Finance Ch. 13 - Leverage and Capital Structure

-No corporate or personal taxes -No bankruptcy costs

Case 1 assumptions

-Corporate taxes, but no personal taxes -No bankruptcy costs

Case 2 assumptions

-Corporate taxes, but no personal taxes -Bankruptcy costs

Case 3 assumptions

true

T/F - the assets of a firm are not directly affected by a capital restructuring

true

T/F financial leverage may not affect the overall cost of capital

True

T/F interest paid on debt is tax deductible

greater;less

The ____ risk of financial distress, the ___ debt will be optimal for the firm

1)Changes in the risk of the cash flows 2)Changes in the cash flows

The change in a firm's value is affected by what two things?

M&M proposition II

a firm's cost of equity capital is a positive linear function of its capital structure

financial distress costs

according to static theory, the gain from the tax shield on debt is offset by what?

capital restructurings

activities that alter the firm's existing capital structure (substituting one capital structure for another)

target capital structure

another name for capital structure

tax rate x interest payment

calculating annual interest tax rate shield

capital structure decisions

decisions about a firm's debt-equity ratio

-Disruption of normal operations, sales lost, employees leave, worthwhile programs languish, profitable investments are missed, inability to obtain terms on purchases -Expensive Legal battles between stockholders and bondholders

examples of indirect costs/financial distress costs

1) issue debt and repurchase outstanding shares 2) issue new shares and retire outstanding debt

how does a firm increase leverage? decrease leverage?

1)cash flows to the firm 2)the risk of the firm's assets

how is the value of the firm to the investor determined? (2)

by maximizing the value of a share of stock (maximizing the value of the whole firm)

how should a firm go about choosing its debt-equity ratio?

EPS, ROE

leverage amplifies the variation in both ____ and ____ ?

magnifies gains and losses (variability in both)

leverage effects to ROE and EPS (1)

minimize WACC

one way to maximize stockholder wealth

reduces -- why?

reducing taxes increases cash flow of the firm, but ____ to overall net income. why?

optimal capital structure

the best debt-to-equity ratio for a firm that maximizes its value

indirect bankruptcy costs

the costs of avoiding a bankruptcy filing incurred by a financially distressed firm

direct bankruptcy costs

the costs that are directly associated with bankruptcy such as legal and administrative costs

financial distress costs

the direct and indirect costs associated with going bankrupt or experiencing financial distress

business risk

the equity risk that comes from the nature of the firm's operating activities (depends on systematic risk)

financial leverage

the extent to which a firm relies on debt (more debt = more leverage)

financial risk

the extra risk that arises from the use of debt financing

the same net earnings for the investor under each scenario, NOT the same effective EPS

the homemade leveraging strategy is designed to produce...

corporate tax shield

the tax saving attained by a firm from the tax deductibility of interest expense

homemade leverage

the use of personal borrowing to change the overall amount of financial leverage to which an individual is exposed

M&M proposition I

the value of a firm is independent of its capital structure - "the size of the pie doesn't depend on how it is sliced" therefore, changing the capital structure of the firm does not change its total value

1) EBIT above break-even point, leveraging will make you more money 2) EBIT below the break even point, leveraging will cost you $ (detrimental to stockholders)

two observations on break-even EBIT analysis

1) business risk 2) financial risk

what are the two parts that make up the total systematic risk of the firm's equity?

increases the cash flow

what does a reduction in taxes do for a firm?

maximize stockholder wealth (overall value of firm)

what is the primary goal of a financial manager?

the value of the firm is maximized when the WACC is minimized

what is the primary reason for studying the WACC?

1) the required rate of return on the firm's assets (Ra) 2) the firm's cost of debt (Rd) 3) the firm's debt to equity ratio (D/E)

what three things does the cost of equity depend on?

1) the required return on the firm's assets (Ra) 2) the cost of equity (Ra - Rd) x (D/E)

what two components can the firm's cost of equity be broken down into?

reduces

when a firm adds debt, it ____ taxes

when the value of its assets = the value of its debt

when does a firm become bankrupt?

if it results in the lowest possible WACC

when does a particular debt-equity ratio represent the optimal capital structure?