Optimal capital structure

Financial gearing:

Financial gearing is a percentage of debt capital in the company’s capital structure. If company has high gearing that means a company borrow a lot debt capital. (Main text book).

Optimal capital structure:

The optimal capital structure for a company is one which offers a balance between the ideal debt-to-equity range and minimizes the firm's cost of capital.

b) Explain why the cost of equity capital (ordinary shares) is normally higher than the cost of debt capital.(slides) Ordinary shares carry higher risk than debt capital, hence will require higher return to persuade investors to invest. Higher issuing cost of equity relative to the cost of issuing debt capital. Dividend on ordinary shares are not allowable against corporate tax while interest payments are.

c) What is meant by the term ‘dividend pay-out ratio’? How is this ratio related to ‘retention ratio’?

Dividend pay-out ratio:

The percentage of earnings paid to shareholders in dividends.

Retention ratio:

The proportion of net income that is not paid out as dividends.

d) Distinguish between the ‘Signalling Effect and the Clientele-Effect’ of dividend of dividend policy.

Signaling Effect:

A theory that suggests company announcements of an increase in dividend payouts act as an indicator of the firm possessing strong future prospects. It comes from game theory. A manager who has good investment opportunities is more likely to "signal" than one who doesn't because it is in his or her best interest to do so.

Clientele-Effect:

The clientele effect is the concept that shareholders are attracted to firms that follow dividend policies are the same as their objectives. The clientele effect encourages stability in dividend policy.

e) From the Formula Sheet provided, copy the formula for the calculation of the beta of a risky individual asset, and explain the meaning of each term in the formula. (sildes)

f) What are the two key differences between Capital Market Theory and Capital Assets Pricing Model.

Two key differences between Capital Market Theory and Capital Assets Pricing Model: CAPM extends Capital Market Theory in a way that allows investors to evaluate the risk-return trade-off for both diversified and undiversified portfolio as well as for individual securities.

g) Distinguish between unsystematic and systematic risks. Give two specific examples of what gives rise to each type of risk. (slides) Overall risk can be separated into systematic risk which represents how share’s returns are affected by systematic factors such as business cycles, government policy and changes in interest rates. Unsystematic risk is the risk specific to a particular share, like the risk of individual company performing badly or going into liquidation. h) Explain the fundamental issues in the valuation of ordinary shares

i) Assuming the Efficient Market Hypothesis is valid, what is the relationship between an ordinary share’s price and the Security Market Line?

Share price consistent with expected return; hence, share lines on the SML (no under\overvalued assets)

j) What is meant by the ‘paradox of efficient market hypothesis？Give three examples of apparent exceptions to the EMH.

Weak-form: January effect. Of the 30.5% small-size premium, half of the effect occurs in January

Semi-strong: Size effect. Market betas could not account for the abnormal returns

Strong-form: persistence of over performance by some fund management.

July short-answer question

a) According to the Capital Market Theory and Capital Assets Pricing Model, what are the characteristics of the Market Portfolio?

Market portfolio is a portfolio consisting of a weighted sum of every asset in the market. Because a market portfolio is completely diversified, it is subject only to systematic risk. Has a...