Is there such thing as an optimum capital structure?
- Debt is cheap, but debt is risky
o Explain why
- Want to try minimise WACC to increase the value of the business
- Briefly discuss three theories
o Traditional view
▪ U shaped WACC graph
o M&M Tax
▪ Flat line WACC graph
o M&M No Tax
▪ WACC decreases
Types of Interest Risk
- Currency Risk
o Lock into FRA
▪ Protects from unexpected deterioration in exchange rate
▪ Won’t benefit if the future spot rate is more favourable
o Money Market Hedge
▪
- Interest rate Risk
o Being locked into fixed or floating rates
▪ Depending on whether the interest rate falls/rises, it can have adverse or
favourable effects
▪ Fixed rates can’t be redeemed until terms are complete
• Competitive disadvantage
- Gap Exposure & Basis Risk
o Interest sensitive assets and liabilities with similar maturities get matched
▪ Risk can arise if rates are on different terms
▪ Negative gap – liabilities exceed assets
Limitations of Dividend Growth Model
- Present value of expected future dividends
o Assumption growth is at constant annual rate
- Future can’t be known with certainty
- Assumes cost of equity is constant
o Dependent on economic environment and systematic risk
Hedges
- Forward Market Currency Hedge
o Eliminates risks of exchange rate movement between contract date and
payment/receipt date
- Currency Futures Hedge
o Simultaneous right and obligation to sell or buy on a specific future date, a standard
amount of currency x at a known price
o March, June, September, December cycles
o Offset by two opposite transactions
, o Require initial deposit (initial margin) which needs topping up or gets credited
- Currency Options Hedge
o Call/put option the right but not obligation to buy/sell currency in future at
particular rate
o Can avoid losing from adverse movements
Types of Risk
- Transaction Risk
o Transaction in a foreign currency is recorded at one rate and then settled at another
rate due to a change in the exchange rate
o Affects cashflow
- Translation Risk
o Domestic currency value of foreign currency assets/liabilities rise or fall
o Doesn’t involve cashflow so doesn’t directly affect shareholder wealth
o Can hedge
▪ Match currency of assets and liabilities
- Economic Risk
o NPV of business’s cashflow is affected by exchange rates
o Difficult to hedge against
Debt vs Equity Finance
- Gearing and financial risk
o Appetite for risk
o Equity decreases gearing and financial risk
- Target capital structure
- Availability of security
o Secured on assets – fixed/floating
- Economic expectations
- Control issues
o Restrictive/negative covenants
o Dilute existing ownership/control
Raising Equity Finance
- Cost
o Debt cheaper
- Cashflows
o Sufficient cash will be generated
- Risk
o Shareholders risk appetite
o Business risk of company
o Affect on gearing
- Availability
- Security and Covenants
- Control
- Duration
- Economic Outlook
, Business Risk
- Nature of a company’s business operations
- Way in which company conducts its business operations
- Variability in shareholder returns
- PBIT changes as revenue changes
o Assessed via operational gearing
Market Efficiency
- Manner in which ordinary share prices reflect info
- Efficient market
o Share prices fully and fairly reflect all available info
- Semi strong efficient market
o Share prices reflect all publicly available info
- Strong form market
o Share prices reflect all info
WACC used as discount rate in investment appraisal
- WACC is average return required by finance providers
- WACC reflects current business and financial risk
o Assumption made these risks are same as investing company
o If not, marginal cost of capital or project specific discount rate
- Business risk will remain the same if project a small extension of existing business operations
- Financial risk will remain the same if debt and equity are raised in the same proportions as
current usage
Methods of issuing new equity shares
- Rights issue
o Easier to price
o Cheaper to arrange
o Limited finance amount
- Private Placing
o Seeking out new investors on an individual basis
o Control diluted
o Cheaper
- Public Offer
o Expensive
o Control diluted
o Wide spread of ownership
o Large amounts of equity
- Initial Public Offering
o Expensive
o Regulation compliance
o For significant amount
Convertible Loan advantages
- Conversion rather than redemption
- Debt is cheap, but debt is risky
o Explain why
- Want to try minimise WACC to increase the value of the business
- Briefly discuss three theories
o Traditional view
▪ U shaped WACC graph
o M&M Tax
▪ Flat line WACC graph
o M&M No Tax
▪ WACC decreases
Types of Interest Risk
- Currency Risk
o Lock into FRA
▪ Protects from unexpected deterioration in exchange rate
▪ Won’t benefit if the future spot rate is more favourable
o Money Market Hedge
▪
- Interest rate Risk
o Being locked into fixed or floating rates
▪ Depending on whether the interest rate falls/rises, it can have adverse or
favourable effects
▪ Fixed rates can’t be redeemed until terms are complete
• Competitive disadvantage
- Gap Exposure & Basis Risk
o Interest sensitive assets and liabilities with similar maturities get matched
▪ Risk can arise if rates are on different terms
▪ Negative gap – liabilities exceed assets
Limitations of Dividend Growth Model
- Present value of expected future dividends
o Assumption growth is at constant annual rate
- Future can’t be known with certainty
- Assumes cost of equity is constant
o Dependent on economic environment and systematic risk
Hedges
- Forward Market Currency Hedge
o Eliminates risks of exchange rate movement between contract date and
payment/receipt date
- Currency Futures Hedge
o Simultaneous right and obligation to sell or buy on a specific future date, a standard
amount of currency x at a known price
o March, June, September, December cycles
o Offset by two opposite transactions
, o Require initial deposit (initial margin) which needs topping up or gets credited
- Currency Options Hedge
o Call/put option the right but not obligation to buy/sell currency in future at
particular rate
o Can avoid losing from adverse movements
Types of Risk
- Transaction Risk
o Transaction in a foreign currency is recorded at one rate and then settled at another
rate due to a change in the exchange rate
o Affects cashflow
- Translation Risk
o Domestic currency value of foreign currency assets/liabilities rise or fall
o Doesn’t involve cashflow so doesn’t directly affect shareholder wealth
o Can hedge
▪ Match currency of assets and liabilities
- Economic Risk
o NPV of business’s cashflow is affected by exchange rates
o Difficult to hedge against
Debt vs Equity Finance
- Gearing and financial risk
o Appetite for risk
o Equity decreases gearing and financial risk
- Target capital structure
- Availability of security
o Secured on assets – fixed/floating
- Economic expectations
- Control issues
o Restrictive/negative covenants
o Dilute existing ownership/control
Raising Equity Finance
- Cost
o Debt cheaper
- Cashflows
o Sufficient cash will be generated
- Risk
o Shareholders risk appetite
o Business risk of company
o Affect on gearing
- Availability
- Security and Covenants
- Control
- Duration
- Economic Outlook
, Business Risk
- Nature of a company’s business operations
- Way in which company conducts its business operations
- Variability in shareholder returns
- PBIT changes as revenue changes
o Assessed via operational gearing
Market Efficiency
- Manner in which ordinary share prices reflect info
- Efficient market
o Share prices fully and fairly reflect all available info
- Semi strong efficient market
o Share prices reflect all publicly available info
- Strong form market
o Share prices reflect all info
WACC used as discount rate in investment appraisal
- WACC is average return required by finance providers
- WACC reflects current business and financial risk
o Assumption made these risks are same as investing company
o If not, marginal cost of capital or project specific discount rate
- Business risk will remain the same if project a small extension of existing business operations
- Financial risk will remain the same if debt and equity are raised in the same proportions as
current usage
Methods of issuing new equity shares
- Rights issue
o Easier to price
o Cheaper to arrange
o Limited finance amount
- Private Placing
o Seeking out new investors on an individual basis
o Control diluted
o Cheaper
- Public Offer
o Expensive
o Control diluted
o Wide spread of ownership
o Large amounts of equity
- Initial Public Offering
o Expensive
o Regulation compliance
o For significant amount
Convertible Loan advantages
- Conversion rather than redemption
