Questions and Answers
Equity holders receive returns in the form of dividends and capital gains.
True
What is the rate of return required by providers of finance called?
What is the capital asset pricing model (CAPM) primarily used for?
To calculate the risk-adjusted discount rate for equity.
Systematic risk is also known as _____ risk.
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What does the weighted average cost of capital represent?
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Which type of debt is considered irredeemable?
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Match the following financing preference types in the pecking order theory:
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Higher operating gearing means lower sensitivity of EBIT to a change in sales.
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What is financial gearing a measure of?
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What is the cost of capital?
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Which of the following are methods for calculating the cost of equity? (Select all that apply)
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Systematic risk can be eliminated through diversification.
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What does the term 'financial gearing' refer to?
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What is the primary focus of capital structure?
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What is the pecking order theory related to?
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The weighted average cost of capital is commonly known as the company's ______.
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Study Notes
The Cost of Capital and Capital Structure
- The cost of capital is the rate of return required by providers of finance, representing investors' opportunity cost.
Cost of Equity
- The Capital Asset Pricing Model (CAPM) is a risk-adjusted discount rate that incorporates risk in the calculation of Ke.
- CAPM assumes the investor holds a well-diversified portfolio and uses β to measure risk.
- Systematic risk (market risk) relates to the market and economy, is caused by macroeconomic factors, and affects all shares in the market.
- Unsystematic risk (company-specific risk) can be eliminated or diversified away and is not impacted by political and economic factors.
Criticisms of CAPM
(Not specified in the text, but it is implied that there are criticisms of the CAPM model)
Dividend Valuation Model
(Not specified in the text, but it is mentioned as an alternative to CAPM)
Cost of Debt
- Irredeemable debt is a perpetual debt that is never paid.
- Redeemable debt is issued as repayable at a premium on nominal value and is usually repaid at nominal value (par).
Weighted Average Cost of Capital (WACC)
- WACC is the minimum return a company must earn on its assets.
- It represents the weighted average return paid to all providers of finance.
Capital Structure
- Capital structure refers to the mix of equity and debt financing that shows how a business is financed.
- The key objective is to maximize the value of the company.
- It is concerned with the balance between equity and non-current liabilities.
Factors Affecting Capital Structure
- Financial leverage or gearing
- Market conditions
- Tax exposure
- Control principle
- Growth
- Cost principle
- Risk principle
Risk Factors Affecting Capital Structure
(Not specified in the text, but it is implied that there are risk factors affecting capital structure)
Financial Gearing
- Financial gearing measures the proportion of debt a company has relative to its equity.
- It is a measure of financial leverage.
Problems Around High Levels of Gearing
(Not specified in the text, but it is implied that there are problems associated with high levels of gearing)
Operating Gearing
- Operating gearing measures the proportion of fixed cost a company has relative to the variable cost.
- It is a measure of the sensitivity of profit to a change in sales.
- The higher the operating gearing, the higher the sensitivity of EBIT to a change in sales.
Capital Structure Theories
- Traditional approach
- Modigliani and Miller (without taxes)
- Modigliani and Miller (with taxes)
Traditional Approach to Capital Structure
(Not specified in the text, but it is mentioned as a theory)
Limitation of Traditional View
(Not specified in the text, but it is implied that there are limitations to the traditional approach)
Modigliani and Miller (Without Tax)
- Assumptions of the MM without tax model are not specified in the text.
Modigliani and Miller (With Tax)
(Not specified in the text, but it is mentioned as an extension of the MM model)
Criticisms of the MM Trade-Off Theory
(Not specified in the text, but it is implied that there are criticisms of the MM model)
Real World Approaches
- Pecking order theory outlines the order of preference for financing decisions:
- Retained earnings
- Straight debt
- Convertible debt
- Preference shares
- Equity shares
- Companies are risk-averse and prefer retained earnings, followed by debt and lastly equity.
The Cost of Capital and Capital Structure
- The cost of capital is the rate of return required by providers of finance, representing investors' opportunity cost.
Cost of Equity
- The Capital Asset Pricing Model (CAPM) is a risk-adjusted discount rate that incorporates risk in the calculation of Ke.
- CAPM assumes the investor holds a well-diversified portfolio and uses β to measure risk.
- Systematic risk (market risk) relates to the market and economy, is caused by macroeconomic factors, and affects all shares in the market.
- Unsystematic risk (company-specific risk) can be eliminated or diversified away and is not impacted by political and economic factors.
Criticisms of CAPM
(Not specified in the text, but it is implied that there are criticisms of the CAPM model)
Dividend Valuation Model
(Not specified in the text, but it is mentioned as an alternative to CAPM)
Cost of Debt
- Irredeemable debt is a perpetual debt that is never paid.
- Redeemable debt is issued as repayable at a premium on nominal value and is usually repaid at nominal value (par).
Weighted Average Cost of Capital (WACC)
- WACC is the minimum return a company must earn on its assets.
- It represents the weighted average return paid to all providers of finance.
Capital Structure
- Capital structure refers to the mix of equity and debt financing that shows how a business is financed.
- The key objective is to maximize the value of the company.
- It is concerned with the balance between equity and non-current liabilities.
Factors Affecting Capital Structure
- Financial leverage or gearing
- Market conditions
- Tax exposure
- Control principle
- Growth
- Cost principle
- Risk principle
Risk Factors Affecting Capital Structure
(Not specified in the text, but it is implied that there are risk factors affecting capital structure)
Financial Gearing
- Financial gearing measures the proportion of debt a company has relative to its equity.
- It is a measure of financial leverage.
Problems Around High Levels of Gearing
(Not specified in the text, but it is implied that there are problems associated with high levels of gearing)
Operating Gearing
- Operating gearing measures the proportion of fixed cost a company has relative to the variable cost.
- It is a measure of the sensitivity of profit to a change in sales.
- The higher the operating gearing, the higher the sensitivity of EBIT to a change in sales.
Capital Structure Theories
- Traditional approach
- Modigliani and Miller (without taxes)
- Modigliani and Miller (with taxes)
Traditional Approach to Capital Structure
(Not specified in the text, but it is mentioned as a theory)
Limitation of Traditional View
(Not specified in the text, but it is implied that there are limitations to the traditional approach)
Modigliani and Miller (Without Tax)
- Assumptions of the MM without tax model are not specified in the text.
Modigliani and Miller (With Tax)
(Not specified in the text, but it is mentioned as an extension of the MM model)
Criticisms of the MM Trade-Off Theory
(Not specified in the text, but it is implied that there are criticisms of the MM model)
Real World Approaches
- Pecking order theory outlines the order of preference for financing decisions:
- Retained earnings
- Straight debt
- Convertible debt
- Preference shares
- Equity shares
- Companies are risk-averse and prefer retained earnings, followed by debt and lastly equity.
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Description
This quiz covers the importance and calculation of cost of capital, including equity and debt, and its role in capital structure. Topics include return on investment, dividends, interest, and opportunity cost.
