Finance Final (Ch. 13)
what is the equity risk that comes from the nature of a firms operating activities
*business risk* of the firm's equity ---- depends on systematic risk of firm's assets
restructurings take place when a firm substitutes one ____ for another while leaving the firm's _____ unchanged
- capital structure ; assets unchanged
??? which increases with leverage, cost of debt or cost of equity
- cost of debt increases - cost of equity may increase
a firm's optimal capital structure is composed by ____ in debt and ____ in equity
- debt: D*/Vl* - equity: (1 - D*/Vl*)
incentives of bondholders and stockholders during potential bankruptcy
- stockholders: incentive to not go bankrupt bc will be cleaned out - bondholders: incentive to go bankrupt bc get control from stockholders
bankruptcy is very valuable because it can...
1) be used strategically to improve a firm's competitive position 2) payments to creditors cease pending the outcome of the bankruptcy process
what are the 2 parts of the total systematic risk of a firm's equity
1) business risk 2) financial risk
what are the 2 implications of proposition 1 in a no-tax case
1) capital structure is irrelevant 2) WACC is the same no matter what mixture of debt and equity is used to finance the firm
a corporation gains no value from an interest tax shield if what 3 things are true...
1) corporation is an all-equity firm 2) corporation has no debt 3) corporate tax rates are zero
if we consider the effect on taxes, what is the optimum capital structure
100% debt
the weighted average cost of capital (WACC) ____ as the firm relies more heavily on debt financing
DECREASES (bc value of firm increases and that's opposite from WACC)
the effect of financial leverage depends on the company's ___
EBIT --- when EBIT is high, the leverage is beneficial
the value of the firm increases as total debt ____
INCREASES
cost of debt will begin to increase as the degree of leverage _____
INCREASES - (increases equity which decreases debt)
if financial leverage does not effect the overall cost of capital, the firm's capital structure is _____
IRRELEVANT - bc changes in cap structure won't affect the value of the firm
the greater the risk of financial distress, the ____ debt will be optimal for firm (and for borrowing)
LESS
a particular debt-equity ratio represents the *optimal capital structure* if it results in the ____ possible WACC
LOWEST
at the optimal debt level (D*) is the optimal D/E* ratio - also at this level of debt financing is the ______ possible WACC*
LOWEST possible WACC*
the value of the firm is _____ when the WACC is _____
MAXIMIZED - MINIMIZED
what is the slope of cost of equity (Re)
Ra - Rd (required rate on firm's assets - firm's cost of debt)
what is the equation for present value of the tax shield
Tc x D
is interest paid on debt tax deductible
YES - good for a firm
what does M&M Proposition II state
a firm's cost of equity capital is a *positive linear function* of its capital structure -- the value of the firm (Vl) increases as total debt increases bc of the interest tax shield
??? an investor who invests in the stock of a levered firm rather than in an all-equity firm will require a higher....
a higher expected return
as debt-equity ratio rises, so does the probability of ____
bankruptcy
why doesn't the capital structure the firm adopts really matter
bc investors can lend, borrow, and replicate all on their own
a firm's choice of how much debt it should have relative to equity is known as a ____
capital structure decision (decisions about a firm's debt-equity ratio)
which is generally lower, cost of debt or cost of equity
cost of debt is generally loswer
direct bankruptcy costs
costs associated directly to bankruptcy ---- *legal and administrative* expenses
indirect bankruptcy costs
costs of avoiding a bankruptcy filing incurred by a financially distressed firm (ex: lost sales; lost reputation; NOT legal expenses)
financial distress costs
direct AND indirect costs of bankruptcy
the WACC rises at higher levels of debt owing to...
financial distress costs
what is the equity risk that comes from the financial policy (i.e. capital structure) of the firm --- the extra risk that arises from the use of debt financing/the risk of leverage
financial risk
the use of personal borrowing to alter the degree of financial leverage is called ____
homemade leverage --- shareholders can adjust the amount of financial leverage by borrowing and lending on their own
a firm can consider it's capital restructuring decisions ____ from its investment deicions
in isolation ---- assets not directly affected by capital restructuring --- examine capital structure decisions separately from other activities
if degree of leverage increases, the cost of debt will ____
increase
as firms increase the financial leverage, cost of equity ____; as a result, firm's overall cost of capital ____
increases ; decreases
the tax savings attained by a firm from the tax deductibility of the interest expense
interest tax shield
financial distress can arise in the form of possible....
legal bankruptcy and business failure
??? M&M Proposition I does not work with corporate taxes because...
levered firms pay lower taxes than unlevered firms
the impact of financial leverage ___ gains and losses
magnifies
capital structure decisions should ___ the value of ____
maximize the value of the whole firm ---- choose the structure so that the *WACC is minimized*
what is the *optimal level of borrowing*
maximum firm value (Vl*) is reached at optimum debt level (D*)
does financial leverage change overall cost of capital
no
financial leverage refers to the extent to which a firm _____
relies on debt --- the more debt, the more financial leverage
activities (issuing stock; issuing bonds) that alter the firm's existing capital structure; that change the debt-equity ratio
restructurings
volatility or ____ increases for equity holders when leverage increases
risk
what is the theory that states a firm borrows up to the point where the tax benefit from an extra dollar of debt exactly equals the cost that comes from the increased probability of financial distress
static theory of capital structure
what is the firm's cost of debt (Rd) determined by
the firm's financial structure --- as firm relies more on debt financing, the required return on equity rises
whats the relationship between the value of the unlevered firm and of the levered firm *once we consider the effect of corporate taxes*
the levered firm exceeds the value of unlevered firm *by the present value of interest tax shield*, Tc x D
(case w bankruptcy costs and corp. taxes) the *optimal capital structure* (D*) is the point at which....
the tax saving from an additional dollar of debt financing is EXACTLY BALANCED by the increased bankruptcy costs associated w the additional borrowing
with no tax, proposition 1 implies that...
value of the leveraged firm = value of unleveraged firm
what does M&M Proposition I state
the value of a firm is independent of its capital structure
a firm goes bankrupt when ______
the value of its assets = value of its debt --- equity has no value; equal to zero
implications of proposition 2 in a no-tax case
1) cost of equity rises as the firm increases its use of debt financing(leverage) 2) the risk of the equity depends on 2 things: business risk and financial risk
according to M&M Prop. II, what 3 things does cost of equity depend on
1) required rate of return on firm's assets (Ra) 2) firm's cost of debt (Rd) 3) firm's debt-equity ratio (D/E)
