Chapter 16 - Financial Leverage and Capital Structure Policy
What would increase the debt-equity ratio? What would decrease it?
-Issuing bonds and using the proceeds to buy back some stock. -Issuing stock and using the money to pay off debt
What are the implications of the Pecking Order?
1. No target capital structure. 2. Profitable firms use less debt. 3. Companies will want financial slack.
What does financial leverage refer to?
The extent to which a firm relies on debt.
How do we determine the Optimal Capital Structure?
-Maximize the price of the firm's stock. -Financial leverage increases financial risk, thus increasing the overall risk AND the firm's WACC. -To maximize the firm's value, you need to minimize its WACC=r
What is the difference between liquidation and reorganization?
1. Termination of the firm as a going concern; involves selling off the assets of the firm. 2. The option of keeping the firm a going concern; involves issuing new securities to replace old securities.
If we consider only the effect of taxes, what is the optimal capital structure?
100% debt.
What is an optimal capital structure?
A particular debt-equity ration IF it results in the lowest possible WACC.
What's the relationship between the WACC and the value of the firm?
As WACC decreases, the firm's value increases, and vice versa.
The ______ of a firm is not directly affected by a capital restructuring.
Assets.
Define Capital Structure Decisions:
Decisions about a firm's debt-equity ratio.
Why might some firms prefer not to issue new equity?
If your stock is undervalued, you can lose money.
What is the APR?
The rule establishing priority of claims in liquidation.
What is the Interest Tax Shield?
The tax savings attained by a firm from interest expense.
What is the relationship between the value of an unlevered firm and the value of a levered firm once we consider the effect of corporate taxes?
The value of a levered firm is equal to the value of an unlevered firm plus the interest tax shield.
What is the M&M Proposition I?
This proposition states that it is completely irrelevant how a firm chooses to arranges its finances. -The firm's overall cost of capital is unaffected by its capital structure.
What's the Break-Even EBIT? How do you compute it?
When the EBIT is at the break-even point, leverage is beneficial. -Calculated by finding the point where alternative financing plans are equal
Why should financial managers choose the capital structure that maximizes the value of the firm?
It is a goal of financial managers to choose a capital structure that minimizes WACC, which will, in turn, maximize the value of the firm.
What regularities do we observe in capital structures?
-U.S. firms do not heavily rely on debt. -The use of debt financing is varied widely across different industries.
What are some differences in implications of the static and pecking-order theories?
1. No target capital structure: under the pecking-order theory, there's no target or optimal debt-equity ratio. 2. Profitable firms use less debt: because profitable firms have greater internal cash flow, they will need less external financing and will therefore have less debt. 3. Companies will want financial slack: To avoid selling new equity, companies will want to stockpile internally generated cash.
Under the Pecking-Order Theory, what's the order in which firms will obtain financing?
1st: Internal financing 2nd: Issue debt 3rd: issue new equity
What are Capital Restructurings?
Activities which alter the firm's existing capital structure. In general, these take place whenever the firm substitutes one capital structure for another while leaving the firm's assets unchanged.
What are the important factors in making capital structure decisions?
Taxes and financial distress.
What is the Business Risk?
The equity risk that comes from the nature of the firm's operating activities.
What is the Financial Risk?
The extra equity risk that arises from the use of debt financing.
What does the extended pie model say about the value of all the claims to a firm's cash flows?
The optimal capital structure is thus the one that maximizes the value of the marketed claims or, equivalently, minimizes the value of nonmarketed claims such as taxes and bankruptcy costs.
The gain in firm value is equal to what?
The present value of the interest tax shield.
What is homemade leverage?
The use of personal borrowing to alter the degree of financial leverage.
Describe the trade-off that defines the static theory of capital structure.
As a firm starts to add debt, the tax shield provides wealth to the owners of the company and the WACC is falling across this range. -At some point, the costs of financial distress begin to enter as more debt is added. -Eventually the additional $1 benefit of the tax shield is exactly offset by the additional cost of financial distress. ---It is at this point that the WACC is lowest and we have the optimal debt-equity ratio.
Why is a firm's capital structure irrelevant?
Because shareholders can adjust the amount of financial leverage by borrowing and lending on their own.
The total systematic risk of the firm's equity has two parts; what are they?
Business risk- depends on the firm's assets and operations; not affected by capital structure. Financial risk- completely determined by financial policy.
What is the difference between a marketed claim and a nonmarketed claim?
Marketed claims CAN be bought and sold in financial markets and nonmarketed claims cannot.
The capital structure that ______ the value of the firm is also the one that ______ the cost of capital.
Maximizes Minimizes
What's the impact of financial leverage on stockholders?
More financial leverage can lead to higher returns for stockholders, when the firm's earnings are good. When firm's earnings are low, more financial leverage results in higher losses for stockholders.
The _____ debt financing a firm uses in its capital structure, the ______ financial leverage it employs.
More.
Do U.S. corporations rely heavily on debt financing?
No, most corporations use much less debt financing than equity financing.
Explain the effect of leverage on EPS and ROE:
ROE = net income/ equity As, the leverage of the company increases, it's equity investment decreases which leads to a rise in the ROE. equity = assets - liabilities , with higher debt, equity decreases. EPS also increases as the financial leverage increases, as the number of shares outstanding decreases which results in an increase in the EPS as EPS = NET INCOME/NO OF SHARES OUTSTANDING. With the use of more debt, fixed costs are incurred and not the higher costs that is involved with equity funds.
What are some of the claims to a firm's cash flows?
Taxes, bankruptcy costs, payments to: stockholders, creditors, the government, any and all claimants to the cash flow of the firm.
What is the M&M Propsition II?
The cost of Equity depends on three things; 1.) The required rate of return on the firm's assets (Ra) 2.) The firm's Cost of Debt (Rd) 3.) The firm's debt-equity ration (D/E)
What is the Unlevered Cost of Capital?
The cost of capital for a firm that has no debt.