Unit 2 Flashcards
Financial leverage
The extent to which a firm relies on debt
The more debt, the more financial leverage is employed
M&M Proposition I
The value of the firm is independent of the firm’s capital structure, in an ideal world
M&M Proposition II
Cost of equity capital is a positive linear function of the capital structure, in an ideal world
Cost of equity is given by a straight line with a slope of (Ra - Rd)
Business risk
The equity risk that comes from the nature of a firm’s operating activities
Unaffected by capital structure
Financial risk
The equity risk that comes from the financial policy
Completely determined by financial policy
Features of debt
Interest paid on debt is tax deductible
Failure to meet obligations can lead to bankruptcy
Interest tax shield
Interest being tax deductible and is generated by paying interest
(Tc × D × Rd)/Rd
= Tc × D
M&M Proposition I with taxes
The value of the firm increases as total debt increases because of the interest tax shield
M&M Proposition II with taxes
A firm’s WACC decreases as the firm relies more heavily on debt financing
The cost of equity rises as the firm relies heavily on debt financing
bankruptcy
When the value of assets is equal to the value of debt
The value of equity is 0, so stockholders turn over control to bondholders legally
Direct bankruptcy costs
Legal and administrative expenses
Bondholders won’t get all that they are owed
Disincentive to debt financing
Indirect bankruptcy costs
Costs of avoiding a bankruptcy filing
Financial distress
When a firm is having significant problems in meeting its debt obligations
Financial distress costs
Direct and Indirect costs associated with going bankrupt
Static theory of capital structure
The gains from the tax shield on debt is offset by financial distress costs
WACC falls because of tax advantage of debt
