Finance Final Exam: Cost of Capital(14)/ Financial Leverage and Capital Structure Policy(16)

Static Theory of Capital Structure (CASES)

1. No taxes, no bankruptcy - value of firm is not affected by debt policy = constant rate 2. Taxes are introduced - firms value critically depends on debt policy -^leverage, ^cost of equity (off set by tax break), = overall cost of capital declines 3. Bankruptcy costs

EBIT Conclusions

1. the effect of financial leverage depends on the company's EBIT. when EBIT is high, leverage is beneficial 2. under the expected scenario, leverage increases the returns to shareholders, as measured by both ROE and EPS 3. shareholders are exposed to more risk under the proposed capital structure because the EPS and ROE are much more sensitive to changes EBIT in this case 4. because of the impact that financial leverage has on both the expected return to stockholders and the riskiness of the stock, capital structure is an important decision

"cram-down" bankruptcy

a class of creditors can be forced to accept a bankruptcy plan even if they vote not to approve it

M&M Proposition 2

a firms cost of equity capital is a positive linear function of the firms capital structure cost of equity depends on: 1. required rate of return of a firms assets 2. cost of debt 3. debt-to-equity ratio

bankruptcy

a legal proceeding for liquidating or reorganizing a business

business failure

a situation in which a business has terminated with a loss to creditors (even an all equity firm can fail)

pecking-order theory

alternative to the static theory - uses short run/ tactical issue of raising funds to financial investments firms prefer to use internal financing whenever possible issue debt is necessary last resort: sell equity! this tells investors the price is too high implications: 1. no target capital structure 2. profitable firms use less debt 3.companies will want financial slack

cost of capital

depends primarily on the use of the funds, NOT the source will reflect both both its costs of debt capital and its cost of equity capital

direct bankruptcy costs

directly associated with bankruptcy (legal and administrative expenses) a fraction of the firm's assets "disappear" and bondholders won't get all they are owed

required return, appropriate discount rate, cost of capital

essentially the same thing

absolute priority rule (APR)

establishes priority of claims in liquidation

reorganization

financial restructuring of a falling firm in attempt to continue operations as a going concern - issuing new securities to replace the old ones

legal bankruptcy

firm/creditor brings petitions to a federal court

accounting insolvency

firms with negative network are insolvent on the books = when the total book liabilities exceed the book value of total assets

cost of preferred stock

fixed dividend / price per share of preferred stock

flotation costs

if a company accepts a new project, it may be required to issue, or float, new bonds and stocks must take into account target weights external equity has a high flotation cost

capital structure goal

maximize value of the whole firm

dividend growth model approach

must estimate the growth rate - historical rates or analysts' forecasts + simple. - applicable only to companies who pay dividends -the estimated cost of equity is very sensitive to the estimated growth rate -does NOT explicitly consider risk

technical insolvency

occurs when a firm is unable to meet its financial obligations

liquidation

termination of the firm as a growing concern - selling off assets

unlettered cost of capital

the cost of capital for a firm that has no debt

indirect bankruptcy costs

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

financial distress costs

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

financial risk

the equity risk that comes from the financial policy (capital structure) of the firm

business risk

the equity risk that comes from the nature of the firm's operating activities

Security Market Line Approach

the required/expected return on a risky investment depends on: 1. RFR 2. market risk premium 3.the systematic risk of the asset relative to average (beta coefficient) +explicitly adjusts for risk +applicable to companies other than just those with steady dividend growth - if MRP and Beta estimates are poor the resulting cost of equity will be inaccurate - we essentially rely on the past to predict the future

cost of equity

the return that equity investors require on their investment in the firm

cost of debt

the return that lenders require on the firm's debt

interest tax shield

the tax saving attained by a firm from interest expense

static theory of capital structure

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

pure play approach

the use of a WACC that is unique to a particular project, based on companies in similar lines of business

homemade leverage

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

M&M Intuition and Theory

the value of the firm depends on the total cash flow of the firm

M&M Proposition 1

the value of the firm is independent of the firms capital structure it is completely irrelevant how a firm choses to arrange its finances

weighted average cost of capital (WACC)

the weighted average of the cost of equity and the aftertax cost of debt the overall return the firm must earn on existing assets to maintain the value of its stock force employees and management to pay attention to the real bottom line: increasing share prices

bankruptcy

value of asset = value of debt value of equity = 0 stockholders turn over control to bondholders