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SU 7
Corporate Capital Governance
90
Accounting
Undergraduate 4
05/16/2015

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Term
What is the perfect balance between the firm's resource and its capital structure? Why?
Definition
The balance sheet.
Term
resources
Definition
assets the firm deploys in its attempts to earn a return
Term
capital structure
Definition
consists of the amounts contributed by outsiders and insiders to make the use of the assets possible
Term
leasing
Definition
means of obtaining the use of plant assets while managing the related liability.
Term
What is the principal form of long-term debt financing for corporations and governmental entities?
Definition
bonds
Term
bond
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).
Term
indenture
Definition
lays out terms of a bond contract (face value, coupon rate, par value, etc.)
Term
How long should a bond last in order to justify the extensive legal and accounting work necessary to pull it off?
Definition
At least 5 years.
Term
term structure (interest rates over time)
Definition
the longer bond term, the higher risk and return
Term
yield curve
Definition
depicts the term structure graphically
Term
bond sinking fund
Definition
segregate and accumulate sufficient assets to pay the bond principal at maturity; may be required by the indenture.
Term
advantages of bonds to the issuer
Definition
Interest paid on debt is tax deductible.
Debtholders do not control the firm.
Term
disadvantages of bonds to the issuer
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.
Term
term bond
Definition
has a single maturity date at the end of its term
Term
serial bond
Definition
matured in stated amounts at regular intervals; investors can choose the maturity that suits their financial needs
Term
variable/floating rate bonds
Definition
pay interest that is dependent on market conditions
Term
zero-coupon/deep-discount bonds
Definition
bear no stated rate of interest and thus involve no periodic cash payments; the interest component consists entirely of the bond's discount
Term
commodity-backed bonds
Definition
payable at prices related to a commodity such as gold
Term
callable bonds
Definition
may be repurchased by the issuer at a specified price before maturity.
Term
When it is wise for an issuer to call bonds?
Definition
During a period of falling interest rates, this allows the issuer to replace old high-interest debt new low-interest debt.
Term
convertible bonds
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.
Term
securitization (of bonds)
Definition
mortgage bonds backed by specific assets, usually real estate
Term
debentures
Definition
backed by borrower's general credit but not by specific collateral
Term
registered bonds
Definition
issued in holder's name. Only the registered holder may receive interest and principal payments.
Term
bearer bonds
Definition
not individually registered. Interest and principal are paid to whomever presents the bond
Term
priority of bonds
Definition
subordinated debentures and second mortgage bonds are junior securities with claims inferior to those of senior bonds.
Term
income bonds
Definition
pay interest contingent on the issuer's profitability
Term
revenue bonds
Definition
issued by governmental units and are payable from specific revenue sources.
Term
bond ratings
Definition
the higher the rating, the less default risk, and the lower the yield
Term
investment-grade bonds
Definition
considered safe investments and thus have the lowest yields. AAA is highest rating.
Term
non-investment grade bonds
Definition
speculative-grade bonds, high-yield bonds, junk bonds, carry high risk.
Term
What is the primary concern of a bond issuer?
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.
Term
premium bond
Definition
Coupon rate > market rate, then Face > Price
Term
discount bond
Definition
Coupon rate < market rate, then Face < Price
Term
par bond
Definition
Coupon rate = market rate, then Face = Price
Term
effective rate (as related to bonds)
Definition
Using the effective rate to determine bond PV ensures that, upon maturity, they will be carried on the books at their face amount.
Term
How are bonds priced?
Definition
To achieve a new yield.
Term
leverage
Definition
relative amount of fixed cost in a firm's overall cost structure. Creates risk because FCs must be covered, regardless of sales levels.
Term
operating leverage
Definition
extent to which a firm's cost of operating are fixed as opposed to variable
Term
degree of operating leverage (DOL) & formula
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
Term
purpose of DOL calculations
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.
Term
financial leverage & DFL formula
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.
Term
degree of total/combined leverage (DTL)
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.
Term
debt covenants
Definition
restrictions that are imposed on a borrower by the creditor in a formal debt agreement or an indenture
Term
debt covenants & risk
Definition
The more restrictive the debt covenant, the lower the default risk. The less risky the investment, the lower the interest rate (premium).
Term
What happens if the debt covenant is breached?
Definition
The debt becomes due immediately.
Term
How are common shareholders' rights determined?
Definition
By the laws of the state of incorporation.
Term
advantages to issuers of common stock (DCT)
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.
Term
disadvantages to issuers of common stock (CNUT)
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.
Term
preemptive rights
Definition
give common shareholders the right to purchase any additional stock issuances in proportion to their current ownership percentages.
Term
voting rights
Definition
as the corporation's owners, they select firm's BOD and vote on resolutions.
Term
On what is common stock valuation based?
Definition
dividend payout models
Term
constant dividend per share (DPS)
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
Term
constant growth/dividend discount model
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).
Term
required rate of return (cost of common stock)
Definition
r = (D1 / P0) + g.
D1 = DPS expected next year
P0 = PPS now
g = growth rate
Term
preferred stock
Definition
Hybrid of debt and equity. Fixed charge, but dividends not obligated.
Stand ahead of shareholders in event of liquidation.
Term
advantages to issuers of preferred stock
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.
Term
disadvantages to issuers of preferred stock
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.
Term
provisions of preferred stock issues
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.
Term
preferred stock valuation
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.
Term
future annual dividends (Dp)
Definition
make up all FCFs from preferred stock
Dp = par value of preferred stock * preferred dividend rate
Term
preferred stock price (Pp)
Definition
Pp = Dp / r
Term
initial public offering (IPO)
Definition
first issuance of securities to the public
Term
going public
Definition
process by which a closely held corporation issues new securities to the public
Term
IPO moarket
Definition
primary market in which securities are first issued
Term
advantages of going public
Definition
Ability to raise additional funds
Establishment of firm's value in the market
An increase in the liquidity of the firm's stock
Term
disadvantages of going public
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
Term
equity financing vs. debt financing
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.
Term
lease
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
Term
capital lease
Definition
purchase-and-financing arrangement; recorded as an asset and a liability on the balance sheet
Term
service/operating lease
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
Term
How do you determine which type of lease is more beneficial?
Definition
Discounting the PV of cash flows associated with a lease using the time value of money.
Term
Why must leases be analyzed?
Definition
The cost of owning must be compared to the cost of leasing.
Term
sale-leaseback
Definition
allows firms to acquire capital from the sale of an asset while retaining the asset's use.
Term
financial lease
Definition
no maintenance services, noncancelable and amortize the cost of the leased asset over the term of the basic lease contract. Installment purchases.
Term
capital lease criteria. How many criteria must be met for it to be recorded as a capital lease? What are the criteria?
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.
Term
What happens when investors do not receive their required return?
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.
Term
cost of capital
Definition
required return for investors
Term
financing structure
Definition
composed of long-term debt, preferred equity and common equity (including retained earnings).
Term
component cost of capital
Definition
rate of return for each component (LTD, PS, CS)
Term
long-term debt component cost
Definition
effective rate * (1 – marginal tax rate)
Term
preferred stock component cost
Definition
cash dividend of PS / market price of PS
market price of PS = gross proceeds – flotation (issuance) costs
Term
common stock component cost
Definition
If the firm cannot provide a profitable use for these funds, they should be distributed to the shareholders.
Term
target capital structure
Definition
optimal mix of LTD, PS, and CS.
Ex)10% debt, 20% pref. stock and 70% comm. stock.
Term
weighted cost of capital (WACC)
Definition
single, composite return on its combined components of capital; weights are based on the target capital structure.
Term
WACC calculation
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.
Term
WACC formula
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
Term
optimal capital structure
Definition
The one that minimizes the WACC and, therefore, maximizes shareholder wealth.
Term
Can an optimal capital structure be determined?
Definition
No optimal point can be precisely located, but an optimal range can be found.
Term
Modigliani-Miller's argument pertaining to capital structure.
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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