Lecture 5,6,7

is not optimal: Financial distress and agency costs exceed the benefits of debt. Firms decrease their debt levels.

Above target debt ratio the value of the firm:

solvent possess adequate liquidity.

Solvency and liquidity are equally important, and healthy companies are both _________ and ________

an enterprise's capacity to meet its long-term financial commitments.

Solvency refers to:

Principal

Subject dealing with the agent

ability to generate sales from its assets

The Asset turnover ratio measures a company's _______ by comparing net sales with average total assets.

a company can use its assets to generate sales.

The Asset turnover ratio shows how efficiently...

profit and ownership sharing: The downside is large. In order to gain the funding, you will have to give the investor a percentage of your company. You will have to share your profits and consult with your new partners any time you make decisions affecting the company. The only way to remove investors is to buy them out, but that will likely be more expensive than the money they originally gave you.

The Cost of equity is ______

the ratio of a firm's returns to assets (R)

The Interest coverage ratio expresses ________ to the amount of interest charges (Id) for a period.

amount of interest charges (Id) for a period.

The Interest coverage ratio expresses the ratio of a firm's returns to assets (R) to the _________

retained earnings >debt >external equity

The Pecking-Order Theory reflects a primary preference of:

Different self interest

The Principal - Agent Problem has ______

the weights

The Weighted Average Cost of Capital uses D/A and E/A as ____

Trade off Theory:

The ______ Gives the optimal D/E ratio

Weighted Average Cost of Capital

The ______ approach assumes that the costs of debt and equity are known values that serve as the basis for establishing leverage policies.

interest costs of debt

The ________ must be converted to an after-tax basis, since an interest obligation is a tax-deductible business expense.

id(1 - t)

The after-tax cost of debt capital =

liquidity is provided at a particular point in time.

The balance sheet is an important source of information about the various ways in which ______

a specific point

The balance sheet measures apply to _________ in time

solvency ratios

The balance sheet measures are typically called

financial leverage (D/E) or capital structure

The combination of debt and equity reflects the firm's ________ or _______

interest expenses, high risk of financial distress

The cost of debt is:

less than the of the equity holder's higher financial risk.

The cost of debt should be ______ cost of equity because _______

increase leverage increases.

The costs of both debt and equity eventually _____ as ______

current liabilities are small the absolute levels of current assets and liabilities are small

The current ratio may be misleading in cases when 1. ______ 2. __________ relative to the overall size of the operation

their liquidity current and non-current

The firm's assets and liabilities are classified according to ______ and into two major categories ________

the higher the firm's liquidity.

The higher the current ratio....

the turnover of assets into income the greater the opportunity for profits

The higher the ratio of the Asset turnover ratio, the more rapid the __________ and _______

after-tax basis

The interest costs of debt must be converted to an _______, since an interest obligation is a tax-deductible business expense.

an interest obligation is a tax-deductible business expense.

The interest costs of debt must be converted to an after-tax basis because

minimum average cost of capital— a debt-to-equity ratio of about 1.0

The optimal combination of debt and equity occurs at the:

increases the other increases decreases the other decreases

The perfect correlation coefficient = 1 meaning if one asset ________ and if one asset _______

1

The perfect correlation coefficient = _____

how many sales are generated from each dollar of company assets.

The total asset turnover ratio calculates net sales as a percentage of assets to show....

• Working Capital • Current Ratio • Working Capital to VFP

Three Measures from the Balance Sheet:

Debt

Too much ______ can be dangerous for a company and its investors.

adjust their current level of debt ratio to achieve a target level

Trade-off theory argues that firms in a stable (static) position will:

transaction costs and asymmetric information

Two major factors motivate the pecking-order theory:

credit downgrades or worse.

Uncontrolled debt levels can lead to _______

Adjustments for personal assets and liabilities

What should be made in the estimation of working capital?

absolute measure of liquidity balance sheet data

Working Capital is a ______ based on _______

each firm represents a unique set and volume of resources.

Working capital by itself is not very useful for comparing the liquidity of one firm to another or to some established standard because _____

a positive value

Working capital should be _______ to signal a liquid situation.

more assets

You can always get a better risk reduction with....

Equity

_____ is not a fixed payment, depends on your profit, profit sharing

The leverage ratio

_____ measures the firm's total obligations to creditors (lenders and lessors) as a percent of the equity capital provided by the owners.

Coverage ratios

_______ serve as a counterpart of the solvency ratios that hold for a specific point in time.

Asymmetric information

favors the issue of debt over equity as the issue of debt signals the boards confidence that an investment is profitable

Pecking-Order Theory

in the ______ the capital structure of a business reflects a preferred hierarchy to various sources of financial capital

coverage ratios of various kinds.

income statement measures are called

an interval

income statement measures reflect _______ of time

to generate sufficient cash to meet its financial commitments as they become due.

liquidity refers to the firm's capacity _______

Liquidity

the term _________ also refers to its capability to sell assets quickly to raise cash.

Agent

• Has more information than the principal • Dr. - patient relationship • Car Dealer

has no preferred capital structure or target level of leverage.

A major implication of the pecking-order theory is that a firm:

A combination of different assets or investments

A portfolio is...

a positive net worth manageable debt load.

A solvent company is one that has ______ and a ______

1.0

A standard rule of thumb for the maximum leverage ratio (D/E) is

relatively greater debt loads be higher

It is commonly accepted, for example, that larger farms and farms with higher tenancy positions (i.e., more leased land) can carry _____. Thus, their leverage ratios tend to _______

an enterprise's ability to pay short-term obligations

Liquidity refers to:

at least as much investment in their own businesses as their lenders do.

Many farm lenders prefer that borrowers have:

both the balance sheet and the income statement

Information about solvency may come from...

Assets - Liabilities Profit = Revenue - Costs

Equity =

greater financial risk associated with higher financial leverage

Equity costs increase because of....

pecking order theory

Farm businesses follow _______ in the short run

cannot meet, or has difficulty paying off, its financial obligations to its creditors

Financial distress is a condition where a company:

high fixed costs, illiquid assets or revenues sensitive to economic downturns.

Financial distress is typically due to:

intermediate level of costs

For Transaction Costs Debt has an:

incur the highest costs.

For Transaction Costs New issues of common stock:

the lowest transaction costs

For Transaction Costs, consistent with the ordering idea, retained earnings have:

Decreases

If Equity Decreases Stock Price _______

sends bad signal to the market

If Equity Increases it ______

• Debt decrease • D/E decreases

If Marginal Benefit of debt < Marginal cost of debt:

• Debt increases • D/E increases

If the Marginal Benefit of debt > Marginal cost of debt:

amount of interest charges for a period.

In the Interest coverage ratio Id stands for

the ratio of a firm's returns to assets

In the Interest coverage ratio R stands for

the weighted average cost of debt and equity

In the Weighted Average Cost of Capital ia is:

the after-tax cost of debt capital

In the Weighted Average Cost of Capital id(1 - t) is:

the cost of equity capital

In the Weighted Average Cost of Capital ie is:

the firm's cost of debt

In the after-tax cost of debt capital calculation id stands for:

insolvent

A farm business is _______ if the sale of all assets fails to generate sufficient cash to pay off all liabilities.

its income tax rate

In the after-tax cost of debt capital calculation t stands for:

low or inadequate liquidity

A current ratio less than 1.0 signals...

solvent company

A ______ company is one that owns more than it owes

to generate the cash to meet all expenses

A critical issue relating to leverage is the firm's ability ____________ and service the debt with an acceptable margin of safety.

service the debt with an acceptable margin of safety.

A critical issue relating to leverage is the firm's ability to generate the cash to meet all expenses and ________

less than 1.0

A current ratio ______ signals low or inadequate liquidity

can still increase the value of the firm because marginal value of the benefits of debt are still greater than the costs associated with the use of debt firms increase their debt.

Below the target debt ratio:

tax-deductible no profit or ownership sharing

Benefits of debt:

risk sharing: The big advantage of equity financing is that the investor takes all of the risk. If your company fails, you do not have to pay the money back. You will also have more cash available because there are no loan payments. Finally, investors take a long-term view and understand that growing a business takes time.

Benefits of equity:

drop in share price

Concerning Asymmetric Information, The issue of equity would signal a lack of confidence in the board. An issue of equity would therefore lead to a:

the least preferred method

Concerning Asymmetric Information, because the issue of equity will lead to a drop in share price, equity financing is

the income statement

Coverage ratios are taken from...

a firm's financial charges to its ability to pay them.

Coverage ratios essentially relate ________

relative claims of debt and equity holders

Coverage ratios taken from the income statement account for the _______ on the returns to farm assets during a period of time.

returns to farm assets during a period of time.

Coverage ratios taken from the income statement account for the relative claims of debt and equity holders on the ______

Fixed payment - Interest

Debt =

greater likelihood of repayment problems, reduced liquidity, and other credit risks associated with higher leverage.

Debt costs increase because of the...

holding a set of different combinations of investments/assets

Diversification is...

1. Reduce risk with the given expected return 2. Increase expected return with the same risk

Reasons for diversification:

Standard Deviation

Risk is always the