ASSESSING LONG-TERM DEBT, EQUITY AND CAPITAL STRUCTURE
1. What is capital structure?
It pertains to how a company finances its operations using debt and equity. It varies from
company to company and each industry has their own standards for the optimal mix of
financing tools.
2. What is the role of a Finance Manager in making financial decisions related to capital
structure?
A finance Manager's role is to find the balance of debt and equity. To make decisions that
utilizes their resources efficiently and according to the company’s operations.
3. How might a firm go about determining its optimal or target capital structure?
In order for a firm to determine the optimal or target capital structure, they have to understand
the nature of their business operations and watch with investors that match with their
financing needs.
4. What is EBIT-EPS analysis?
The EBIT-EPS analysis is a method financial managers use to evaluate different financing
options and their impact on a firm’s earnings per share at various levels of earnings before
interest and taxes. It is a data-driven financial decision-making approach that helps determine
the optimal capital structure that maximizes earnings per share.
5. How to find an EBIT-EPS indifference point?
First, ou calculate EPS for each financing plan:
- Determine the number of common shares outstanding for each plan.
- Calculate the profit available to equity shareholders for each plan (EBIT - Interest -
Taxes).
- Divide the profit available to equity shareholders by the number of common shares
outstanding to find EPS for each plan.
Second, you set the EPS equations equal to each other:
- Equate the EPS formula for each financing plan, representing the EBIT-EPS
indifference point.
Third, you solve for EBIT:
- Rearrange the equation to isolate EBIT and solve for its value at the indifference
point.
6. What are the major criticisms of EBIT-EPS analysis?
EBIT-EPS analysis primarily emphasises maximising EPS, potentially overlooking other
critical financial factors like stability, liquidity, and risk management. It doesn't account for
the increased risk associated with higher debt levels, which can be problematic during
economic downturns. EBIT-EPS analysis does not consider external economic factors like
interest rates and economic cycles. It doesn't address the risk of overcapitalisation, which
means that adding more debt or equity may not generate enough profits to justify their
expenses.
7. What are the factors other than wealth considerations that may influence capital
structure decisions?
A firm takes into consideration the current market conditions and the firm’s growth plans in
order to choose the best capital structure. Each company also has their own dividends policy.
SOURCES OF LONG-TERM FINANCING
8. Corporate debt has been expanding very dramatically since World War II. What has
been the impact on interest coverage, particularly since 1977?
This expansion is driven by factors like low interest rates, increased availability of credit, and
corporate strategies to finance share buybacks and mergers & acquisitions. While this
expansion can indicate firms have more flexibility to invest and expand, it also raises
concerns about potential financial instability if not managed carefully.
9. What are some features of bond agreements?
So known as Bond indentures are contract documents outlining the terms of a bond issue. It
includes the details such as the Issuer’s name, the principal amount, interest rate, maturity
date, interest payment schedule, callability, convertibility and covenants between parties
involved.
10. What method of “bond repayment” reduces debt and increases the amount of ordinary
equity shares outstanding?
The conversion of bonds to common stock is a method that reduces debt and increases the
amount of ordinary equity shares outstanding. This can happen if bonds are convertible
according to contract or if the company offers exchange.
11. What is the purpose of serial repayments and sinking funds?
There are strategies or methods in how a firm manages their debt, this includes Serial
repayments and sinking funds and they work in different ways. Paying off a debt gradually
over time with a portion of the principal being repaid at regular intervals is what we call
Serial repayments. On the other hand, setting aside money to accumulate and be used for a
lump-sum repayment at a later date is called a Sinking funds.
