Finance Chapter 17: Capital Strucutre Determination

Two Firms that are alike in every respect EXCEPT ______ MUST have the same ______. Otherwise _______ is possible.

Capital Structure Market Value Arbitrage

O

Net operating income

Who bears the costs of Agency costs?

Shareholders

as financial leverage increases, ________ increase as do _________ and ________

Tax-shield benefits bankruptcy and agency costs

The total value principle(TVP): M&M advocates what

That the relationship between financial leverage and the cost of capital is explianed by the NOI approach

The yield on the company's debt results in what?

The valuation of a perpetual bond

Ki

The yield on the company's debt

V

Total market value of the firm

what is flexibility often referred to as?

Unused debt capacity

Value of levered firm formula

Value of firm if unlevered + Present value of Tax-shield benefits of debt - present value of bankruptcy and agency costs

Uncertainty of Tax-Shield benefits

increases the possibility of bankruptcy and liquidation, which reduces the value of the tax shield

Monitoring costs tend to rise at a(n) ________ rate with financial leverage

increasing

Net Operating Income Equals

interest paid plus earnings available to common shareholders

Present value of Tax shield benefits of debt formula

(r*B*Tax%)/r

Assume what with Capital Structure?

1. investment and asset management decisions are held constant and 2. consider only Debt-versus-equity financing

Tax Shield

A tax-deductible expense. The expense protects (shields) an equivalent dollar amount of revenue from being taxed by reducing taxable income

Traditional Approach

A theory of capital Structure in which there exists an optimal capital structure and where management can increase the total value of the firm through the judicious use of financial leverage

I

Annual interest on Debt

Monitoring associated with Agency Costs incudes

Bonding of agents, auditing financial statements and explicitly restricting management decisions or actions

Agency Costs

Costs associated with monitoring management to ensure that it behaves in ways consistent with the firm's contractual agreements with creditors and shareholders

Value of firm if unlevered formula

EAT/required rate of return%

when finding the yield on the company's debt when do you assume interest is paid?

Each and every Year

E

Earnings available to common shareholders

All Capital Structures are equally as acceptable for Arbitrage because

Equity share price in A rises based on increased share demand Equity share price in B falls based on selling pressures from arbitrage to A Arbitrage continues until total firm values are identical for both A and B

The judicious use of _________ provides a favorable impact on a company's total valuation

Financial leverage (i.e. debt)

With Corporate Tax Effects the greater the amount of debt the

Greater the tax-shield benefits and greater the value of the firm

When finding the yield on the company's debt what do you assume is the life on a Bond?

Infinite

As B/S Increases what happens to Ko, Ke, and Ki?

Ki and Ko stay the same while Ke increases

what is the critical assumption with the Net Operating Income Approach?

Ko remains constant

With the NOI approach, as long as Ki is constant, Ke is a...

Linear function of the Debt-to-Equity ratio

With Corporate Tax Effects the greater the financial leverage the

Lower the cost of capital of the firm

B

Market Value of Debt

S

Market Value of common stock oustanding

With the traditional approach, initially low-cost debt is______ and replaces more expensive equity financing. Then _________ and the associated __________ in ____ and ____ more than offsets the benefits of the lower cost debt financing

Not Rising Increasing financial leverage increase in Ke and Ki

TVP:M&M states that total risk for all security holders of the firm is _______ by the capital structure

Not altered

The cost of capital is dependent on what with the Traditional Approach?

The capital Structure of the firm

Capitalization Rate (Ko)

The discount rate used to determine the present value of a stream of expected cash flows

Ke

The expected return on the company's equity (Financial Leverage)

Capital Structure

The mix (or proportion) of a firm's permanent long-term financing represented by debt, preferred stock, and common stock equity

Optimal Capital Structure in the traditional approach location

Where Ko is at its lowest point on the graph

When finding out the yild on the company's debt, how do you treat taxes?

You do not use them

The adjusted M&M proposition on optimal strategy Implies

a capital structure of almost 100% debt which is not consistent with actual behavior

TVP: M&M provides behavior justifications for.....

a constant Ko over the entire range of financial leverage possibilities

Flexibility

a decision today impacts the options open to the firm for the future financing options - thereby reducing flexibility

Net Operating income approach

a theory of capital structure in which the weighted average cost of capital and the total value of the firm remain constant as financial leverage is changed

Timing

after appropriate capital structure determined it is still difficult to decide when to issue debt or equity and in what order

Ko

an overall capitalization rate for the firm

informational asymmetry

based on the idea that insiders (managers) know something about the firm that outsiders do not

Arbitrage

finding two assets that are essentially the same and buying the cheaper and selling the more expnsive

With TVP:M&M the total value of the firm ______ altered by the capital structure

is not

What do you assume about the dividend payout when finding the expected rate on the company's equity?

its 100%

Corporate plus personal taxes

reduce the corporate tax advantage associated with debt this is only a small portion of the explanation why corporate debt usage is not near 100%

The adjusted M&M proposition suggests an optimal strategy is to

take on the maximum amount of financial leveage

M&M assumes what of taxes and market imperfections?

the absence of them

Optimal Capital Structure

the capital structure that minimizes the firm's cost of capital and thereby maximizes the value of the firm

Factors considered in timing

the current and expected health of the firm and market conditions

What to be concerned with regarding Capital Structure?

the effect of capital market decisions on security prices

changing the capital structure to include more debt conveys that....

the firm's stock price is undervalued This is a valid signal because of the possibility of bankruptcy

A manager may use capital structure changes to convey information about

the profitability and risk of the firm

With the Net Operating Income Approach and increase in cheaper debt funds is exactly offset by an increase in...

the required rate of return on equity

At what point is the firm's total value the largest with the traditional approach?

the same point at which optimal capital structure is achieved

the expected rate on the company's equity results in what?

the valuation of a perpetuity

According to NOI what is the optimal capital structure?

there is not one

What do you assume about earnings when finding the expected rate on the company's equity?

they are not expected to grow