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Gleim BEC > Subunit 8: Corporate Capital Structure > Flashcards

Subunit 8: Corporate Capital Structure Flashcards

1
Q

Describe the relationship between the interest rate and time to maturity of bonds (the term structure of interest rates).

A

In general, the longer a bond’s term (time to maturity) is, the higher the return demanded by investors to compensate for increased risk.

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2
Q

How is the bond price measured?

A

The bond price is the sum of
* The present value of the principal of the bond and
* The present value of the total interest payments discounted at the market (effective) interest rate.

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3
Q

When is a bond issued at premium/discount/par?

A
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4
Q

How is a firm’s degree of operating leverage (DOL) calculated?

A
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5
Q

How is a firm’s degree of financial leverage (DFL) calculated?

A
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6
Q

How is a firm’s degree of total (combined) leverage (DTL) calculated?

A

Degree of total (combined) leverage (DTL) is the product of the degree of operating leverage multiplied by the degree of financial leverage.

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7
Q

What is the relationship between the values of an unlevered firm and a levered firm?

A

The value of a levered firm is the value of an unlevered firm plus the present value of the interest tax savings.

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8
Q

What is a debt covenant?

A

A debt covenant is a restriction imposed on a borrower by the creditor in the formal bond agreement. If the debtor (borrower) violates the covenant, the debt may become due immediately.

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9
Q

Define a bond.

A

A formal contract to pay a monetary amount to the holder at a certain date. Most bonds provide for a series of cash interest payments based on a specified percentage (stated or coupon rate) of the face amount at specified intervals. It is the main form of LT debt financing for corporations and governments.

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10
Q

What is an indenture?

A

The legal document containing the bond agreement.

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11
Q

What is a bond sinking fund?

A

A fund designated in an indenture to accumulate sufficient assets to pay the bond principal at maturity. The amounts transferred into this account earn revenues over time. The fund accumulates the necessary funds to repay the bonds in the future.

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12
Q

What are the advantages of bonds to the issuer? What are the disadvantages?

A

Advantages: 1) interest paid on debt is tax deductible (tax shield); 2) debtholders do not share control of the firm
Disadvantages: 1) payment of interest and principal on debt is a legal obligation (insufficient cash flows may lead to insolvency); 2) legal requirement to pay interest and principal increases a firm’s risk and reduces RE (shareholders less likely to invest, decreasing share price); 3) bonds may require collateral; 4) limits on debt financing amounts (most creditors require a certain debt to equity ratio, cost of debt beyond that may rise rapidly or be unavailable)

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13
Q

What are the maturity pattern bond types? Describe each.

A

1) term bond: single maturity date at the end of its term
2) serial bond: matures in stated amounts at regular intervals

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14
Q

How are bonds valued? Describe each.

A

1) variable (or floating) rate bonds: pay interest that depends on market conditions; the interest rate of the bonds changes (or floats)
2) zero-coupon or deep-discount bonds: no stated rate of interest and require no periodic cash payments; interest component consists entirely of the bond’s discount
3) commodity-backed bonds: payable at prices related to a commodity such as gold

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15
Q

What are the redemption provisions of bonds? Define each.

A

1) Callable bonds: may be repurchased by the issuer at a specified price before maturity; when interest rates decline, the issuer can replace high-interest debt with low-interest debt.
2) Convertible bonds: may be converted into equity securities of the issuer at the option of the holder under certain conditions; the ability to become equity holders is an incentive to potential investors

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16
Q

How do call provisions work? When are they advantageous or disadvantageous?

A

Call provisions allow the issuer to repurchase and retire the bonds early. They typically specify when the bond may be called and the call price. They have higher interest rates than comparable noncallable bonds. If the sum of interest payments avoided exceeds the premium paid to retire the debt, it advantages issuers and disadvantages investors to call the bond.

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17
Q

What are the types of securitization? Describe each.

A

1) mortgage bonds: backed by specific assets, usually real estate
2) debentures: backed by the issuer’s credit, not specific assets

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18
Q

What are the types of bond ownership? Describe each.

A

1) registered bonds: issued in the name of the holder; only the registered holder may receive interest and principal payments
2) bearer bonds: not individual registered; interest and principal paid to whoever presents the bond

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19
Q

What is bond priority?

A

It deals with the order in which claims are settled or bond payments are made when conflicting claims exist. Subordinated debentures and second mortgage bonds are junior securities with claims inferior to those of senior bonds.

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20
Q

What are repayment provisions? Describe each.

A

These involve the source of funds from which bond payments are made.
1) income bonds: pay interest contingent on the issuer’s profitability
2) revenue bonds: issued by governmental units and are payable from specific revenue sources

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21
Q

What do bond ratings accomplish? What are the two types of bond grades?

A

Credit-rating agencies judge the creditworthiness of bonds. The higher the rating, the more likely the firm will pay the interest and principal.
1) investment-grade bonds: safe investments and have the lowest yields; highest rating assigned is AAA, and lowest investment-grade bond is BBB-; some fiduciary organizations are only allowed to invest in these bonds
2) noninvestment-grade bonds: also called speculative-grade, high-yield, or junk bonds, they have high risk; ratings range from BB+ to DDD

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22
Q

What is a bond issuer’s main concern? How is this concern valued?

A

The main concern is the cash received from investors. Bond valuation is how we determine the cash received from investors on the day the bonds are sold.
This amount equals the present value of the cash flows from the bonds (principal at maturity and periodic interest) discounted at the market (effective) interest rate.

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23
Q

What are the three types of bond valuation? How do the cash proceeds of each type compare to the face value of the bond?

A

1) at par: stated rate equals the market rate at the time of sale (PV = face value)
2) at a discount: stated rate is lower than the market rate, periodic interest payments are lower than those currently available
3) at a premium: stated rate is higher than the market rate, periodic interest payments are higher than those currently available

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24
Q

What does amortizing a discount or premium over the bond term accomplish?

A

The carrying amount at maturity equals the face amount
The effective interest method must be used unless not materially different from another method

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25
Q

What happens to bonds in a secondary market?

A

When bonds are traded among investors, the issuer is not a party to the transaction and receives no cash
Resale bond price is determined by a risk assessment of the issuer and the market rate of interest at trade; bonds are priced to achieve a new yield

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26
Q

What is leverage? What comprises leverage?

A

The relative amount of fixed cost in a firm’s cost structure—the amount of debt a firm has. Leverage creates risk because fixed costs must be paid, regardless of sales. Total leverage consists of operating leverage and financial leverage.

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27
Q

What is operating leverage? How does it explain risk?

A

The extent to which a firm’s costs of operating are fixed. The DOL measures the effect that given fixed operating costs have on earnings. A firm with a high percentage of fixed costs is riskier than a firm in the same industry that relies more on variable costs. It generates more earnings by increasing sales.

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28
Q

What is financial leverage? How does it explain risk?

A

The degree of debt (fixed financial costs) in the firm’s financial structure. The DFL measures the effect that an amount of fixed financing costs has on EPS. When a firm has a high percentage of fixed financial costs, it must accept more risk to increase its EPS.

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29
Q

How is EPS calculated?

A

EPS = Net income available to common shareholders / Wght-avg common shares outstanding

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30
Q

How does DTL explain risk?

A

A firm with a higher DTL provides a higher return to investors, but it is also riskier due to a higher likelihood of default.

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31
Q

What is the value of a levered firm?

A

Value of a levered firm = value of an unlevered firm + PV of interest tax savings
Interest tax savings = Tc * (r-debt * D)
PV of the interest tax savings = TC * (r-debt * D) / r-debt (if debt is permanent)
TC = corporate tax rate
r-debt = interest rate on the debt
D = amount of debt

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32
Q

What is the present value calculation for the face amount of a bond?

A

PV = FV / (1 + i)^n
OR
PV = FV * table rate of a single payment

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33
Q

What is the present value calculation of the interest payments of a bond?

A

PV = Pmt1 / (1 + r)^1 + Pmt2 / (1 + r)^2 + … + Pmtn / (1 + r)^n
OR
PV = Pmt * tabe rate of an ordinary annuity

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34
Q

What are debt covenants?

A

Restrictions imposed on a borrower by the creditor in a formal debt agreement (indenture).

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35
Q

What are examples of debt covenants?

A

1) Limitations on issuing additional LT or ST debt
2) Limitations on dividend payments
3) Maintenance of certain financial ratios
4) Maintenance of specific collateral that secures the debt

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36
Q

How do debt covenants explain risk? What happens if the debtor violates the covenant?

A

The more restrictive the debt covenant, the lower the risk the borrower will not pay. The less risky the investment, the lower the interest rate on the debt (risk premium is lower).
If the debtor violates the covenant, the debt becomes due immediately.

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37
Q

How is the stock price calculated under the dividend growth model?

A
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38
Q

How is the price of a preferred stock calculated?

A
39
Q

How is the dividend payout ratio calculated?

A
40
Q

How is the shareholder return (both common and preferred stock) calculated?

A
41
Q

Compare debt financing and equity financing.

A
42
Q

What rights do common stock shareholders have? What is the risk involved?

A

Common shareholders are owners of a corporation. (Rights may vary depending on state laws.) They ordinarily have a preemptive right to purchase additional stock issues in proportion to their current ownership. They have voting rights—select the BoD and vote on resolutions.
Equity ownership involves risk because common shareholders are not guaranteed a return and are lowest priority during liquidation. Shareholders’ capital is a source of funds for repaying creditors if losses occur during liquidation.

43
Q

What is market capitalization (market cap)?

A

The market value of a company’s outstanding shares.
Market cap = shares of CS outstanding * FMV per share

44
Q

What are the advantages and disadvantages to the corporation of common stock?

A

Advantages: 1) common stock does not require a fixed dividend (dividends are paid from profits when available); 2) common stock has no fixed maturity date for capital repayments; 3) common stock sales increase the creditworthiness of the firm by providing more capital for the corporation to use
Disadvantages: 1) cash dividends are not tax-deductible and are paid from the after-tax profits, meaning common stockholders are doubled taxed—once on corporate income and once on personal dividend income (and paying dividends does not decrease NI); 2) new common stock sales dilute EPS to current shareholders; 3) underwriting costs are typically higher for common stock than debt; 4) too much equity may riase the avg. cost of capital of the firm above its optimal level

45
Q

What is the basis for common stock valuation?

A

Common stock valuation is based on dividend payout models.

46
Q

If the dividend per share of common stock is constant and expected to be paid continuously, how is the price per share calculated?

A

P0 = D / r
Where
P0 = Current price per share
D = Dividend per share (constant)
r = Required rate of return

47
Q

When is the dividend growth model used?

A

It assumes that dividends per share and price per share increase at the same constant rate (which can be positive or negative).

48
Q

How is the required rate of return (the cost of common stock) derived from the dividend growth model calculated?

A

r = D1 / P0 + g

49
Q

What are the disadvantages of the dividend growth model?

A

1) It assumes the dividend growth rate is constant and is always less than the required rate of return
2) It cannot be used to value stock price if a company does not pay dividends

50
Q

How is the dividend discount model calculated?

A

P0 = [D1 / (1 + r)^1] + [D2 / (1 + r)^2] + … + [Dt / (1 + r)^t]
Where
P0 = Current stock price per share
D = Dividends per share
r = discount rate
t = final period

51
Q

What is preferred stock? How is it established?

A

It is a hybrid of debt and equity, usually established in terms of issuance as a percentage of par value, making preferred stock dividends fixed payments.
Preferred stock has priority over common stock for dividend payments, but preferred stock dividends are not requirement payments. It also takes priority over common shareholders in bankruptcy.

52
Q

What are the advantages and disadvantages to the corporation of preferred stock?

A

Advantages: 1) preferred stock is equity and increases the firm’s creditworthiness; 2) preferred stock rarely has voting rights, so common shareholders retain control; 3) superior earnings of the firm are usually still reserved for common shareholders; 4) preferred stock does not require periodic payments (nonpayment of dividends does not lead to bankruptcy)
Disadvantages: 1) cash dividends on preferred stock are not tax-deductible and are paid from after-tax profits (substantially greater cost relative to bonds because preferred stockholders also enjoy the value of ownership); 2) during economic difficulties, dividends in arrears may create managerial and financial problems for the firm

53
Q

What are the typically preferred stock provisions?

A

1) priority in assets and earnings
2) accumulation of dividends
3) convertibility
4) participation (preferred stock may participate with common stock in excess earnings, received preferred dividend and common shareholder dividends on a pro-rata basis) unless preferred stock is specified as nonparticipating
5) par value (par value = liquidation value, % of par = preferred dividend)

54
Q

How is preferred stock valued?

A

It applies the same method used to value bonds
1) Future cash flows associated with the security are discounted at an investor’s rate of return
2) Future cash flows are assumed to consist of the estimated future annual dividends (Dp)
Dp = Par value of preferred stock * Preferred dividend rate
3) Preferred stock is assumed to be outstanding in perpetuity; discount rate used is the investor’s required rate of return (r)
Preferred stock price (Pp) = Dp / r

55
Q

What is the fundamental goal of any corporation? How is the success of that goal measured?

A

Increasing shareholder wealth is the fundamental goal. The dividend payout ratio and dividend yield ratio measure this goal.

56
Q

What is the dividend payout ratio? How is it calculated?

A

It measures what portion of accrual-basis earnings was actually paid out to common shareholders in the form of dividends.
Dividend payout ratio = Dividend paid per share / EPS = Cash dividend / NI

57
Q

What is the dividend yield ratio? How is it calculated?

A

It measures how much a company distributes to shareholders relative to its price per share
Dividend yield = Dividend per share / Market price per share

58
Q

What is the shareholder return? How is it calculated?

A

It measures the return on a purchase of stock.
Shareholder return = (Ending stock $ - Beginning stock $ + Annual dividends per share) / Beginning stock $

59
Q

How is the percentage cost of common equity calculated?

A

Percentage cost of common equity = (Net dividend ÷ Net issue proceeds) + Dividend growth rate

60
Q

Give examples of measures (ratios) of solvency.

A

Measures of solvency include:
* Times-interest-earned ratio
* Total debt ratio
* Total-debt-to-total-capital ratio
* Debt-to-equity ratio
* Long-term-debt-to-total-equity ratio

61
Q

What is debt?

A

Debt is the creditor’s interest in the firm.

62
Q

What is solvency?

A

Solvency is a firm’s ability to pay its noncurrent obligations as they come due and to remain in business in the long run. It is the big, long-term picture of the company.

63
Q

What makes up a firm’s capital structure?

A

A firm’s capital structure includes its sources of financing (external debt and internal equity), both LT and ST.

64
Q

Define debt. What are the main identifiers?

A

Debt is the creditor interest in the firm.
1) Debt is a contractual obligation to repay debtholders, terms specified in the agreement.
2) If the return on debt exceeds the interest paid, debt financing advantages the firm. The return increases because debt interest payments are tax-deductible.
3) It disadvantages the firm by increasing risk. It must repay debt regardless of profitability.

65
Q

Define equity. What are the main identifiers?

A

Equity is the ownership interest in the firm.
1) Equity is permanent capital contributed by owners to earn a return.
2) Return on equity is uncertain. It is residual interest in the firm’s assets, claimable only after the firm pays debt.
3) Periodic returns to owners of excess earnings are dividends.

66
Q

How does capital structure decisions affect a firm’s risk?

A

A firm with a higher % of debt capital is riskier than a firm with a higher % of equity capital. When the relative debt is high, equity investors demand a higher rate of return to compensate for additional risk of financial leverage. A firm with a larger equity capital may encourage debt holders to accept a lower interest rate in exchange for lower risk.

67
Q

What information does the times-interest-earned ratio provide? How is it calculated?

A

It’s a solvency measure that gauges the firm’s ability to service debt from current earnings as part of the effective use of leverage. The key elements of solvency are the firm’s capital structure and degree of leverage.
TIE ratio = EBIT / Interest expense

68
Q

What information do capital structure ratios provide?

A

They report the relative proportions of debt and equity in a firm’s capital structure.

69
Q

What does the total debt ratio measure? How is it calculated?

A

Also called the debt to total assets ratio, it reports the total debt burden carried by a firm per dollar of assets. A decrease is seen as an improvement.
Total debt ratio = Total debt / Total assets

70
Q

What does the total debt to total capital ratio measure? How is it calculated? What does the information tell you?

A

It measures the percentage of the firm’s capital provided by creditors. Total capital includes equity and interest-bearing debt. (decrease in ratio shows less reliance on debt, firm is less leveraged)
Total debt to total capital = Total debt / Total capital
When total debt to total cap is low, more of the firm’s cap is supplied by the shareholders. Creditors prefer this ratio to be low to cushion against losses.

71
Q

What does the debt-to-equity ratio measure? How is it calculated? What does the information tell you?

A

It’s a direct comparison of the firm’s debt with its equity.
Debt to equity = Total debt / Shareholders’ equity
The ratio reflects LT debt-payment ability. A low ratio means a lower relative debt and less creditor risk.

72
Q

What does the long-term-debt-to-total-equity ratio measure? How is it calculated? What does the information tell you?

A

It reports LT debt per dollar of equity.
LT debt to total equity = LT debt / Shareholders’ equity
A firm with a low ratio has a better chance of obtaining new debt financing at a favorable rate.

73
Q

What are the three components of a firm’s cost of capital?

A
  • Cost of long-term debt,
  • Cost of preferred equity, and
  • Cost of common equity (retained earnings).
74
Q

In the calculation of the cost of capital, how is the component cost of long-term debt calculated?

A

The component cost of long-term debt is the after-tax interest rate on debt because interest payments are tax-deductible. The component cost is therefore calculated using the following formula:
Component cost of long-term debt = Effective rate × (1.0 – Marginal tax rate)

75
Q

In the calculation of the cost of capital, how is the component cost of preferred stock calculated?

A

Component cost of old preferred stock = Cash dividend on PS / (PS market $ - Flotation costs)
OR
CC of old PS = Cash dividend on PS / PS market $

76
Q

Why do investors provide capital to firms?

A

Investors provide funds with the understanding that management will productively use those funds to pass returns to investors. If management does not provide the required RoR, investors sell their stock on the secondary market, and stock market value drops. Creditors demand higher rates on debt. Investors’ RoR (also called their opportunity cost of capital) becomes the firm’s cost of capital.

77
Q

Who demands higher returns? Why?

A

Equity holders demand higher returns than debt holders. Equity cap providers are exposed to more risk because the firm has no legal obligation to pay them a return, and they have low priority during liquidation. To compensate for higher risk, equity investors demand a higher return, making equity financing more expensive than debt.

78
Q

For what does a firm use the cost of capital figure?

A

It is used to discount future cash flows of LT projects under consideration. Potential investments with a RoR higher than the cost of cap will increase the value of the firm and shareholders’ wealth, and vice versa.

79
Q

What is a firm’s cost of capital?

A

It is the required RoR by investors on the firm’s debt and equity (both preferred and common).

80
Q

How does the debt issuance cost impact the effective rate of LT debt?

A

If debt is issued at face value, effective rate = coupon rate
If debt is issued at a premium or discount, effective rate = coupon payment / issue price
(Pmt / issue price) * (1 – marginal tax rate)

81
Q

How do you calculate the market price of preferred stock? What are flotation costs?

A

The market price of PS upon issuance is the net proceeds (gross proceeds less flotation costs). Flotation or issuance costs reduce the net proceeds received, raising the cost of capital. These are the costs associated with issuing a share of stock.

82
Q

What is the component cost of retained earnings?

A

It is the rate of return required by common shareholders. If the firm cannot use RE profitably, it should distribute it to common shareholders as dividends.

83
Q

What is the traditional formula for the cost of common equity? What is the advanced formula?

A

Rce (basic) = Next dividend per share / Share price
Rce (advanced) = Next dividend per share / Share price + Dividend growth rate
NOTE: The methods of calculating the cost of common equity include the CAPM.

84
Q

What is expected value?

A

Expected value is a means of associating a dollar amount with each possible outcome of a probability distribution. The outcome yielding the highest expected value (which may or may not be the most likely one) is the optimal alternative.

85
Q

What is a criticism of expected value?

A

Expected value is based on repetitive trials, but many business decisions ultimately involve only one event.

86
Q

How is expected value calculated?

A

By multiplying the probability of each outcome by its payoff and adding the products. This calculation is often called a payoff table.

87
Q

Why must companies establish a probability distribution?

A

Constructing a payoff table is difficult due to determining all possible outcomes of decisions and their probabilities. Assigned probabilities may reflect prior experience with similar decisions, research results, or subjective estimates.

88
Q

What is an advantage of expected value?

A

While exact probabilities are possibly unknown, the use of expected value analysis forces managers to evaluate decisions logically or at least consider all outcomes.

89
Q

What is a firm’s weighted-average cost of capital (WACC)?

A

A firm’s WACC combines the costs of the three components of capital into one composite rate of return on the combined components of capital based on the capital structure.

90
Q

What is WACC?

A

Corporate management usually designated a target capital structure, i.e. the proportion of each component of cap: LT debt, preferred equity, and common equity. The WACC combines the three components of capital into one composite rate of return. The weights are based on the target capital structure, which is effectively an expected value analysis.

91
Q

What are the WACC weights based on? Why?

A

Weights are based on components’ respective market values, NOT book values
Market value provides best information about investors’ expectations

92
Q

Elaborate on the market value in the WACC. How are tax benefits incorporated?

A

The market values of the firm’s debt, common equity, and preferred equity should reflect the targeted capital structure rather than the current capital structure.
Although WACC uses the market value of debt, the carrying amount may be used as a proxy. If the firm is in financial distress, these values may differ greatly.
Multiply debt by (1 – T) to incorporate the tax benefit of interest expense.

93
Q

What is a company’s business risk?

A

Business risk is the risk that the cash flow of an issuer will be impaired because of adverse economic conditions, making it difficult for the issuer to meet its operating expenses.

Gleim BEC (5 decks)

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