Advanced Corporate Finance AFC3140 Essay

Submitted By Jennifer-Vickers
Words: 2032
Pages: 9


Financial Management
Association of Australia
(FMAA) Monash
Important Notice
The following notes have been prepared and provided as a skeleton (sketch) of the course for this unit.
It is the responsibility of the student to make note of any changes in course content.
These notes may exclude some topics and therefore be inconsistent with current faculty teaching.
These notes should not be relied upon solely.
These notes should only be used to provide a basis from which students can create an individual extensive set of notes in preparation for unit assessments.
These notes should not be duplicated, either in part or in full, during assessments

Capital structure theory
Capital structure is the mix of a company’s debt (D) and equity (E). Optimal capital structures, that maximise company value, exist for companies that operate within imperfect capital markets.
Business risk, or systematic risk, is the risk that arises from the operation of a company’s assets to generate operating cash flows and it is borne equally by holders of company E, typically shareholders, and D, typically bondholders.
Financial risk is the risk that arises from a company’s leverage as E holders may receive zero or no dividends because D holders have priority to distribution of a company’s cash flows. This risk is borne solely by E holders.
Cost of capital (K0) reflects the business risk of a company. It is the rate of return that holders of D or
E in a company require. WACC is used as the cost of capital for levered companies.
K0 = WACC = = Rf + β0 (Rm – Rf)
Asset beta (β0) is a parameter that measures how sensitive a company’s generation of operating cash flows from use of assets is to movements within the market that a company operates in, that is, it is a measure of business risk. β0 = βe (E/V) + βd (D/V)
Cost of equity (Ke) reflects both business risk and financial risk because holders of E are exposed to the company’s risk of default to holders of D (see above).
Ke =Rf + βe (Rm – Rf)
Equity beta () is a parameter that measures how sensitive cash flows to E holders are to movements within the market. It reflects E holders’ exposure to both business risk and financial risk. βe = β0 + (β0 – βd) (D/E)
Optimal value calculation (limited to corporate taxation and bankruptcy costs)
For levered companies corporate taxation provides a tax shield because of the deductibility of interest payments which increases company value, however, the probability of default imposes a present value of bankruptcy costs burden on the company which decreases the company’s value.
VL = VU + PV (tax savings on debt) – PV (bankruptcy costs) = VU + tc x D – Pr (default) x costs
Arbitrage transactions
When the market applies a different cost of capital to companies with the same degree of business risk and a different capital structure, opportunities for arbitrage arise. Homemade gearing, which is borrowing on personal account, allows investors to substitute investments in a company for investments in another company, whilst maintaining a constant level of gearing in their investment despite investing in a company with a different capital structure.

Leasing theory
A lease is a contractual arrangement whereby the owner of an asset (lessor) provides the asset to a user (lessee) for use but does not transfer legal ownership.
Operating leases are short‐term rental agreements whereby the lessee can use the asset for a specified period for a fee. Most risk is borne by the lessor. These are treated as an expense by the lessee. Financial leases are long‐term uncancellable arrangements whereby the lessee can use the asset for the economic life of the asset but is responsible for maintaining the asset. Most risk is borne by the lessee. These are treated as both an asset and a liability by the lessee.
Lease calculations