Chapter 16 - Financial Leverage and Capital Structure Policy

Which of the following industries tend to have a high leverage?

-Airlines -Cable television

Volatility or ______ increases for equity holders when leverage increases.

Risk

In the absence of taxes, the value of a firm is the same with debt financing as it is with equity financing because _______

1) MM demonstrated that debt financing is neither better nor worse than equity financing in the absence of taxes 2) the asset to be financed is the same

What two factors does the static model point out?

1) Taxes - the tax benefit from leverage is important to firms that are in a tax paying position. Firms with accumulated losses will get little value from the interest tax shield. Firms that have substantial tax shields will get less benefit from leverage. ALL firms face the same 21% federal tax rate --> The higher the effective tax rate, the greater the incentive to borrow 2) Financial distress - greater risk = borrow less

According to the Tax Cuts and Jobs Act of 2017, after 2021, the net interest deduction drops to what percent of EBIT?

30

In 2019, the net interest deduction is limited to what percent of EBITDA?

30%

An investor who invests in the stock of a levered firm rather than in an all-equity firm will require ___.

A higher expected return

What are bankruptcy costs?

As the debt equity ratio rises, so too does the probability that the firm will be unable to pay its bondholders what was promised to them

During bankruptcy, the ownership of the firm's assets is transferred from stockholders to ___.

Bondholders

The equity risk that comes from the nature of a firm's operating activities is known as _____ risk.

Business

When calculating the cash flow for a levered firm, you must consider _____.

Cash flows to both bondholders and stockholders

The two broad types of costs of financial distress are ___ costs.

Direct and indirect

The equity risk that comes from the financial policy or capital structure decisions of the firm is known as _____ risk.

Financial

The weighted average cost of capital rises at higher levels of debt owing to _____.

Financial distress costs

______ is the term that describes the capital structure when debt is used to finance assets.

Financial leverage

The value of the firm is given by the following expression _____.

Firm value = value of equity + value of debt

Which of the following assumptions is necessary for MM Proposition I to hold?

Individuals can borrow on their own at an interest rate equal to that of the firm.

What is the static theory of capital structure?

It says that firms borrow 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. We call this the static theory because it assumes that the firm is fixed in terms of its assets and operations and it considers only possible changes in the debt equity ratio The static model is NOT capable of identifying a precise optimal capital structure.

The risk of too much _______ is bankruptcy.

Leverage

Under MM Proposition II, a firm's cost of equity capital is ______ related to the firm's debt-equity ratio provided the cost of capital for an all-equity firm exceeds the cost of debt.

Positively

How does the level of debt affect the weighted average cost of capital (WACC)?

The WACC initially falls and then rises as debt increases.

What is financial risk?

The extra risk that arises from the use of debt financing

What is the famous M&M Proposition II?

This tells us that the cost of equity depends on (3) things 1) The required rate of return on the firm's assets --> R^A 2) The firm's cost of debt --> R^D 3)The firm's debt equity ratio --> D/E Cost of equity capital = R^E As the firm raises its debt equity ratio, the increase in leverage raises the risk of the equity and therefore the required return or cost of equity

What are indirect bankruptcy costs?

When a firm is having significant problems in meeting its debt obligations = financial distress. The cost of avoiding a bankruptcy filing incurred by a financially distressed firm is called INDIRECT BANKRUPTCY COSTS. We use the term FINANCIAL DISTRESS COSTS to refer generically to the direct and indirect costs associated with going bankrupt or avoiding a filing.

What are direct bankruptcy costs?

When the value of a firm's assets equals the value of its debt, then the firm is economically bankrupt in the sense that the equity has no value. The formal turnover over of the assets to the bondholders is a legal process

The manager of a firm should change the capital structure if and only if ________

it increase the value of the firm

A beneficial rule to follow is to set the firm's capital structure so that ___.

the firm's value is maximized

The firm's capital structure refers to:

the mix of debt and equity used to finance the firm's assets.

(T/F) It is easy to measure indirect costs of financial distress.

False --> While the existence of indirect costs is recognized, these costs are not easy to measure.

A company should select the capital structure that _____.

Maximizes the company's value

What is a business risk?

The risk inherent in a firm's operations *depends on the systematic risk*

M&M Proposition I does not work with corporate taxes because ___.

Levered firms pay lower taxes than unlevered firms

What are the effects of financial leverage?

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

What is financial leverage?

The extent to which a firm relies on debt. The more debt financing a firm uses in its capital structure, the more financial leverage it employs

M&M Proposition II shows that the firm's cost of equity can be broken down into (2) components

The first component R^A, is the required return on the firm's assets overall and it depends on the nature of the firm's operating activities. The second component in the cost of equity (R^A - R^D) X (D/E) is determined by the firm's financial structure. For an all-equity firm, this component is zero. As the firm begins to rely on debt financing, the required return on equity rises. This occurs because the debt financing increases the risks borne by the stockholders.

What are the two components of the static theory?

The tax benefits of debt and the costs of financial distress

Why do we study the WACC?

The value of the firm is maximized when the WACC is minimized. The WACC is the appropriate discount rate for the firm's overall cash flows. Because values and discount rates move in opposite directions

The value of a levered firm will be greater than the value of an identical unlevered firm because the levered firm's taxes will be ______.

Lower

The value of the firm is maximized when the weighted average cost of capital (WACC) is (minimized/maximized).

Minimized

The value of the firm is maximized when the weighted average cost of capital (WACC) is _____.

Minimized

The value of a levered firm in MM Proposition I with corporate taxes equals the value of an all-equity firm ___.

Plus the tax rate times the value of debt

The expected return on equity is _____ to leverage.

Positively related

What is the Debt equity ratio?

R^E = R^A + (R^A - R^D) X (D/E) by M&M Proposition II R^A = WACC = (E/V) X R^E + (D/V) X R ^D where V = D+E

Which of the following will apply when a firm's 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.