Finance Final (Ch. 13)

what is the equity risk that comes from the nature of a firms operating activities

*business risk* of the firm's equity ---- depends on systematic risk of firm's assets

restructurings take place when a firm substitutes one ____ for another while leaving the firm's _____ unchanged

- capital structure ; assets unchanged

??? which increases with leverage, cost of debt or cost of equity

- cost of debt increases - cost of equity may increase

a firm's optimal capital structure is composed by ____ in debt and ____ in equity

- debt: D*/Vl* - equity: (1 - D*/Vl*)

incentives of bondholders and stockholders during potential bankruptcy

- stockholders: incentive to not go bankrupt bc will be cleaned out - bondholders: incentive to go bankrupt bc get control from stockholders

bankruptcy is very valuable because it can...

1) be used strategically to improve a firm's competitive position 2) payments to creditors cease pending the outcome of the bankruptcy process

what are the 2 parts of the total systematic risk of a firm's equity

1) business risk 2) financial risk

what are the 2 implications of proposition 1 in a no-tax case

1) capital structure is irrelevant 2) WACC is the same no matter what mixture of debt and equity is used to finance the firm

a corporation gains no value from an interest tax shield if what 3 things are true...

1) corporation is an all-equity firm 2) corporation has no debt 3) corporate tax rates are zero

if we consider the effect on taxes, what is the optimum capital structure

100% debt

the weighted average cost of capital (WACC) ____ as the firm relies more heavily on debt financing

DECREASES (bc value of firm increases and that's opposite from WACC)

the effect of financial leverage depends on the company's ___

EBIT --- when EBIT is high, the leverage is beneficial

the value of the firm increases as total debt ____

INCREASES

cost of debt will begin to increase as the degree of leverage _____

INCREASES - (increases equity which decreases debt)

if financial leverage does not effect the overall cost of capital, the firm's capital structure is _____

IRRELEVANT - bc changes in cap structure won't affect the value of the firm

the greater the risk of financial distress, the ____ debt will be optimal for firm (and for borrowing)

LESS

a particular debt-equity ratio represents the *optimal capital structure* if it results in the ____ possible WACC

LOWEST

at the optimal debt level (D*) is the optimal D/E* ratio - also at this level of debt financing is the ______ possible WACC*

LOWEST possible WACC*

the value of the firm is _____ when the WACC is _____

MAXIMIZED - MINIMIZED

what is the slope of cost of equity (Re)

Ra - Rd (required rate on firm's assets - firm's cost of debt)

what is the equation for present value of the tax shield

Tc x D

is interest paid on debt tax deductible

YES - good for a firm

what does M&M Proposition II state

a firm's cost of equity capital is a *positive linear function* of its capital structure -- the value of the firm (Vl) increases as total debt increases bc of the interest tax shield

??? an investor who invests in the stock of a levered firm rather than in an all-equity firm will require a higher....

a higher expected return

as debt-equity ratio rises, so does the probability of ____

bankruptcy

why doesn't the capital structure the firm adopts really matter

bc investors can lend, borrow, and replicate all on their own

a firm's choice of how much debt it should have relative to equity is known as a ____

capital structure decision (decisions about a firm's debt-equity ratio)

which is generally lower, cost of debt or cost of equity

cost of debt is generally loswer

direct bankruptcy costs

costs associated directly to bankruptcy ---- *legal and administrative* expenses

indirect bankruptcy costs

costs of avoiding a bankruptcy filing incurred by a financially distressed firm (ex: lost sales; lost reputation; NOT legal expenses)

financial distress costs

direct AND indirect costs of bankruptcy

the WACC rises at higher levels of debt owing to...

financial distress costs

what is the equity risk that comes from the financial policy (i.e. capital structure) of the firm --- the extra risk that arises from the use of debt financing/the risk of leverage

financial risk

the use of personal borrowing to alter the degree of financial leverage is called ____

homemade leverage --- shareholders can adjust the amount of financial leverage by borrowing and lending on their own

a firm can consider it's capital restructuring decisions ____ from its investment deicions

in isolation ---- assets not directly affected by capital restructuring --- examine capital structure decisions separately from other activities

if degree of leverage increases, the cost of debt will ____

increase

as firms increase the financial leverage, cost of equity ____; as a result, firm's overall cost of capital ____

increases ; decreases

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

interest tax shield

financial distress can arise in the form of possible....

legal bankruptcy and business failure

??? M&M Proposition I does not work with corporate taxes because...

levered firms pay lower taxes than unlevered firms

the impact of financial leverage ___ gains and losses

magnifies

capital structure decisions should ___ the value of ____

maximize the value of the whole firm ---- choose the structure so that the *WACC is minimized*

what is the *optimal level of borrowing*

maximum firm value (Vl*) is reached at optimum debt level (D*)

does financial leverage change overall cost of capital

no

financial leverage refers to the extent to which a firm _____

relies on debt --- the more debt, the more financial leverage

activities (issuing stock; issuing bonds) that alter the firm's existing capital structure; that change the debt-equity ratio

restructurings

volatility or ____ increases for equity holders when leverage increases

risk

what is the theory that states a firm borrows up to the point where the tax benefit from an extra dollar of debt exactly equals the cost that comes from the increased probability of financial distress

static theory of capital structure

what is the firm's cost of debt (Rd) determined by

the firm's financial structure --- as firm relies more on debt financing, the required return on equity rises

whats the relationship between the value of the unlevered firm and of the levered firm *once we consider the effect of corporate taxes*

the levered firm exceeds the value of unlevered firm *by the present value of interest tax shield*, Tc x D

(case w bankruptcy costs and corp. taxes) the *optimal capital structure* (D*) is the point at which....

the tax saving from an additional dollar of debt financing is EXACTLY BALANCED by the increased bankruptcy costs associated w the additional borrowing

with no tax, proposition 1 implies that...

value of the leveraged firm = value of unleveraged firm

what does M&M Proposition I state

the value of a firm is independent of its capital structure

a firm goes bankrupt when ______

the value of its assets = value of its debt --- equity has no value; equal to zero

implications of proposition 2 in a no-tax case

1) cost of equity rises as the firm increases its use of debt financing(leverage) 2) the risk of the equity depends on 2 things: business risk and financial risk

according to M&M Prop. II, what 3 things does cost of equity depend on

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