Chapters 16 & 17: Capital Structure

Higher debt ratios would be more likely to be found in industries where earnings are pretty (a) steady or (b) volatile?

(a) steady. Steady earnings imply lower business risk.

Factors that affect EBIT affect the business risk of the firm. Examples include:

-Variability in sales volume. -Variability in selling price. -Variability in costs. -operating leverage (Note: Fixed costs do not decline when demand declines.)

If a firm's tax rate is 10% and the interest rate on debt is 12%, what is the after tax cost of debt? What if the tax rate is 40%?

.12 (1 - .10) = 10.8% AT cost of debt = 7.2%

Four factors influencing capital structure decisions:

1. Business Risk. 2. Firm's tax rate. 3. Financial flexibility. 4. Managerial conservatism or aggressiveness

how can covenants affect the cost of debt?

Bond holders may require a lower interest rate which reduces the cost of debt for the firm

Risk inherent in a firm's operations. Uncertainty about operating income (EBIT)

Business risk

Expected sales=250,000 Variable Operating costs= 60% of sales Fixed Operating costs=(75,000) If Sales are 5% lower than expected, What is the degree of operating leverage

Expected: Sales=250,000 VC= (150,000) Gross Profit= 100,000 FC= (75,000) Net operating income=EBIT=25,000 Sales -5%: Sales=237,500 VC= (142,500) Gross Profit= 95,000 FC= (75,000) Net operating income=EBIT=20,000 % Δ: Sales=-5% VC= -5% GP= -5% FC= 0 EBIT= -20% DOL= %Δ EBIT/%Δ Sales =-.2/-.05 = 4x

How does financial leverage affect firm performance, as measured by common accounting variables such as net income, EPS, or ROE

Increasing leverage (D/E) has increased the riskiness of EPS and ROE. Performance is amplified: -In a bad year, performance will be even worse. -In a good year performance will be even better

Understand what we mean by financial distress costs.

Indirect Costs: - Agency costs of debt. - Lost Sales. - Inability to enter into long-term contracts. Direct Costs (e.g., legal costs of bankruptcy)

Know the degree of operating leverage concept.

Operating leverage refers to the amount of fixed costs. Higher fixed cost = higher operating leverage

Managers prefer internal over external financing. If external financing is needed, choose safest securities first.

Pecking Order Theory

As the firm uses more debt financing, how does this affect stockholders?

Stockholders will have more financial risk

How does intangible vs tangibles assets affect the capital structure.

The more the value of the firm is dependent upon intangible assets, the less likely it is to use debt in its capital structure.

What is the optimal capital structure for a firm?

The optimal capital structure for a company is one that offers a balance between the ideal debt-to-equity range and minimizes the firm's cost of capital.

What are the agency costs of debt? What are some examples?

There is a conflict of interests between stockholders and bondholders. -The role of limited liability... - Limited liability creates an incentive for firms to take on riskier projects (share holders lots to gain, little to lose) - Bondholders do not benefit from the upside potential of risk and may even be hurt if the risky project fails.

Rules and/or limitations on the actions a company can take. Used to protect bondholders

bond covenants