Financing Decisions and Capital Structure
Domain scope
This domain tests financing choices, cost of capital and capital structure. You must calculate WACC and component costs, apply Modigliani-Miller (MM) reasoning, and recommend a financing mix that balances tax shields, distress costs, control and flexibility.
Core rules
- WACC = (E/V) x ke + (D/V) x kd x (1 - t), using market values and after-tax cost of debt.
- ke from CAPM = Rf + beta x (Rm - Rf); or dividend growth model ke = D1/P0 + g. kd is the yield to maturity, not the coupon.
- MM without tax: firm value and WACC are independent of gearing. MM with tax: value rises by tD because interest is tax-deductible. Trade-off theory adds financial distress and agency costs, so an optimal gearing range may exist.
- Pecking order: firms prefer retained earnings, then debt, then new equity, because of asymmetric information and issue costs.
- Gearing can be measured by debt/equity (market values), net debt/EBITDA or interest cover. High gearing raises financial risk and ke.
Worked example
A firm has market value equity £60m and debt £40m, so V = £100m. Rf = 3%, beta = 1.2, market risk premium = 5%. ke = 3% + 1.2 x 5% = 9%. Pre-tax kd = 6%, tax = 25%, so after-tax kd = 4.5%. WACC = 0.6 x 9% + 0.4 x 4.5% = 5.4% + 1.8% = 7.2%. A project of similar risk with an expected return of 8% adds value; one returning 6.5% destroys value. If the firm borrows more, kd and ke may both rise; WACC could fall initially through the tax shield and then rise as distress costs dominate.
Traps
- Using book values or historical cost of debt/equity.
- Inserting pre-tax kd into WACC.
- Mixing cum-dividend and ex-dividend share prices in ke.
- Assuming MM with tax means infinite gearing is optimal.
- Ignoring issue costs, covenants and control dilution.