Capital Structure Part 1 Flashcards
A bond will sell at a ______________ when the stated coupon rate on the bond is greater than the market interest rate on the bond at a given date.
premium
Which of the following types of bonds is most likely to maintain a constant market value?
Floating-rate bond
What bonds would automatically adjust the return on a financial instrument to produce a constant market value for that instrument. No premium or discount would be required since market changes would be accounted for through the interest rate?
Floating-rate
What bonds have, in effect, a fixed stated rate of return that would require assignment of a premium or discount to the underlying security to produce a market rate of interest if that market yield is different from the stated rate?
Zero-coupon
What financial product typically does NOT have an active secondary market?
Commercial Paper
Generally, what is the time frame for maturity on commercial paper?
Less than 270 days
The following are characteristics/advantages of which market?
-Avoids the expense of maintaining a compensating balance with a commercial
bank.
-Provides a broad distribution for borrowing.
-Accrues a benefit to the borrower because its name becomes more widely
known
The commercial paper market
What is a risk reward ratio, assuming standard deviation is a good measure of risk?
Mean return / Standard Deviation
Note: the higher the number, the better.
What is the formula for market capitalization?
number of common shares outstanding X fair market value per share
Note: Bonds are NOT part of this calculation!!!!
Which of the rate is most commonly compared to the internal rate of return to evaluate whether to make an investment?
The weighted-average cost of capital (WACC)
NOTE: The weighted-average cost of capital is frequently used as the hurdle rate within capital budgeting techniques. Investments that provide a return that exceeds the weighted-average cost of capital should continuously add to the value of the firm.
What is the rate of return required to cover the cost of resources employed?
“The overall cost of capital” a.k.a. “hurdle rate”
What can be used as a measure of the overall cost of capital, because it factors the company’s proportion of its cost of debt and its cost of equity?
The weighted-average cost of capital (WACC)
The optimal capitalization for an organization is usually determined by?
The lowest weighted-average cost of capital (WACC)
_________________ does not require any payment, it does not mature and, because it increases equity while having no effect on debt, it decreases the debt equity ratio and increases the credit-worthiness of the firm.
Common stock
What is the after tax WACC formula?
Calculate investment structure percentage.
Using: debt/total = debt percentage & equity/total = equity percentage (common and preferred separately if needed)
Multiply each times their respective cost of investment.
For debt only, account for tax effect and use the after tax #.
Add the two percentages together to derive the Weighted-average cost of capital (WACC).
Which portion of the WACC formula needs to be accounted for by the marginal tax rate (multiplied by 1 - tax rate)
DEBT
note. common and preferred stock are not subject to “tax effect” in the WACC calculation.
Cost of debt is measured as?
Cost of debt minus tax savings
What is typically the cheapest source of new capital (after tax)?
Bonds aka Debt
NOTE: Preferred stock does NOT have any tax advantage
When calculating net cost of debt, does the calculation use the “coupon rate” or “effective interest rate”?
Effective interest rate
When calculating annual/semi-annual disbursements of bonds/debentures, does the calculation use the “coupon rate” or “effective interest rate”?
Coupon rate
What is the formula for calculating the cost of preferred stock?
Dividend paid / Net Proceeds = Cost of preferred shares
Dividend paid = (par value x dividend %)
Net proceeds = pref stk sold price - flotation cost
Note: Flotation cost is the cost of issuing the stock, and therefore is subtracted from the sale price of the preferred stock.
What is the formula by which BETA measures inherent volatility/risk?
% change in stock price divided by % change in overall market price.
What does beta measure in the CAPM?
The volatility of a stock relative to the market
What is the CAPM formula?
R = RF + B (RM - RF)
R = Required rate of return on equity
RF = Risk-free rate earned on US treasury Bonds
B = Beta coefficient
RM = Expected Market Return
Cost of retained earnings = Risk Free Rate + [Beta x (Market return - Risk Free Rate)]
