FIN 357 final ch. 16 Financial Leverage & Capital Structure
16. if the current share price of an all-equity firm is $25, going to a capital structure with 50% debt and 50% equity will result in a new share price of ______ when igorning the impact of taxes
$25
16. High levered industries
-Cable -Airlines
16. Which of the following statements are true regarding the effect of financial leverage and the firms operating earnings (EBI)
-Financial leverage increases the slope of the EPS line -Below the indifference or break-even point in EBIT, an unlevered capital structure is best -The rate of return on assests is unaffected by leverage
16. What are the advantages of using internal financing?
-It prevents the adverse market reaction that tends to accompany a stock issue -it may be cheaper than debt or equity issues
16. Nonmarketed claims to the firms cash flows?
-Legal fees -Taxes
16. In the absence of taxes, the value of a firm is the same with debt financing as it is with equity financing because ____ - -
-MM demonstrated that debt financing is neither better nor worse than equity financing in the absence of taxes -the asset to be financed is the same
16. General truths about the cost of equity and the cost of debt - - -
-The cost of debt increases with leverage -The cost of debt is generally lower than the cost of equity -The cost of equity may increase with leverage
16. MM prop II
-The expected return on equity is positively related to leverage -Firms EQUITY return increases with increased leverage -Increased leverage also means
16. Some consequences of nonpayment of debt obligations - -
-The firm will encounter some form of financial distress -A firm may be forced to file for bankruptcy
16. MM Prop 1
-The value of a levered firm (Vl) is the same as the value of an unlevered firm (Vu) -An optimal capital structure does not exist -Perfect market assumptions, firms total cash flows and the risks are unchanged
16. -Current stock price is $20 -Managers estimate of value is $10 manager perceives the firms equity is ______ will issue _____
-overpriced -equity
16. -Current stock price is $20 -Managers estimate of value is $30 manager should issue______ because the firms equity is _______
-retained earnings/debt -underpriced
16. steps to calculate the value of a levered firm with perpetual cash flows in order starting with the first step.
1. Calculate EBIT 2. Multiply EBIT by 1 minus the corporate tax rate. 3. Divide by the cost of equity for an all-equity firm 4. Add the present value of the debt tax shield.
16. preferred source of financing for firms according to the pecking-order theory?
1. Retained earnings 2. Debt 3. Common stock
16. Order of priority of payment
1.Administrative expenses associated with the bankruptcy. 2.Other expenses arising after the filing of an involuntary bankruptcy petition but before the appointment of a trustee. 3.Wages, salaries, and commissions. 4.Contributions to employee benefit plans. 5.Consumer claims. 6.Government tax claims. 7.Payment to unsecured creditors. 8.Payment to preferred stockholders. 9.Payment to common stockholders.
16. Broad types of costs of financial distress? - -
Direct costs Indirect costs
16. Assumption necessary for MM Proposition 1 to hold
Individuals can borrow on their own at an interest rate equal to that of the firm
16. The ________ theory is the dominant theory of capital structure
TRADE-OFF!
16. How does the level of debt affect the weighted average cost of capital
The WACC initially FALLS and then rises as debt increases
16. What is the upper limit on payments to bondholders by the corporation regardless of the level of profits?
The obligation due in terms of INTEREST AND PRINCIPAL
16. When calculating the cash flow for a levered firm, you must consider?
cash flows to both bondholders and stockholders
16. The value of the firm is given by the following expression:
firm value = value of equity + value of debt
16. The value of the firm is maximized when the weighted average cost of capital (WACC) is _______
minimized
16. An individual can duplicate a levered firm through a strategy called _____ where the investory uses his own funds plus borrowed funds to buy stocks
Homemade Leverage
16. MM prop II, a firms cost of equity capital is _______ related to the firms debt-equity ratio
POSITIVELY
16. Omega has $20 million in perpetual debt outstanding with a coupon rate of 8%. The tax rate is 21%. What is the PV of the tax shield?
PV= Tc*D =.21*20,000,000 = $4,200,000
16. Alpha has a debt-equity ratio of .6, a pretax cost of debt of 7.5%, and an unlevered cost of equity of 12%. What is alphas cost of equity if you ignore taxes?
RE = RA + (RA − RD) × (D/E) = .12 + (.12-.075) * .6 = 14.7%
16. Stockholders and bondholders are not ____
The only claimants to the cash flows of the firm
16. Where do the ownership of assets go when a bankruptcy ruling is issued?
Transferred from the shareholders to the bondholders.
16. Solid Rock is an unlevered firm with an EBIT of $10 million and an unlevered cost of capital of 12%. if the tax rate is 21% What is the value of the firm?
Vu = EBIT*(1-Tc)/Ru = 10,000,000*.79/.12 =$65.83 million
16. An investor who invests in the stock of a levered firm rather than in an all-equity firm will require ______
a higher expected return
16. The expected return on equity is _______ to leverage
positively related
16. MM Proposition II shows that ____
the cost of equity rises with leverage
16. Bankruptcy is very valuable because: - -
-Payments to creditors cease pending the outcome of the bankruptcy process -It can be used strategically to improve a firm's competitive position
16. tax saving from an additional dollar in debt financing is exactly balanced by the increased costs of bankruptcy associated with additional borrowing is the essence of the _______
-Static theory of capital structure
16. These apply when a firms debt levels are extremely high. - - -
-The benefits of debt financing may be more than offset by the costs of financial distress -The possibility of financial distress will become a chronic problem
