost of debt capital
in this case the firm, by increasing the proportion of its finance which is in the form of debt, manages to reduce the overall cost of capital and thus to increase the value of the firm and shareholder wealth
scenario 4: the cost of equity rises to more than offset the effect of the lower cost of debt
here the equity holders are demanding much higher returns as compensation for the additional volatility and risk of liquidation
Modigliani and Miller's argument in a world with no taxes
a. Proposition 1: The total market value of any company is independent of its capital structure
b. Proposition 2: the expected rate of return on equity increases proportionately with the gearing ratio
c. proposition 3: the cut-off rate of return for new projects is equal to the weighted average cost of capital- which is constant regardless of gearing
The capital structure decision in a world with tax
additional considerations
a. financial distress : where obligations to creditors are not met or are met with difficulty
trade-off model
b. some factors influencing the risk of financial distress costs
i. the sensitivity of the company's revenues to the general level of economic activity
ii. the proportion of fixed to a variable costs
iii. the liquidity and marketability of the firm's assets
iv. the cash-generative ability of the business
c. agency costs : are the direct and indirect costs of attempting to ensure that agents act in the best interest of principals as well as the loss resulting from failure to get them to act this way
d. borrowing capacity
e. managerial preferences
f. pecking order
adverse selection problem
line of least resistance
g. market timing
h.market timing
i. financial slack: means having cash (or near-cash) and/or spare debt capacity
j. signalling
k. control
l. tax exhaustion
m. industry group gearing
some further thoughts on debt finance
a. motivation
recapitalisation
b. reinvestment risk
c. operating and strategic efficiency
leverage buy-outs (LBOs)
summary