CH 14 - Capital Structure and Leverage

Financial Risk

An increase in stockholders' risk, over and above the firm's basic business risk, resulting from the use of financial leverage.

Capital

Investor-supplied funds such as long- and short- term loans and institutions, preferred stock, common stock, and retained earnings.

Net Debt

Net debt = Total debt - Cash and equivalents Companies often look at this measure when setting their target capital structure.

Reserve Borrowing Capacity

The ability to borrow money at a reasonable cost when good investment opportunities arise. Firm often use less debt than specified by the MM optimal capital structure in "normal" times to ensure that they can obtain debt capital later if necessary.

Optimal Capital Structure

The capital structure that maximizes a stock's intrinsic value.

Trade-Off Theory

The capital structure theory that states that firms trade off the tax benefits of debt financing against problems caused by potential bankruptcy.

Financial Leverage

The extent to which fixed-income securities (debt and preferred stock) are used in a firm's capital structure.

Unlevered Beta bu

The firm's beta coefficient if it has no debt.

Operating Breakeven

The output quantity at which EBIT = 0.

Business Risk

The riskiness inherent in the firm's operations if it uses no debt. A commonly used *measure of business risk is the standard deviation of the firm's return on invested capital (ROIC): ROIC = EBIT(1-T) / Investor-supplied capital *Factors that Affect Business Risk [8]: 1) Competition 2) Demand variability 3) Sales price variability 4) Input cost variability 5) Product obsolescence 6) Foreign risk exposure 7) Regulatory risk and legal exposure 8) The extent to which costs are fixed: operating leverage

Pecking Order

The sequence in which firms prefer to raise capital: first spontaneous credit, then retained earnings, then other debt, and finally new common stock.

Symmetric Information

The situation where investors and managers have identical information about firm's prospects.

Asymmetric Information

The situation where managers have different (better) information about firm's prospects than do investors.

Signal

an action taken by a firm's management that provides clues to investors about how management views the firm's prospects.

Operating Leverage

the extent to which fixed costs are used in a firm's operations.

Capital Structure

the mix of debt, preferred stock, and common equity that is used to finance the firm's assets.

Windows of Opportunity

the occasion where a company's managers adjust its firm's capital structure to take advantage of certain market situations.

Checklist for Capital Structure Decisions [12]

1) Sales stability 2) Asset structure 3) Operating leverage 4) Growth rate 5) Profitability 6) Taxes 7) Control 8) Management attitudes 9) Lender and rating agency attitudes 10) Market conditions 11) The firm's internal condition 12) Financial flexibility