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F9 Important theory notes
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F9 Important theory notes that are repeatedly asked in exams
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CAPITAL STRUCTURECapital Structure theories try to assess the relationship between the capital structure and the
WACC. It has mainly got 4 main theories:
1) Traditional Approach
2) MM W/0 Tax
3) MM with tax
4) Pecking order.
1)TRADITIONAL APPROACH
The traditional theory states that debt equity affects WACC.
- As gearing increases the Ke increases inorder to compensate for the financial risk
- Kd remains constant upto a certain point . As the gearing further increases , even the debt
holders start to face risk and the Kd starts to rise.
- Traditional theory proposes that larger production is possible at lower cost and hence
initially the wacc reduces upto an optimal point. WACC is minimised at this optimal point
and therefore the value of the company is maximised.Later the WACC starts to raise .The
shape of WACC is like that of a saucer .
- There is no theoretical justification for this
- Assumes no tax .
2) MM W/O TAX 1958
This theory states that in the absence of tax relief on debt, capital structure will have no influence on
the WACC or the value of the company .
In their 1958 theory, MM proposed that the total market value of the company in the absence of tax
relief will be determined by two factors:-
1. The total earnings of the company
2. The level of operating risk associated with those earnings
This implies that:
- The cost of debt remains unchanged as the level of gearing increases.
- The cost of equity increases so as to compensate the WACC being constant .
Assumptions
1) MM assumes a perfect capital market , where all investors have same information on which
they all act rationally, to arrive at the same conclusion about the future earnings .
2) No tax and transaction cost.
3) Debt is risk free and is available freely at the same cost to all investors and firms.
,MM justified this with the use of arbitrage . Arbitrage is when the purchase and sale of a security
takes place simultaneously in different markets with the aim of making risk free profits by
exploiting the price difference between the markets .
3)MM with TAX
In 1963 , MM modified their theory to admit that tax relief on interest does lower the WACC.
- In the presence of tax benefit on debt,lower Kd reduce the increase happening in cost of
equity.
- The wacc reduces as the gearing increases , to a level where gearing is 100%
MM assumes a perfect market . However in reality, market imperfections exists such as :
1. Bankruptcy Cost : MM assumes a perfect market and that companies will always be able to
raise finance .In reality, the increased gearing , increases the risk of the company being
unable to meets its interests and the being declared bankrupt.
2. Agency Cost : The increased level of gearing of the companies will result in agency costs ,
imposed by the debt holders .
3. Tax Exhaustion: There may reach a point where there is not enough profits from which to
obtain tax benefits .
4)Pecking Order
This theory implies that there is no relation b/w WACC and capital structure .
- Path of least resistance
- There is no theoretical justification
Pecking Order :
1. Retained Earnings
2. Straight debt
3. Convertible debt
4. Preference share
5. Equity shares
Methods of issuing new equity shares
Rights issue
A rights issue involves issuing shares to the existing shareholders in proportion to their
existing holding. Rights issues are often successful, easier to price and are cheaper to
arrange than a public issue but the amount of finance raised is limited as there is a
finite amount that shareholders will be willing to invest. A rights issue would be
mandatory if shareholders have not elected to waive their pre‐emptive rights.
Private placing
, A private placing is when a company, usually with the assistance of an intermediary,
seeks out new investors on a one‐to‐one basis. Shares are normally issued to financial
institutions when performing a placing rather than to individuals. This can be a useful
source of new equity for an unlisted company but control of the company will be
diluted as a result. A placing is also cheaper to arrange than a public issue but only
useful for relatively small issues.
Public offer
If the company is listed, it may undertake a public offer whereby shares are offered for
sale to the public at large. This is an expensive way of issuing shares as there are
significant regulatory costs involved and like the placing, control of the existing
shareholders will be diluted. A public issue will, however, allow very large amounts of
equity finance to be raised, and will also give a wide spread of ownership.
Initial public offering (IPO)
If the company is not listed, it can list through the process of an IPO which will raise
equity at the same time. An IPO will be more expensive than a public offer as there are
further regulations having to be complied with, increasing costs. Consequently, only a
large company wishing to raise a significant amount of finance would consider this
option.
DIVIDEND POLICY
Framing a good dividend policy is of great importance to a company. Dividends act as a signal to
investors about the performance of the company. Shareholders may prefer stable dividends with
steady growth.A cut in dividends might signal weak performance. Large fluctuations will
undermine the investor’s confidence.
Factors affecting dividend policy :
1. The profitability: Dividends are paid out of profits , and an unprofitable company will not be
able to go on indefinitely paying dividends out of the retained earnings from the past.
2. The law on distributable profits : Company legislations might make the companies bound to
pay dividends solely out of accumulated net realizable profits, as in the UK.
3. Governments might impose direct regulations on the amount that companies can pay out
as dividends
4. The effect of inflation : There may be a need to retain some profits within the business to
maintain the operating capability.
5. Any restraints imposed by the loan agreements and covenants . A loan covenant may
restrict the amounts that the company can pay out as dividends. This provides protection for
the lenders.
6. The signaling effect of dividends on the shareholders and the financial markets in general.
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