Term
| What is the perfect balance between the firm's resource and its capital structure? Why? |
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Definition
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Term
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Definition
| assets the firm deploys in its attempts to earn a return |
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Term
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Definition
| consists of the amounts contributed by outsiders and insiders to make the use of the assets possible |
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Term
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Definition
| means of obtaining the use of plant assets while managing the related liability. |
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Term
| What is the principal form of long-term debt financing for corporations and governmental entities? |
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Definition
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Term
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Definition
| formal contractual obligation to pay an amount of money (called the par value, maturity amount, or face amount) to the holder at a certain date, plus interest payments at stated intervals (coupon rate * face value). |
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Term
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Definition
| lays out terms of a bond contract (face value, coupon rate, par value, etc.) |
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Term
| How long should a bond last in order to justify the extensive legal and accounting work necessary to pull it off? |
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Definition
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Term
| term structure (interest rates over time) |
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Definition
| the longer bond term, the higher risk and return |
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Term
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Definition
| depicts the term structure graphically |
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Term
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Definition
| segregate and accumulate sufficient assets to pay the bond principal at maturity; may be required by the indenture. |
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Term
| advantages of bonds to the issuer |
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Definition
Interest paid on debt is tax deductible.
Debtholders do not control the firm. |
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Term
| disadvantages of bonds to the issuer |
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Definition
The payment of interest and principal is a legal obligation.
The legal requirement to pay debt service raises a firm's risk level b/c shareholders demand higher capitalization rates.
Bonds require some collateral that restricts the entity's assets.
The amount of debt financing available to the individual firm is limited. |
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Term
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Definition
| has a single maturity date at the end of its term |
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Term
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Definition
| matured in stated amounts at regular intervals; investors can choose the maturity that suits their financial needs |
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Term
| variable/floating rate bonds |
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Definition
| pay interest that is dependent on market conditions |
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Term
| zero-coupon/deep-discount bonds |
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Definition
| bear no stated rate of interest and thus involve no periodic cash payments; the interest component consists entirely of the bond's discount |
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Term
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Definition
| payable at prices related to a commodity such as gold |
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Term
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Definition
| may be repurchased by the issuer at a specified price before maturity. |
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Term
| When it is wise for an issuer to call bonds? |
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Definition
| During a period of falling interest rates, this allows the issuer to replace old high-interest debt new low-interest debt. |
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Term
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Definition
| may be converted into equity securities of the issuer at the option of the holder under certain conditions. The ability to become equity holders is an inducement to potential investors. |
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Term
| securitization (of bonds) |
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Definition
| mortgage bonds backed by specific assets, usually real estate |
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Term
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Definition
| backed by borrower's general credit but not by specific collateral |
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Term
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Definition
| issued in holder's name. Only the registered holder may receive interest and principal payments. |
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Term
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Definition
| not individually registered. Interest and principal are paid to whomever presents the bond |
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Term
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Definition
| subordinated debentures and second mortgage bonds are junior securities with claims inferior to those of senior bonds. |
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Term
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Definition
| pay interest contingent on the issuer's profitability |
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Term
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Definition
| issued by governmental units and are payable from specific revenue sources. |
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Term
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Definition
| the higher the rating, the less default risk, and the lower the yield |
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Term
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Definition
| considered safe investments and thus have the lowest yields. AAA is highest rating. |
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Term
| non-investment grade bonds |
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Definition
| speculative-grade bonds, high-yield bonds, junk bonds, carry high risk. |
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Term
| What is the primary concern of a bond issuer? |
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Definition
| The amount of cash received from investors on the day the bonds are sold. This cash is equal to the PV of cash flows associated with the bonds discounted at the interest rate prevailing in the market at the time. |
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Term
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Definition
| Coupon rate > market rate, then Face > Price |
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Term
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Definition
| Coupon rate < market rate, then Face < Price |
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Term
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Definition
| Coupon rate = market rate, then Face = Price |
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Term
| effective rate (as related to bonds) |
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Definition
| Using the effective rate to determine bond PV ensures that, upon maturity, they will be carried on the books at their face amount. |
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Term
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Definition
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Term
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Definition
| relative amount of fixed cost in a firm's overall cost structure. Creates risk because FCs must be covered, regardless of sales levels. |
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Term
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Definition
| extent to which a firm's cost of operating are fixed as opposed to variable |
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Term
| degree of operating leverage (DOL) & formula |
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Definition
ratio that measures the effect that a given level of fixed operating costs has on the earnings of the firm
DOL = % change in EBIT / % change in sales |
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Term
| purpose of DOL calculations |
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Definition
DOL can help the firm determine the most appropriate level of operating leverage that maximizes the firm's EBIT.
Firms with high % of fixed costs are riskier but generate more earnings by increasing sales. |
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Term
| financial leverage & DFL formula |
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Definition
degree of debt (fixed financial costs) in the firm's financial structure
DFL = % change in EPS / % EBIT
When a firm has a high % of fixed financial costs, the firm takes more risk to increase its EPS. |
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Term
| degree of total/combined leverage (DTL) |
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Definition
DTL = DOL * DFL = (% change in EBIT / % change in sales) * (% change in EPS / % EBIT) = (% change in EPS / % sales)
A firm with a higher DTL has a higher return to the investors, but it is also more risky. |
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Term
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Definition
| restrictions that are imposed on a borrower by the creditor in a formal debt agreement or an indenture |
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Term
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Definition
| The more restrictive the debt covenant, the lower the default risk. The less risky the investment, the lower the interest rate (premium). |
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Term
| What happens if the debt covenant is breached? |
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Definition
| The debt becomes due immediately. |
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Term
| How are common shareholders' rights determined? |
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Definition
| By the laws of the state of incorporation. |
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Term
| advantages to issuers of common stock (DCT) |
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Definition
Dividend paid by profits, not a fixed dividend.
Common stock carries no fixed maturity date for repayment of capital.
The sale of common stock increases the creditworthiness of the firm by providing more equity. |
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Term
| disadvantages to issuers of common stock (CNUT) |
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Definition
Cash dividends on common stock are not tax-deductible and must be paid out of after-tax profits.
New common stock sales dilute earnings per share available to existing shareholders.
Underwriting costs are typically higher common stock issues.
Too much equity may raise the average cost of capital of the firm above its optimal level. |
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Term
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Definition
| give common shareholders the right to purchase any additional stock issuances in proportion to their current ownership percentages. |
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Term
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Definition
| as the corporation's owners, they select firm's BOD and vote on resolutions. |
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Term
| On what is common stock valuation based? |
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Definition
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Term
| constant dividend per share (DPS) |
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Definition
When the DPS of common stock is constant and expected to be paid continuously, the price per share is calculated as follows:
price per share (PPS) now = DPS (constant) / required rate of return, or P0 = D / r |
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Term
| constant growth/dividend discount model |
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Definition
assumes that DPS and PPS grow at the same constant growth rate (g).
P0 = D0 (1 + g) / (r - g) = D1 (1 + g) / (r -g). |
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Term
| required rate of return (cost of common stock) |
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Definition
r = (D1 / P0) + g.
D1 = DPS expected next year
P0 = PPS now
g = growth rate |
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Term
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Definition
Hybrid of debt and equity. Fixed charge, but dividends not obligated.
Stand ahead of shareholders in event of liquidation. |
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Term
| advantages to issuers of preferred stock |
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Definition
Form of equity and therefore builds the creditworthiness of the firm.
Control is still held by common shareholders (preferred stock rarely carries voting rights).
Superior earnings of firm are reserved for the common shareholders.
Since preferred stock does not require periodic payments, failure to pay dividends will not lead to bankruptcy. |
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Term
| disadvantages to issuers of preferred stock |
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Definition
Cash dividends on preferred stock are not tax-deductible and paid with taxable income unlike bonds.
In periods of economic difficulty, dividends in arrears can create major financial and managerial problems for the firm. |
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Term
| provisions of preferred stock issues |
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Definition
Priority in assets and earnings.
Dividends in arrears must be paid before common dividends.
Convertibility into common stock.
Participation in excess company earnings unless it is nonparticipating stock.
Par value is the liquidation value, and a % of par equals the preferred dividend. |
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Term
| preferred stock valuation |
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Definition
| PV of future cash flows associated with the security discounted from the prevailing interest rate (required return) can also be used for preferred stock. |
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Term
| future annual dividends (Dp) |
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Definition
make up all FCFs from preferred stock
Dp = par value of preferred stock * preferred dividend rate |
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Term
| preferred stock price (Pp) |
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Definition
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Term
| initial public offering (IPO) |
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Definition
| first issuance of securities to the public |
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Term
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Definition
| process by which a closely held corporation issues new securities to the public |
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Term
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Definition
| primary market in which securities are first issued |
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Term
| advantages of going public |
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Definition
Ability to raise additional funds
Establishment of firm's value in the market
An increase in the liquidity of the firm's stock |
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Term
| disadvantages of going public |
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Definition
Costs of reporting requirements of the SEC and other agencies
Access to the firm's operating data by competing firms
Access to net worth information of major shareholders
Limitations on self-dealing by corporate insiders
Pressure from outside shareholders for earnings growth
Stock prices that do not accurately reflect the true net worth of the firm
Loss of control by management as ownership is diversified
Increased shareholder servicing costs |
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Term
| equity financing vs. debt financing |
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Definition
Equity affects company control.
Equity more expensive than debt to issue.
Debt affects net income.
Equity dilutes EPS.
Debt affects firm solvency.
Debt is tax-deductible. |
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Term
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Definition
| long-term, contractual agreement in which the owner of property (the lessor) allows another party (the lessee) the right to use the property for a stated period in exchange for a stated payment |
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Term
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Definition
| purchase-and-financing arrangement; recorded as an asset and a liability on the balance sheet |
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Term
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Definition
long-term rental contract (preferred by lessees because it is rent expense, not an asset or liability to be reported on the balance sheet)
both financing and maintenance services |
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Term
| How do you determine which type of lease is more beneficial? |
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Definition
| Discounting the PV of cash flows associated with a lease using the time value of money. |
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Term
| Why must leases be analyzed? |
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Definition
| The cost of owning must be compared to the cost of leasing. |
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Term
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Definition
| allows firms to acquire capital from the sale of an asset while retaining the asset's use. |
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Term
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Definition
| no maintenance services, noncancelable and amortize the cost of the leased asset over the term of the basic lease contract. Installment purchases. |
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Term
| capital lease criteria. How many criteria must be met for it to be recorded as a capital lease? What are the criteria? |
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Definition
At least one of the four criteria must be met.
The four criteria are:
Title passes to the lessee at the end of the lease.
The lease contains a bargain purchase option.
PV of the minimum lease payments (payments to be made during the lease term) equal 90% or more of the fair value of the leased property.
The lease term is 75% or more of the useful economic life of the property. |
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Term
| What happens when investors do not receive their required return? |
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Definition
| If investors do not receive their required return from management, they will sell their stock, causing the stock's value to drop. Creditors will then demand higher rates on the firm's debt. Therefore, the required return for investors is also the firm's cost of capital. |
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Term
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Definition
| required return for investors |
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Term
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Definition
| composed of long-term debt, preferred equity and common equity (including retained earnings). |
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Term
| component cost of capital |
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Definition
| rate of return for each component (LTD, PS, CS) |
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Term
| long-term debt component cost |
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Definition
| effective rate * (1 – marginal tax rate) |
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Term
| preferred stock component cost |
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Definition
cash dividend of PS / market price of PS
market price of PS = gross proceeds – flotation (issuance) costs |
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Term
| common stock component cost |
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Definition
| If the firm cannot provide a profitable use for these funds, they should be distributed to the shareholders. |
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Term
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Definition
optimal mix of LTD, PS, and CS.
Ex)10% debt, 20% pref. stock and 70% comm. stock. |
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Term
| weighted cost of capital (WACC) |
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Definition
| single, composite return on its combined components of capital; weights are based on the target capital structure. |
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Term
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Definition
| Take each component and multiply its target weight * component cost of capital. Then, sum the weighted cost of each component to get the WACC. |
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Term
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Definition
WACC = (E / V * Re) +[ D / V * Rd * (1 – T)]
Re = cost of equity
Rd = cost of debt
E = market value of firm's equity
D = market value of firm's debt
T = corporate tax rate
V = D + E = capital used to generate profits |
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Term
| optimal capital structure |
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Definition
| The one that minimizes the WACC and, therefore, maximizes shareholder wealth. |
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Term
| Can an optimal capital structure be determined? |
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Definition
| No optimal point can be precisely located, but an optimal range can be found. |
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Term
| Modigliani-Miller's argument pertaining to capital structure. |
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Definition
No optimal capital structure; financing style has no effect on shareholder wealth.
Increase in expected return from debt financing is offset by increased required returns for equity financing.
DOL and debt-to-equity ratios would then be of no use to shareholders. |
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