Subunit 8: Corporate Capital Structure Flashcards

Question

What happens to bonds in a secondary market?

Answer 1

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

Answer 2

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.

Answer 3

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.

Answer 4

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.

Answer 5

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

Answer 6

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

Answer 7

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

Answer 8

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

Answer 9

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

Answer 10

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

Answer 11

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

Answer 12

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.

Answer 13

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.

Answer 14

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

Answer 15

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

Answer 16

Common stock valuation is based on dividend payout models.

Answer 17

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

Answer 18

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

Answer 19

r = D1 / P0 + g

Answer 20

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

Answer 21

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

Answer 22

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.

Answer 23

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

Answer 24

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)

Answer 25

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

Answer 26

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

Answer 27

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

Answer 28

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

Answer 29

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

Answer 30

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

Answer 31

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

Answer 32

Debt is the creditor’s interest in the firm.

Answer 33

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.

Answer 34

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

Answer 35

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.

Answer 36

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.

Answer 37

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.

Answer 38

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

Answer 39

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

Answer 40

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

Answer 41

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.

Answer 42

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.

Answer 43

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.

Answer 44

* Cost of long-term debt, * Cost of preferred equity, and * Cost of common equity (retained earnings).

Answer 45

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)

Answer 46

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 $

Answer 47

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.

Answer 48

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.

Answer 49

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.

Answer 50

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

Answer 51

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)

Answer 52

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.

Answer 53

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.

Answer 54

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.

Answer 55

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.

Answer 56

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

Answer 57

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

Answer 58

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.

Answer 59

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

Answer 60

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.

Answer 61

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.

Answer 62

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

Answer 63

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.

Answer 64

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.

Subunit 8: Corporate Capital Structure Flashcards

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