Association of Corporate Treasurers (ACT) Qualifications Corporate Finance and Capital Structure Flashcards

24 sample cards from the Corporate Finance and Capital Structure deck

Sampled from the end of the deck, so these are different cards from the ones shown on the syllabus page.

1. State Modigliani–Miller Proposition II (cost of equity rises with gearing).

   $$k_{e} = k_{0} + (k_{0} - k_{d})\frac{D}{E}$$ The cost of equity increases linearly with the debt-to-equity ratio to compensate shareholders for the extra financial risk, leaving WACC unchanged (no-tax case).

2. How does Modigliani–Miller theory change once corporate taxes are introduced?

   Interest is tax-deductible, creating a debt tax shield. The levered firm is worth more: $$V_{L} = V_{U} + (T \times D)$$ Implying WACC falls as gearing rises, suggesting (in theory) maximum debt is optimal.

3. Describe the trade-off theory of capital structure.

   The optimal capital structure balances the tax-shield benefits of additional debt against the rising present value of financial distress and bankruptcy costs. The optimum is where the marginal benefit of the tax shield equals the marginal cost of distress.

4. What is the pecking order theory of financing?

   Due to asymmetric information, firms prefer internal funds (retained earnings) first, then debt, and issue new equity only as a last resort. It implies there is no well-defined target gearing ratio; financing follows a hierarchy.

5. What is financial gearing (leverage) and how is it commonly measured?

   Gearing measures the proportion of debt in the capital structure. Common measures: $$Gearing = \frac{Debt}{Debt + Equity} \quad \text{or} \quad \frac{Debt}{Equity}$$ using market or book values; also interest cover $= \frac{EBIT}{Interest}$.

6. What is operating gearing versus financial gearing?

   Operating gearing reflects the proportion of fixed to variable operating costs — high fixed costs magnify the effect of sales changes on EBIT. Financial gearing reflects the use of fixed-cost debt — it magnifies the effect of EBIT changes on earnings per share.

7. Define the optimal capital structure.

   The mix of debt and equity that minimises the firm's WACC and thereby maximises the total market value of the firm, balancing the benefits of the debt tax shield against the costs of financial distress and reduced flexibility.

8. What is financial flexibility and why do treasurers value it?

   Financial flexibility is the firm's capacity to raise funds or adjust financing at reasonable cost to meet unexpected needs or exploit opportunities. Treasurers value spare debt capacity and committed facilities so the firm is not forced to raise capital on poor terms.

9. How do credit ratings relate to capital structure decisions?

   Rating agencies assess default risk using gearing and coverage ratios. Higher debt can lower the rating, raising borrowing cost and reducing access to debt markets. Firms often target a minimum rating (e.g. investment grade, BBB-/Baa3 or above) as a capital-structure constraint.

10. What is the boundary between investment-grade and sub-investment-grade (junk) ratings?

    Investment grade runs from AAA down to BBB- (S&P/Fitch) or Aaa to Baa3 (Moody's). Anything BB+/Ba1 or below is sub-investment grade ('high yield' or 'junk'), carrying materially higher spreads and reduced market access.

11. State and explain the residual theory of dividends.

    Dividends are a residual: the firm first funds all positive-NPV projects from earnings, and only pays out what is left over. Under this view dividends fluctuate with investment needs and have no intrinsic value-signalling role.

12. According to Modigliani–Miller, why might dividend policy be irrelevant?

    In perfect markets (no taxes or transaction costs), shareholders can create 'home-made dividends' by selling shares, or reinvest unwanted dividends. Value depends on investment/earning power, so the split between dividends and retentions does not affect firm value.

13. What is the signalling effect of dividends?

    Because managers dislike cutting dividends, a dividend increase signals confidence in sustainable future earnings, while a cut signals difficulty. Markets therefore react to unexpected dividend changes — the 'information content' of dividends.

14. Compare paying dividends with a share buyback as a means of returning cash.

    Both return cash to shareholders. Dividends are received by all holders and tend to be 'sticky'. Buybacks reduce the share count (raising EPS), are more flexible/discretionary, can have tax advantages, and signal that shares may be undervalued.

15. State the Net Present Value (NPV) decision rule for project appraisal.

    $$NPV = \sum_{t=0}^{n}\frac{CF_{t}}{(1+r)^{t}}$$ Accept a project if $NPV > 0$ (it adds value); reject if $NPV < 0$. For mutually exclusive projects, choose the one with the highest positive NPV.

16. Define the Internal Rate of Return (IRR) and its decision rule.

    IRR is the discount rate at which $NPV = 0$. Decision rule: accept the project if $IRR >$ cost of capital (hurdle rate). It represents the project's break-even required return.

17. What are the main weaknesses of IRR compared with NPV?

    IRR can give multiple values with unconventional cash flows, assumes reinvestment at the IRR itself, ignores project scale, and can rank mutually exclusive projects incorrectly. NPV is preferred because it measures absolute value added in money terms.

18. What is the payback period and the discounted payback period?

    Payback is the time taken for cumulative cash inflows to recover the initial outlay; it ignores the time value of money and post-payback cash flows. Discounted payback uses discounted cash flows, improving on this but still ignoring flows after the cut-off.

19. Which cash flows are 'relevant' in project appraisal?

    Only incremental, future, after-tax cash flows that change as a result of the decision. Include opportunity costs and incremental working capital. Exclude sunk costs, allocated/unavoidable overheads, and non-cash items such as depreciation (except via its tax effect).

20. How is depreciation (capital allowances) treated in DCF appraisal?

    Depreciation itself is a non-cash item and is excluded from cash flows. However, tax-allowable capital allowances reduce taxable profit, so the resulting 'tax shield' (capital allowance $\times$ tax rate) is included as a relevant cash inflow.

21. How can risk be incorporated into project appraisal?

    Methods include: risk-adjusted discount rates (raising the hurdle rate for riskier projects), sensitivity analysis, scenario analysis, probability/expected-value and simulation (Monte Carlo), and certainty-equivalent cash flows. These quantify or adjust for variability in outcomes.

22. What is capital rationing, and how do single-period selections differ between divisible and indivisible projects?

    Capital rationing is selecting projects when funds are limited. For divisible projects, rank by the profitability index ($PI = \frac{PV\ of\ inflows}{Initial\ outlay}$) and fund highest first. For indivisible projects, test combinations to maximise total NPV within the budget.

23. List common motives (rationale) for mergers and acquisitions and give two examples of synergy.

    Motives include growth, market power, diversification, acquiring capabilities/economies of scale, and tax benefits. Synergies: revenue synergies (cross-selling, larger market) and cost synergies (eliminating duplicate functions, purchasing economies); financial synergies include lower cost of capital and use of surplus cash.

24. What is the difference between an asset purchase and a share purchase in deal structuring, and how do equity- versus debt-financed deals compare?

    In a share purchase the buyer acquires the legal entity with all its liabilities; in an asset purchase the buyer cherry-picks specific assets/liabilities. Financing: equity (shares) avoids cash outflow and shares risk but dilutes ownership; debt/cash preserves control but increases gearing and the fixed-charge burden. The treasurer also addresses M&A integration — combining banking, funding, cash management and hedging — and corporate restructuring such as demergers, spin-offs and disposals to refocus the business and release value.

What this deck covers

Corporate Finance and Capital Structure flashcards FAQ