FRL 367 Midterm 2

Determinants of Beta

- Cyclicality of revenues - Operating leverage - Financial leverage

Pay a dividend or make a capital expenditure

A firm with excess cash can either ________ or _______.

Financial asset

A firm with excess cash can either pay a dividend or make a capital expenditure. Because stockholders can reinvest the dividend in risky financial assets, the expected return on a capital budgeting project should be at least as great as the expected return on a _______ ______ of comparable risk.

Agency cost of equity

Conflict between managers and shareholders.

Rb

Cost of debt

Business

Cyclicality of revenues and operating leverage may affect ______ risk.

Double

Dividends face ______ taxation (since the firm pays tax for it and the shareholder pays for it individually as well), which suggests a stockholder receives the net amount: (1-Tc)x(1-Ts)

No (It is the costs associated with bankruptcy that lowers cash flows)

Does bankruptcy itself reduce a firm's cash flows?

Highly cyclical stocks (with higher betas)

Empirical evidence suggests that retailers, automotive, and high-tech firms fluctuate with the business cycle, which makes them -

Financial

Financial leverage may affect _________ risk.

Business risk

If a firm remains in the same industry, then the ________ risk, also known as the asset beta, is the same.

R0

In a world without corporate taxes, Rwacc must always equal ___.

Project based

Is cost of capital project based or firm based?

Selfish strategy 1

Selfish strategy where firms near bankruptcy often take great chances because they believe that they are playing with someone else's money.

Beta

Sensitivity of a stock's return to the return on the market portfolio -also known as the slope of the regression line

True

The cost of debt is NOT the coupon rate. T/F

Aftertax interest payment

The difference between the cash flow that equityholders receive in an unlevered firm and the cash flow that equityholders receive in a levered firm is the -

interest tax shield

The tax savings of the firm derived from the deductibility of interest expense is called the: -depreciable basis. -financing umbrella. -tax-loss carry forward savings. -interest tax shield. -current yield.

Correlation

The tightness of fit around the regression line

Wasteful

Too much free cash flow may lead managers to pursue ______ activities.

CAPM

While dividend growth (discount) model and capital asset pricing model (CAPM) both measure cost of equity capital, _______ may have more advantages because it adjusts for risk & it is applicable to companies that pay no dividends or whose dividend growth is difficult to estimate.

Stockholders (because they are not legally entitled to dividends in the way bondholders are legally entitled to interest and principal payments)

Who bears the costs associated with bankruptcy?

Factors that affect the D/E ratio

-Taxes: Since interest is tax deductible, highly profitable firms should use more debt (ie: greater tax benefit). -Types of assets: The costs of financial distress depend on the types of assets the firm has. Firms with large investments in tangible assets are likely to have higher target debt-equity ratios than firms with large investments in research and development. -Uncertainty of Operating Income: Even without debt, firms with uncertain operating income have a high probability of experiencing financial distress. Thus, these firms must finance mostly with equity. -Pecking Order and Financial Slack: Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient.

Assumptions of the M&M model with corporate taxes

-corporations are taxed at the rate tc, on earnings after interest -no transaction or bankruptcy costs -individuals and corporations borrow at the same rate

Assumptions of the M&M Model without taxes (Modigliani and Miller)

-homogenous expectations -homogenous business risk classes -perpetual cash flows -perfect capital markets: -perfect competition -firms and investors can borrow/lend at the same rate -equal access to all relevant information -no transaction costs -no taxes

Three approaches to valuation for the levered firm (in the presence of debt financing)

1. Adjusted Present Value Approach (APV) 2. Flow To Equity Approach (FTE) 3. Weighted Average Cost of Capital Approach (WACC

Problems with beta

1. Betas may vary over time 2. Sample size may be inadequate 3. Betas are influenced by changing financial leverage and business risk

Steps in the FTE approach

1. Calculate the levered cash flows (LCFs) 2. Calculate Rs. 3. Value the levered cash flows at Rs.

Types of financial distress costs

1. Direct costs (3% of market value of firm) -Legal and administrative costs 2. Indirect costs (10-20% of market value of firm) -Impaired ability to conduct business

Side effects of financing (also known as the net present value of debt which is the sum of all these four)

1. The tax subsidy to debt 2. The costs of issuing new securities 3. The costs of financial distress 4. Subsidies to debt financing

Solutions to beta problems

1. While betas may vary over time and sample size may be inadequate, it can be moderated by more sophisticated statistical techniques 2. Betas, influenced by changing financial leverage and business risk, can be lessened by adjusting for changes in business and financial risk 3. Look at average beta estimates of several comparable firms in the industry

Levered

A ______ firm is a firm with some debt in its capital structure.

Levered

A ______ firm with debt pays less in taxes than does the all-equity firm. Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.

Cyclicality of revenues

A determinant of beta. -When revenues of some firms are quite cyclical, they do well in the expansion phase of the business cycle and do poorly in the contraction phase -May affect business risk, which is the asset beta -Not the same as variability, where stocks with high standard deviations need not have high betas

Protective covenants

A part of the indenture or loan agreement between stockholders and bondholders that limits or requires certain actions by a company during the term of the loan to protect the lender's interest. These agreements should reduce the costs of bankruptcy, ultimately increasing the value of the firm.

Scale-enhancing project

A project that is similar to those of the existing firm.

Tax subsidy to debt

A side effect of financing that points out for perpetual debt, the value of the tax subsidy is tcB

Costs of issuing new securities

A side effect of financing: Investment bankers participate in the public issuance of corporate debt. These bankers must be compensated for their time and effort, a cost that lowers the value of the project.

Subsidies to debt financing

A side effect of financing: The interest on debt issued by state and local governments is not taxable to the investor. Because of this, the yield on tax-exempt debt is generally substantially below the yield on taxable debt. Frequently corporations can obtain financing from a municipality at the tax-exempt rate because the municipality can borrow at that rate as well. As with any subsidy, this adds value.

Costs of financial distress

A side effect of financing: the possibility of financial distress, and bankruptcy in particular, arises with debt financing. Financial distress imposes costs, thereby lowering value.

Homemade leverage

A substitution where if levered firms are priced too high, rational investors will simply borrow on their personal accounts to buy shares in unlevered firms. As long as individuals borrow (and lend) on the same terms as the firms, they can duplicate the effects of corporate leverage on their own.

Flow To Equity (FTE)

A valuation approach that emphasizes cash flows to equity (from the equityholders perspective, not the firm)

Pie model of capital structure

A visual depiction of the firm that shows its full value as a circle with different claims dividing it into portions. Claims may be either marketable (stockholders) or nonmarketable (government)

MM Proposition I

An implication of _________ is that Rwacc is constant for a given firm, regardless of the capital structure.

Harder

An individual will work ______ for a firm if he is one of the owners than if he is one of the "hired help." Free cash flow hypothesis provides this opportunity.

Beta & covariance

Both _____ & _____ measure the responsiveness of a security to movements in the markets.

Agency costs

Costs of conflicts of interest among stockholders, bondholders, and managers when there is a probability of bankruptcy or financial distress. Stockholders may use the three types of selfish strategies to hurt the bondholders and help themselves. Selfish strategy 1: Incentive to take large risks Selfish strategy 2: Incentive toward underinvestment Selfish strategy 3: Milking the property

Financial distress; bankruptcy

Debt provides tax benefits to the firm. However, debt also puts pressure on the firm because interest and principal payments are obligations. If these obligations aren't met, the firm may risk some sort of ______ _____, where the ultimate distress is __________. These obligations are fundamentally different from stock obligations.

Value of a firm

Defined to be the sum of the value of the firm's debt and the firm's equity.

Financial distress

Events preceding and including bankruptcy such as violation of loan contracts.

increasing the volatility of the firm's net income

Financial leverage impacts the performance of the firm by: -decreasing the volatility of the firm's net income. -increasing the volatility of the firm's net income. -maintaining the same level of volatility of the firm's EBIT. -decreasing the volatility of the firm's EBIT. -None of these.

Lower cyclical stocks (with lower betas)

Firms in industries such as utilities, railroads, food, and airlines are less dependent on the business cycle, which makes them -

Rs

For a firm with leverage, __ must be greater than R0, the cost of capital for an unlevered firm.

FTE

For a highly levered firm, _____ approach is a reasonable choice.

shareholders because debtholders will pay less for the debt providing less cash for the shareholders.

Given realistic estimates of the probability and cost of bankruptcy, the future costs of a possible bankruptcy are borne by: -management because if the firm defaults they will lose their jobs. -all investors in the firm. -debtholders only because if default occurs interest and -principal payments are not made. -None of these. -shareholders because debtholders will pay less for the debt providing less cash for the shareholders.

Equity

Growth implies significant _____ financing, even in a world with low bankruptcy costs. Thus high-growth firms will have lower debt ratios than low-growth firms.

decrease; advantage

Growth opportunities _______ the _____ of debt financing. -decrease; advantage -increase; advantage -None of these -Both increase; advantage and decrease; disadvantage -decrease; disadvantage

High

Highly cyclical stocks have _____ betas because they move with the market movement

Free cash flow hypothesis

Hypothesis that states: -an increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities -an increase in debt will reduce the ability of managers to pursue wasteful activities more effectively than dividend increases Argues that a shift from equity to debt will boost firm value, since bonds are an obligation while dividends are not.

Should not

If an executive believes that the operations of the firm are fundamentally different from those in the rest of the industry, the firm's beta _______ (should/should not) be used.

Debt-equity ratio

If the goal of the management of the firm is to make the firm as valuable as possible, then the firm should pick the _________ that makes the pie (the total value) as big as possible

Security Market Line (SML)

If the project is similar to the firm, the cost of equity can be estimated using the ______ ______ line for the firm's equity.

Project's beta

If the project's beta differs from that of the firm, the discount rate should be based on the ______ _____, estimated by determining the average beta of the project's industry.

Debt consolidation

If we minimize the number of parties, contracting or negotiating costs fall should financial distress occur.

Should

If you believe that the operations of a firm are similar to the operations of the rest of industry, you _____ (should/should not) use the industry beta simply to reduce estimation error.

The same as

If you use the stock beta and the security market line to compute the discount rate for a project, you are assuming that the new project's risk is _____ (riskier, less riskier, the same as) the risk of the firm as a whole, and that the firm is financed entirely with equity.

Implications of the pecking-order theory

Implications: 1. There is no target amount of leverage. (No target D/E ratio) Each firm choose its leverage ratio based on financing needs. Firms first fund projects out of retained earnings. Once exhausted, additional projects are funded with debt, then equity when debt becomes exhausted. -> Amount of leverage is determined by the happenstance of available projects. 2. Profitable firms use less debt. Profitable firms generate cash internally, implying less need for outside financing. Because firms desiring outside capital turn to debt first, profitable firms end up relying on less debt. 3. Companies like financial slack. Because firms know that they will have to fund profitable projects at various times in the future, they accumulate cash today. They are then not forced to go to the capital markets when a project comes up. but not too much free cash as managers may pursue wasteful activities.

APV

In ___ approach, the value of the project when financed with some leverage is equal to the value of the project when financed with all equity plus the tax shield from the debt.

MM Proposition I that the market value of the firm is invariant to the capital structure

In a world of no corporate taxes if the use of leverage does not change the value of the levered firm relative to the unlevered firm is known as: -MM Proposition III that the cost of stock is less than the cost of debt. -MM Proposition II that the cost of equity is always constant. -MM Proposition I that the market value of the firm is invariant to the capital structure. -MM Proposition I that leverage is invariant to market value. -MM Proposition III that there is no risk associated with leverage in a no tax world.

II

In a world of no taxes, M&M Proposition ___ states that leverage increases the risk and return to stockholders.

M&M Prop I with tax

In a world of taxes but no bankruptcy costs, this proposition states that the value of the firm increases with leverage. VL = VU + TC B

II

In a world of taxes, M&M Proposition __ states that leverage increases the risk and return to stockholders.

False (A reduction in leverage will decrease both the risk of the stock and its expected return. Modigliani and Miller state that, in the absence of taxes, these two effects exactly cancel each other out and leave the price of the stock and the overall value of the firm unchanged.)

In a world with no taxes, no transaction costs, and no costs of financial distress, is this following statement true or false? -If a firm issues equity to repurchase some of its debt, the price per share of the firm's stock will rise because the shares are less risky.

False (Modigliani-Miller Proposition II (No Taxes) states that the required return on a firm's equity is positively related to the firm's debt-equity ratio [RS = R0 + (B/S)(R0 - RB)]. Therefore, any increase in the amount of debt in a firm's capital structure will increase the required return on the firm's equity.)

In a world with no taxes, no transaction costs, and no costs of financial distress, is this following statement true or false? -Moderate borrowing will not increase the required return on a firm's equity.

vary significantly across industries

In general, the capital structures used by U.S. firms: -tend to be those which maximize the use of the firm's available tax shelters. -are easily explained in terms of earnings volatility. -vary significantly across industries. -are easily explained by analyzing the types of assets owned by the various firms. -tend to overweigh debt in relation to equity.

Present value

In the APV approach, debt is a fixed proportion of the ______ _____ of the project, not a fixed proportion of the initial investment.

Equal

In the real world, executives would make the assumption that the business risk of the non-scale-enhancing project would be about _____ to the business risk of firms already in business. *business risk = asset beta = unlevered beta No exact formula exists for this. Some executives might select a discount rate slightly higher on the assumption that the new project is somewhat riskier since it is a new entrant

Flow To Equity (FTE)

In this approach, we discount the cash flow from the project to the equity holders of the levered firm at the cost of the levered equity capital, Rs.

Reduces (This reduction in taxes reduces our cost of debt -> after-tax cost of debt)

Interest expenses ________ our tax liability, while dividends do not as they are not tax deductible.

Individual

Interest payments are taxed at the ______ level since they are tax deductible by the corporation, so the bondholder receives: (1-Tb)

Intuition of MM Prop I w/ tax

Intuition that because corporations can deduct interest payments but not dividend payments, corporate leverage lowers tax payments

Intuition of MM Prop II (no tax)

Intuition that the cost of equity rises with leverage because the risk to equity rises with leverage.

Intuition of MM Prop II w/ tax

Intuition that the cost of equity rises with leverage because the risk to equity rises with leverage.

Intuition of MM Prop I (no tax)

Intuition that through homemade leverage individuals can either duplicate or undo the effects of corporate leverage

Intuition of selfish strategy 2

Intuition where a project with a positive NPV hurts stockholders because stockholders contribute the full investment, but both stockholders and bondholders share the benefit. In the recession, the bondholders take away most of the cash flow from the project.

Intuition of selfish strategy 1

Intuition where the high risk project increases firm value in a boom and decreases firm value in a recession. The increase in value in a boom is captured by stockholders because the bondholders are paid in full in both cases. The drop in value in a recession is born by bondholders alone because the stockholders get nothing in a recession anyway.

Signal

Investors view debt as a _______ of firm value. -Firms with low anticipated profits will take on a low level of debt. -Firms with high anticipated profits will take on a high level of debt.

Equity beta

Levered beta, representing FINANCIAL RISK -The asset beta adjusted for leverage. The beta of the publically traded stock of the firm.

all of these

MM Proposition I with corporate taxes states that: -All of these. -None of these. -firm value is maximized at an all debt capital structure. -by raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value. -capital structure can affect firm value

it is completely irrelevant how a firm arranges its finances

MM Proposition I with no tax supports the argument that: -business risk determines the return on assets. -a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress. -it is completely irrelevant how a firm arranges its finances. -the cost of equity rises as leverage rises. -financial risk is determined by the debt-equity ratio.

the value of the firm increases as total debt increases because of the interest tax shield

MM Proposition I with taxes is based on the concept that: -the cost of equity increases as the debt-equity ratio of a firm increases. -the firm is better off with debt based on the weighted average cost of capital. -the value of the firm increases as total debt increases because of the interest tax shield. -the optimal capital structure is the one that is totally financed with equity. -the capital structure of the firm does not matter because investors can use homemade leverage.

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

MM Proposition II is the proposition that: -the cost of equity depends on the return on debt, the debt-equity ratio and the tax rate. -the cost of equity is equivalent to the required return on the total assets of a firm. -supports the argument that the size of the pie does not depend on how the pie is sliced. -a firm's cost of equity capital is a positive linear function of the firm's capital structure. -supports the argument that the capital structure of a firm is irrelevant to the value of the firm.

has the same general implications as MM Proposition II without taxes

MM Proposition II with taxes: -supports the argument that business risk is determined by the capital structure employed by a firm. -has the same general implications as MM Proposition II without taxes. -reveals how the interest tax shield relates to the value of a firm. -reaches the final conclusion that the capital structure decision is irrelevant to the value of a firm. -supports the argument that the cost of equity decreases as the debt-equity ratio increases.

Highest

Managers should choose the capital structure that they believe will have the _______ (lowest/highest) firm value because this capital structure will be most beneficial to the firm's stockholders.

Adjusted Present Value (APV)

Net Present Value adjusted for taxes, financial distress costs, and other financial side effects.

Both the firm turning down positive NPV projects that it would clearly accept in an all equity firm; and stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project

One of the indirect costs to bankruptcy is the incentive toward underinvestment. Following this strategy may result in: -stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project. -Both the firm always choosing projects with the positive NPVs; and stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project. -the firm turning down positive NPV projects that it would clearly accept in an all equity firm. -the firm always choosing projects with the positive NPVs. -Both the firm turning down positive NPV projects that it would clearly accept in an all equity firm; and stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project.

Increases

Operating leverage ______ (decreases/increases) as fixed costs rise and variable costs fall. -The higher the operating leverage, the higher the beta.

Negative covenant

Part of the indenture or loan agreement that limits or prohibits actions that the company may take Examples: -limitations are placed on the amount of dividends a company may pay -the firm may not pledge any of its assets to other lenders -the firm may not merge with another firm -the firm may not sell or lease its major assets without approval by the lender -the firm may not issue additional long-term debt

Positive covenant

Part of the indenture or loan agreement that specifies an action that the company must undertake. Examples: -the company agrees to maintain its working capital at a minimum level -the company must furnish periodic financial statements to the lender

Market portfolio

Portfolio of all assets in the economy. In practice, a broad stock market index, such as the S&P composite, is used to represent the market

I

Proposition ___ holds because shareholders can achieve any pattern of payouts they desire with homemade leverage.

MM Prop II w/ tax

Proposition that states some of the increase in equity risk and return is offset by the interest tax shield. -in this case, Rwacc has a downward slope

MM Proposition II (No Taxes)

Proposition that states the expected return on equity is positively related to leverage because the risk to equityholders increases with leverage.

MM Proposition I (No Taxes)

Proposition that states the value of a levered firm is the same as the value of the unlevered firm. -We can create a levered or unlevered position by adjusting the trading in our own account. -Homemade leverage in this proposition suggests that capital structure is irrelevant in determine the value of the firm

Homemade leverage

Refers to the use of borrowing on the personal level as opposed to the corporate level.

Rs

Required return on levered equity, also known as cost of equity (or expected return on equity or stock)

R0

Required return on unlevered equity, also known as the cost of capital for an all-equity firm

Rules of pecking-order theory

Rules of theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient. Rule 1: Use internal financing first Rule 2: Issue debt next, equity last (straight debt before convertible debt since it is more risky)

Market value

Selfish strategies are costly because they will lower the ______ value of the whole firm.

Selfish strategy 2

Selfish strategy where stockholders of a firm with a significant probability of bankruptcy often find that new investment helps the bondholders at the stockholders' expense. (therefore, stockholders have an incentive toward underinvestment)

Selfish strategy 3

Selfish strategy where they pay out extra dividends or other distributions in times of financial distress, leaving less in the firm for bondholders. This strategy goes one step further than strategy 2 of incentive toward underinvestment because equity is actually withdrawn through the dividend. This increases perquisites to shareholders &/ management.

Financial leverage

Sensitivity to a firm's fixed costs of financing. -the extent to which a firm relies on debt -as THIS increases, beta increases as well -always increases the equity beta relative to the asset beta

Operating leverage

Sensitivity to the firm's fixed costs of production. -The degree to which a company's costs of operation are fixed as opposed to variable. The larger the fixed costs compared to variable costs, the larger THIS is. -basically measures how sensitive a firm (or project) is to its fixed costs -magnifies the effect of cyclicality on beta

T

T or F: While costs of debt can be reduced, it cannot be eliminated entirely.

Cost of equity capital

The _____ __ _____ ______, denoted by Rs, is positively related to the firm's debt-equity ratio. The firm's weighted average cost of capital, Rwacc, is invariant to the firm's debt-equity ratio.

Discount rate

The _______ rate is also known as the REQUIRED RETURN on a project (project should only be accepted if the project generates a return above what is required) & its COST OF CAPITAL.

positive as equityholders gain the tax shield on the debt interest

The change in firm value in the presence of corporate taxes only is: -negative because of the increased risk of default and fewer shares outstanding. -positive as equityholders face a lower effective tax rate. -positive as equityholders gain the tax shield on the debt interest. -negative because of a reduction of equity outstanding. -None of these.

all of these

The cost of capital for a firm, R-WACC, in a zero tax environment is: -equal to the expected earnings divided by market value of the unlevered firm. -equal to the overall rate of return required on the levered firm. -All of these. -is constant regardless of the amount of leverage. -equal to the rate of return for that business risk class.

Expected return

The discount rate of a project should be the _______ ______ on a financial asset of comparable risk.

Business risk

The equity risk arising from the nature of the firm's operating activity, and is directly related to the systematic risk of the firm's assets.

Financial risk

The equity risk that is due entirely to the firm's chosen capital structure. As financial leverage, or the use of debt financing, increases, so does this risk and, hence, the overall risk of the equity.

Dependent

The expected return on any asset is ______ (independent/dependent) on its beta.

Optimized

The firm's capital structure is _______ where the marginal subsidy to debt = the marginal cost.

Debt

The free cash flow hypothesis implies that _____ reduces the opportunity for managers to waste resources.

a higher variability of EPS with debt than all equity

The increase in risk to equityholders when financial leverage is introduced is evidenced by: -a higher variability of EPS with debt than all equity. -equivalence value between levered and unlevered firms in the presence of taxes. -increased use of homemade leverage. -higher EPS as EBIT increases. -None of these.

I, III, IV

The interest tax shield has no value for a firm when: I. the tax rate is equal to zero. II. the debt-equity ratio is exactly equal to 1. III. the firm is unlevered. IV. a firm elects 100% equity as its capital structure.

the net cost of debt to a firm is generally less than the cost of equity

The interest tax shield is a key reason why: -the net cost of debt to a firm is generally less than the cost of equity. -firms prefer equity financing over debt financing. -the required rate of return on assets rises when debt is added to the capital structure. -the cost of debt is equal to the cost of equity for a levered firm. -the value of an unlevered firm is equal to the value of a levered firm.

WACC is based on a target debt level, while APV is based on the amount of debt

The main difference between WACC & APV approach is:

FTE uses levered cash flows while the other two use unlevered

The main difference between the FTE approach and the other two approaches are that:

Rwacc

The overall expected return the firm must earn on its existing assets to maintain its value, reflecting the risks and capital structure of the firm's existing assets.

Odds

The pecking-order theory is at ______ with the tradeoff theory.

Negative

The possibility of bankruptcy has a ______ (positive/negative) effect on the value of the firm.

MM Proposition I with no tax

The proposition that the value of a levered firm is equal to the value of an unlevered firm is known as: -MM Proposition I with tax. -MM Proposition II with tax. -MM Proposition II with no tax. -static theory proposition. -MM Proposition I with no tax.

Cost of equity capital

The required expected return (also known as discount rate) on a stockholders' investment in the firm

Expected return

The required return on a stock, also viewed as the firm's cost of equity capital

Cost of debt

The required return on our company's debt, best estimated by computing the yield-to-maturity on the existing debt. (may also use estimates of current rates based on the bond rating we expect when we issue new debt)

Levered cash flow (LCF)

The residual to equityholders after interest has been deducted.

Dividend Growth Model Approach & CAPM (Capital Asset Pricing Model)

The two approaches to estimate cost of equity capital are:

Bankruptcy

The ultimate distress of financial distress, where ownership of the firm's assets is legally transferred from the stockholders to the bondholders.

the cost of capital for a firm with no debt in its capital structure

The unlevered cost of capital is: -the cost of capital for a firm with no debt in its capital structure. -the cost of preferred stock for a firm with equal parts debt and common stock in its capital structure. -the cost of capital for a firm with no equity in its capital structure. -equal to the profit margin for a firm with some debt in its capital structure. -the interest tax shield times pretax net income.

Adjusted Present Value (APV)

The value of a project to the firm can be thought of as the value of the project to an unlevered firm (NPV) plus the present value of the financing side effects (NPVF)

Weighted Average Cost of Capital

The weighted average cost of a firm's common equity, preferred stock, and debt

Weighted average cost of capital (WACC)

The weighted average cost of a firm's common equity, preferred stock, and debt. -This "average" is the required return on our assets, based on the market's perception of the risk of those assets. -Weights are determined by how much of each type of financing that we use

Pecking-order theory

Theory that states due to asymmetric information between managers and investors, investors tend to discount securities offered by firms. Thus, firms shall issue securities according to the degree of potential discount.

Trade-off theory (Modern capital structure theory 1)

Theory that states there is a trade-off between the tax advantage of debt and the costs of financial distress. The implication is that there is an optimal amount of debt for any individual firm. This amount of debt becomes the firm's target debt level.

How firms choose capital structure in practice

Things to consider: 1. Most corporations have low debt-asset ratios. 2. A number of firms use no debt 3. There are differences in the capital structures of different industries. 4. Most corporations employ target debt-equity ratios 5. Capital structures of individual firms can vary significantly over time. 6. Changes in financial leverage affect firm value -Stock price increases with leverage and vice-versa; which is consistent with M&M with taxes. -Firms signal good new when they level up

Weighted average cost of capital

To find the value of the project, discount the unlevered cash flows (UCF) at the weighted average cost of capital

Direct costs

Type of financial distress cost that includes legal and administrative costs of liquidation or reorganization, such as lawyer fees (since they are involved in all the stages before and during bankruptcy), administrative and accounting fees, expert witness fees (if a trial does take place), etc. -estimated as about 3% of the market value of the firm

Indirect costs

Type of financial distress cost that is the impaired ability to conduct business. Sales are frequently lost because of both fear of impaired service (the fear of bankruptcy) and loss of trust. Also an incentive toward selfish strategies such as taking large risks, underinvesting, and milking the property -estimated as about 10-20% of the market value of the firm

Asset beta

Unlevered beta, representing BUSINESS RISK. -It is the sensitivity of the value of the firm's assets to changes in the market

APV

Use ____ approach if the project's level of debt is known over the life of the project (level of debt is constant)

WACC & FTE

Use _____ or ____ approach if the firm's target debt-to-value ratio applies to the project over its life. (debt ratio is constant)

Rwacc

We use this as our discount rate, and we set up the usual discounted cash flow model by forecasting the firm's entire net cash flow (free cash flow) up to a horizon along with a terminal value of the firm.

Taxes, asset types, and uncertainty of operating income

What three factors are important to consider in determining a target debt to equity ratio? -Taxes, asset types, and uncertainty of operating income -Taxes, asset types, and pecking order and financial slack -Asset types, uncertainty of operating income, and pecking order and financial slack -Taxes, financial slack and pecking order, and uncertainty of operating income -None of these.

R0

When a firm has no debt, the discount rate is:

increase; decreasing

When a firm uses one discount rate for all projects, they may over time _______ (increase/decrease) the risk of the firm while ________ (increasing/decreasing) its value. Using one discount rate leads us to incorrectly accept negative NPV projects and incorrectly reject positive NPV projects.

Market value

When calculating Rs in the FTE approach, we need the target debt/equity ratio (B/S). If it is given, we can use that ratio in the formula. If it is not, we need to compute the debt/equity ratio based on the ______ value of the equity.

positive agency costs, as bondholders impose various restrictions and covenants which will diminish firm value

When shareholders pursue selfish strategies such as taking large risks or paying excessive dividends, these will result in: -lower agency costs, as shareholders have more control over the firm's assets. -no action by debtholders since these are equity holder concerns. -positive agency costs, as bondholders impose various restrictions and covenants which will diminish firm value. -investments of the same risk class that the firm is in. -undertaking scale enhancing projects.

0

When we assume that debt is risk-free, we assume that beta of debt is equal to:

There are no differences in the capital-structure of different industries

Which of the following is not empirically true when formulating capital structure policy? -Debt ratios in most countries are considerably less than 100%. -Some firms use no debt. -Debt levels across industries vary widely. -Most corporations have low debt-asset ratios. -There are no differences in the capital-structure of different industries.

Investors will generally view an increase in debt as a positive sign for the firm's value

Which of the following is true? -A firm with low anticipated profit will likely take on a high level of debt. -Rational firms raise debt levels when profits are expected to decline. -A successful firm will probably take on zero debt. -Investors will generally view an increase in debt as a positive sign for the firm's value. -Rational investors are likely to infer a higher firm value from a zero debt level.

Investors will generally view an increase in debt as a positive sign for the firm's value.

Which of the following is true? -A successful firm will probably take on zero debt. -Investors will generally view an increase in debt as a positive sign for the firm's value. -A firm with low anticipated profit will likely take on a high level of debt. -Rational firms raise debt levels when profits are expected to decline. -Rational investors are likely to infer a higher firm value from a zero debt level.

Stockholders (ultimately because rational bondholders know that when financial distress is imminent, they cannot expect help from stockholders. Stockholders are likely to choose investment strategies that reduce the value of the bonds. Bondholders then protect themselves accordingly by raising the interest rate that they require on the bonds. Stockholders must pay these high rates, leading them to ultimately bear the costs of selfish strategies)

Who pays for the cost of selfish investment strategies?

Leverage

____________ increases the likelihood of bankruptcy. However, bankruptcy does not, by itself, lower the cash flows to investors. Rather, it is the costs associated with bankruptcy that lower cash flows.