Capital structure theories 1 / 1

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MC Question 4

Which of the following statements concerning capital structure theory is correct?

A. In the traditional view, there is a linear relationship between the cost of equity and financial risk
B. Modigliani and Miller said that, in the absence of tax, the cost of equity would remain constant
C. Pecking order theory indicates that preference shares are preferred to convertible debt as a source of finance
D. Business risk is assumed to be constant as the capital structure changes

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Question 4ab

Grenarp Co is planning to raise $11,200,000 through a rights issue. The new shares will be offered at a 20% discount to the current share price of Grenarp Co, which is $3·50 per share. The rights issue will be on a 1 for 5 basis and issue costs of $280,000 will be paid out of the cash raised. The capital structure of Grenarp Co is as follows:
$m $m
Equity
Ordinary shares ($0·50 nominal) 10
Reserves 75
85
Non-current liabilities
8% Loan notes 30
115

The net cash raised by the rights issue will be used to redeem part of the loan note issue. Each loan note has a nominal value of $100 and an ex interest market value of $104. A clause in the bond issue contract allows Grenarp Co to redeem the loan notes at a 5% premium to market price at any time prior to their redemption date.

The price/earnings ratio of Grenarp Co is not expected to be affected by the redemption of the loan notes.

The earnings per share of Grenarp Co is currently $0·42 per share and total earnings are $8,400,000 per year. The company pays corporation tax of 30% per year.

Required:
(a) Evaluate the effect on the wealth of the shareholders of Grenarp Co of using the net rights issue funds to redeem the loan notes. (8 marks)

(b) Discuss whether Grenarp Co might achieve its optimal capital structure following the rights issue. (7 marks)

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Specimen
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MC Question 6

Which of the following statements concerning capital structure theory is correct?

A. In the traditional view, there is a linear relationship between the cost of equity and financial risk
B. Modigliani and Miller said that, in the absence of tax, the cost of equity would remain constant
C. Pecking order theory indicates that preference shares are preferred to convertible debt as a source of finance
D. Business risk is assumed to be constant

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Question 2e

Card Co has in issue 8 million shares with an ex dividend market value of $7·16 per share. A dividend of 62 cents per share for 2013 has just been paid. The pattern of recent dividends is as follows:

Year 2010201120122013
Dividends per share (cents)55.157.959.162.0

Card Co also has in issue 8•5% bonds redeemable in five years’ time with a total nominal value of $5 million. The market value of each $100 bond is $103•42. Redemption will be at nominal value.
Card Co is planning to invest a significant amount of money into a joint venture in a new business area. It has identified a proxy company with a similar business risk to the joint venture. The proxy company has an equity beta of 1•038 and is financed 75% by equity and 25% by debt, on a market value basis.

The current risk-free rate of return is 4% and the average equity risk premium is 5%. Card Co pays profit tax at a rate of 30% per year and has an equity beta of 1•6.

Required:

Discuss whether changing the capital structure of a company can lead to a reduction in its cost of capital and hence to an increase in the value of the company. (8 marks)

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