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Flashcards in BEC 3 Capital management Deck (114)
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Operational leverage

1. the degree to which a firm uses fixed operating costs, as opposed to variable operating costs.
2. A firm that has HIGH operating leverage has HIGH fixed operating costs and relatively LOW variable operating costs.
3. A firm that has LOW operating leverage has LOW fixed operating costs and HIGH variable operating costs


High operating leverage

must produce sufficient sales revenue to cover its high fixed costs, but when they are covered, additional revenue goes straight to operating income


Low operating leverage

new sales dollars can only be achieved with additional variable costs


Operational Leverage computation

Degree of operating leverage = % change in Earnings Before Interest & Tax / % change in Sales


Financial leverage

1. The degree to which a firm's use of debt to finance the firm magnifies the effects of a given % change in earnings before interest and taxes (EBIT) on the percentage change in its earnings per share (EPS)
2. When making financing decisions, a firm can choose to issue debt or equity.
- When debt is issued, the firm must pay fixed interest costs.
- When equity is issued, it does not result in increase in fixed cost, because dividend payments are not required.


Debt issuance

a company that issues debt must produce sufficient operating income (EBIT) to cover its fixed interest costs. When they are covered, additional EBIT goes to to net income


Financial leverage computation

Degree of financial leverage = % change in Earnings per share / % change in EBIT


Applying financial leverage to risk/return decision

1. Firms with HIGHER % of fixed financial costs will have a HIGHER degree of financial leverage.
2. Small change in earnings before interest and taxes will have a greater effect on profits and shareholders value.
3. Higher = more profitability and risk


Combined leverage

results from the use of fixed operating costs and fixed financing costs to magnify returns to the firm's owners


Combined leverage computation

degree of combined leverage = % change in EPS / % change in sales= DOL x DFL


Combined leverage - implications

HIGH DCL = a greater portion of sales goes to the bottom line


Applying combined leverage to Risk/Return decisions

Firms with a higher % of fixed operating leverage in addition to fixed financing costs will have a higher degree of combined leverage.


The weighted average cost of capital and optimal capital structure

seves as a major link between the long term investment decisions associated with a corporation's capital structure and the wealth of a corporation's owners.


Capital structure and firm value

the value of a firm can be computed as the present value of the cash flow it produces, discounted by the costs of capital used to finance it. The lower the overall cost of capital, the higher value of the firm.


Computing the weighted average cost of capital

the average cost of debt and equity financing associated wit ha firm's existing assets and operations.
WACC = (Cost of equity x % equity in capital structure) / (Weighted average cost of debt x % debt in capital structure)


Weighted average cost of debt

debt costs are stated as the interest rate of the various debt instruments.
Weighted average interest rate = (Effective annual interest payments/Debt cash available)


Individual capital components

1. Long term elements - long term debt, preferred stock, common stock, retained earnings
2. Short term elements - short term interest bearing debt, current liabilities
3. After tax cash flows - the most relevant


Optimal capital structure

the lowest WACC


The optimal cost of capital

the ratio of debt to equity that produces the lowest WAAC


Application of capital budgeting

the historic WACC may be not appropriate for all projects unless it has the same risks


Cost of capital components

1. cost of borrowing - interest rates on debt
2. cost of equity - return required by investors in exchange for assumed risk


Cost of long term debt kdx

after tax cost of raising long term funds by borrowing


Pre tax cost of debt kdt

cost of debt before considering the tax shielding effects of the debt


after tax cost of debt kdx

interest on debt is deductible
avoided taxes reduce the cost of debt
Pre tax cost of debt x (1-Tax rate)
or kdt x (1-Tax rate)


Cost of preferred stock kps

after tax considerations are irrelevant with equity securities because dividends are not tax deductible. Preferred stock cash dividends represent payments to preferred stockholders.


Net proceeds of preferred stocks nps

the net proceeds from a preferred stock issuance can be calculated as the gross proceeds net of flotation costs


Preferred stock cash dividends dps

the finance charge to the company for raising capital with preferred stock.
Preferred stock dividends can be stated as a dollar amount or a percentage.


Formula kps

kps = dps / nps


Cost of retained earnings - kre

the cost of equity capital obtained through retained earnings, kre, is equal to the rate of return required by the firm's common stockholders.


Common methods of computing kre (cost of retained earnings)

1. Capital asset pricing model (CAPM)
2. Discounted cash flow (DCF)
3. Bond yield plus risk premium (BYRP)