Chapter 16

Net cash flow

(operating cash flow minus investing cash flows, sometimes called free cash flow or cash flow from assets)

if you are saving for a goal that is more than 15 years into the future, what percentage of your investment should be allocated to stocks, rather than bonds?

70% or more

Pretax cost of debt

= YTM = Market Rate

Chapter 11 reorganization

A bankruptcy method that allows the reorganization of the debtor's financial affairs under the supervision of the bankruptcy court

technical insolvency

A firm cannot meet its financial obligations

accounting insolvency

A firm has negative equity (liabilities exceed assets)

Bankruptcy

A legal proceeding to either liquidate or restructure the firm

Chapter 7 Liquidation

A provision of the U.S. bankruptcy code in which a trustee is appointed to oversee the liquidation of a firm's assets through an auction. The proceeds from the liquidation are used to pay the firm's creditors, and the firm ceases to exist.

Assuming perfect capital markets (that is, no taxes), what will be the value of the firm after the recapitalization?

According to M&M, in perfect capital markets (where there are no taxes, etc.), the capital structure of the firm will have no impact on the value of the firm.

Options for reducing costs

Avoid issuing debt: will eliminate the opportunity to add value to the firm Issue debt without restrictions: but lenders will increase the cost of debt because of the increased risk they will not be repaid Write protective and restrictive covenants into loan agreements and bond indentures: protect lenders without great costs to owners therefore increase the value of the firm

Proposition 2 (no taxes)

Both investors and firms can borrow at the same rate, There are no transaction costs, The use of financial leverage (debt) rises, the risk for owners (equity holders) also rises Result: Owners demand a greater return on equity

The 2 parts of the systematic risk of a firm's equity

Business risk (which determines Ra) and financial risk (which determines D/E) Beta

1978 Bankruptcy Reform Act

Created to ensure that creditors are treated fairly and the value of the assets is not needlessly destroyed

Pecking order theory

Firms specific financing order: Rule 1: use internally-generated funds before seeking external financing Rule 2: Issue safe securities before risky securities First issue debt Last resort issue new common stock

True or false: In determining the optimal capital structure, managers should keep in mind that

Higher effective tax rates lead to greater incentive to borrowing.

Proposition 1 (No taxes)

Investors are indifferent between investing in a levered firm or borrowing money to invest in an unlevered firm, Without taxes capital structure is 100% irrelevant: Vl=Vu

Which of the following statements regarding risk is/are true?

Investors should expect to be compensated for taking systematic risk, The risk premium of a security depends on its systematic risk, Firm-specific risk is diversifiable

signaling theory

Issue stock if they believe the stock is overvalued Issue bonds if they believe the stock is undervalued, There is not an optimal capital structure for each firm; instead managers will issue new common stock only when no other alternatives exists or when stock is overvalued

Bankruptcy is very valuable due to which of the following?

It can be used strategically to improve a firm's competitive position. Payments to creditors cease pending the outcome of the bankruptcy process.

What are the advantages of using internal financing?

It may be cheaper than debt or equity issues. It prevents the adverse market reaction that tends to accompany a stock issue.

Which of the following are non marketed claims to the firms cash flows?

Legal fees Taxes

A firm's cost of equity is a positively related to financial leverage. This statement is true, according to:

MM Proposition II, both with and without income taxes

Based on the static theory, what should the managers attempt to maximize and minimize while developing capital structure policy?

Maximize the tax shield benefit of debt and minimize financial distress costs

Default

Occurs when a firm fails to make the required interest or principal payments on its debt or violates a debt covenant After a firm defaults debt holders are given certain rights to the assets of the firm an may even take legal ownership of the firms assets through bankruptcy

Of the investments/accounts listed below, which one is the most likely way to ensure that you will have enough money to support yourself once you retire?

Roth 401(k) account beginning with your first employer at age 22

Trade-off/Static theory

Suggests that companies should weigh the benefits of the tax shield against the cost of potential financial distress, Low leverage levels: tax benefits of debt outweigh bankruptcy costs High leverage levels: bankruptcy cost outweigh tax benefits of debt, There is optimal capital structure for each firm where the benefit of debt is balanced against the cost of financial distress

Business failure

The firm closes, but has not paid creditors what they are owed

Value of the an unlevered firm =

The market value of a firm that has no debt in its capital structure, (EBIT*(1-income tax rate))/ (unlevered cost of capital), Eps is higher with debt

Capital structure

The mix of debt and equity a firm uses to finance (pay for) assets

MM Proposition 1 (with Taxes)

The more the firm borrows the greater the value of the firm, Rwacc is lower with taxes than without taxes, shows that the cost of equity rises with the use of debt financing (aka financial leverage) because the risk to equity rises with financial leverage.

Which of the following is likely to be true when a bankruptcy ruling is issued?

The ownership of assets is transferred from the shareholders to the bondholders.

What is the relationship between the pre-tax cost of the company's debt and its after-tax cost?

The pre-tax cost of debt is higher than the after-tax cost of debt

What does the trade-off (also called static) theory of capital structure imply?

There is an optimal level of debt for any given firm

What is the first rule of financing a firm's operations and capital projects, according to pecking-order theory of capital structure?

Use internal financing first

V = E + D

V = market value of the firm D = Market value of the firm's debt (bonds) Number of bonds * amt currently priced at E = Market value of the firm's equity (stock) Shares of common stock * amt currently priced at

The value of a firm is equal to the value of its _____.

debt plus equity

According to M&M Proposition I, a firm's capital structure choices _____.

do not affect the value of the firm

Voluntary arrangements to restructure a company's debt to avoid bankruptcy may be beneficial to all involved parties. This may involve _____.

extension or composition

Firms with lots of ___ have higher targets (bc cost of financial distress costs is low)

intangibles assets

What is the second rule of financing a firm's operations and capital projects, according to pecking-order theory of capital structure?

is to issue the safest securities first.

The benefits of debt financing _____ the costs of financial distress.

may be more than offset by

Frim with _____ have higher targets ( because profitability of financial stress is low)

predictable EBIT

after-tax cost of debt

pretax cost of debt x (1-tax rate)

bonds are marketed and shares of stock are marketed therefore

so are Interest payments and dividend payments

What is the the Yield to Maturity (YTM), also known as

the cost of debt, or the required rate of return or the market rate of return, on the debt

direct bankruptcy costs

the costs that are directly associated with bankruptcy, such as legal and administrative expenses, Reduce the net value that investors receive

value of a levered firm

the market value of a firm that has debt in its capital structure, (unlevered value of the firm +(income tax rate*debt)), Eps is lower with debt

The interest tax shield is a key reason why:

the net cost of debt to a firm is generally less than the cost of equity, If the firm is earning positive profits the risk of the interest tax shield should be the same as the risk on its debt

Beta measures:

the systematic risk of an investment & an investment's risk relative to the market

The standard deviation measures:

the total risk of an investment

The trade-off (also called static) theory of capital structure says

there is a trade-off between the tax benefits of debt and the costs of financial distress, and the optimal level of debt is the trade-off point.

Indirect Bankruptcy costs (financial distress costs)

types : Loss of customers, supplies, employees, receivables Fire sale of assets Delayed liquidation Costs to creditors

homemade leverage

when investors use leverage in their own portfolios to adjust the leverage choice made by a firm

What is the main difference between a US large company (large cap) stock fund, and a US large company (large cap) stock index fund? The index fund:

will attempt to earn the same amount as an index.

invest 100% of her retirement savings in a money market mutual fund. Accordingly, which one of the following statements is true? Her 401(k) retirement account:

will likely earn very low average annual returns, may be free from default risk, may earn negative real average annual returns, is subject to significant inflation risk