Finance Final Exam: Cost of Capital(14)/ Financial Leverage and Capital Structure Policy(16)
Static Theory of Capital Structure (CASES)
1. No taxes, no bankruptcy - value of firm is not affected by debt policy = constant rate 2. Taxes are introduced - firms value critically depends on debt policy -^leverage, ^cost of equity (off set by tax break), = overall cost of capital declines 3. Bankruptcy costs
EBIT Conclusions
1. the effect of financial leverage depends on the company's EBIT. when EBIT is high, leverage is beneficial 2. under the expected scenario, leverage increases the returns to shareholders, as measured by both ROE and EPS 3. shareholders are exposed to more risk under the proposed capital structure because the EPS and ROE are much more sensitive to changes EBIT in this case 4. because of the impact that financial leverage has on both the expected return to stockholders and the riskiness of the stock, capital structure is an important decision
"cram-down" bankruptcy
a class of creditors can be forced to accept a bankruptcy plan even if they vote not to approve it
M&M Proposition 2
a firms cost of equity capital is a positive linear function of the firms capital structure cost of equity depends on: 1. required rate of return of a firms assets 2. cost of debt 3. debt-to-equity ratio
bankruptcy
a legal proceeding for liquidating or reorganizing a business
business failure
a situation in which a business has terminated with a loss to creditors (even an all equity firm can fail)
pecking-order theory
alternative to the static theory - uses short run/ tactical issue of raising funds to financial investments firms prefer to use internal financing whenever possible issue debt is necessary last resort: sell equity! this tells investors the price is too high implications: 1. no target capital structure 2. profitable firms use less debt 3.companies will want financial slack
cost of capital
depends primarily on the use of the funds, NOT the source will reflect both both its costs of debt capital and its cost of equity capital
direct bankruptcy costs
directly associated with bankruptcy (legal and administrative expenses) a fraction of the firm's assets "disappear" and bondholders won't get all they are owed
required return, appropriate discount rate, cost of capital
essentially the same thing
absolute priority rule (APR)
establishes priority of claims in liquidation
reorganization
financial restructuring of a falling firm in attempt to continue operations as a going concern - issuing new securities to replace the old ones
legal bankruptcy
firm/creditor brings petitions to a federal court
accounting insolvency
firms with negative network are insolvent on the books = when the total book liabilities exceed the book value of total assets
cost of preferred stock
fixed dividend / price per share of preferred stock
flotation costs
if a company accepts a new project, it may be required to issue, or float, new bonds and stocks must take into account target weights external equity has a high flotation cost
capital structure goal
maximize value of the whole firm
dividend growth model approach
must estimate the growth rate - historical rates or analysts' forecasts + simple. - applicable only to companies who pay dividends -the estimated cost of equity is very sensitive to the estimated growth rate -does NOT explicitly consider risk
technical insolvency
occurs when a firm is unable to meet its financial obligations
liquidation
termination of the firm as a growing concern - selling off assets
unlettered cost of capital
the cost of capital for a firm that has no debt
indirect bankruptcy costs
the costs of avoiding a bankruptcy filing incurred by a financially distressed firm
financial distress costs
the direct/indirect costs associated with going bankrupt or experiencing financial distress
financial risk
the equity risk that comes from the financial policy (capital structure) of the firm
business risk
the equity risk that comes from the nature of the firm's operating activities
Security Market Line Approach
the required/expected return on a risky investment depends on: 1. RFR 2. market risk premium 3.the systematic risk of the asset relative to average (beta coefficient) +explicitly adjusts for risk +applicable to companies other than just those with steady dividend growth - if MRP and Beta estimates are poor the resulting cost of equity will be inaccurate - we essentially rely on the past to predict the future
cost of equity
the return that equity investors require on their investment in the firm
cost of debt
the return that lenders require on the firm's debt
interest tax shield
the tax saving attained by a firm from interest expense
static theory of capital structure
the theory that a firm borrows 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
pure play approach
the use of a WACC that is unique to a particular project, based on companies in similar lines of business
homemade leverage
the use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed
M&M Intuition and Theory
the value of the firm depends on the total cash flow of the firm
M&M Proposition 1
the value of the firm is independent of the firms capital structure it is completely irrelevant how a firm choses to arrange its finances
weighted average cost of capital (WACC)
the weighted average of the cost of equity and the aftertax cost of debt the overall return the firm must earn on existing assets to maintain the value of its stock force employees and management to pay attention to the real bottom line: increasing share prices
bankruptcy
value of asset = value of debt value of equity = 0 stockholders turn over control to bondholders