MGF: Ch. 13 (Leverage and Capital Structure)

What will apply when a firm's debt levels are extremely high?

- Possibility of financial distress will become a chronic problem - benefits of debt financing may be more than offset by the costs of financial distress

The following are generally true about the cost of equity and the cost of debt:

- cost of debt is generally lower than equity - cost of equity may increase with leverage - cost of debt increase with leverage

The tax shield afforded by debt will be of the least use to firms with:

- losses carried forward - negative EBT

Bankruptcy is valuable because:

- payments to creditors cease pending the outcome of the process - can be a strategical to improve a firm's competitive position

MM Proposition I states if the assets and operations for two firms are the same, then

- the value of the two firms is equal - how the firms are financed is irrelevant

Order of priority of payment

1. bankruptcy admin expense 2. wages, salaries, and commissions 3. consumer claims 4. payment to common shareholders

Based on MM Proposition I, the optimal capital structure is

100% debt

Alpha Co. has a debt-equity ratio of .6, a pretax cost of debt of 7.5%, and an unlettered cost of equity of 12%. What if the cost of equity?

12%+.6(12%-7.5%)=14.7%

Financial Risk

Addition or extra risk

according to MM Proposition I, a firm's capital structure choices:

Do nor affect the value of the firm

True or false: There is a precise mathematical equation for determining the optimal level of debt for any firm

False: its determined in a subjective manner

The WACC 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

Static Theory of Capital Structure

Suggests employing debt to the point that its cost equals the cost of the increased probability of bankruptcy(financial distress)

Business Risk

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

True or False: Its possible for the PV of distress costs to exceed the PV of tax savings

True

The costs of financial distress depend mostly on how easily the ownership of the firm's ___ can be transferred

assets

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

MM Proposition II shows that

the cost of equity rises with leverage