20.1: Financing Sources

Question 1

What is the financial structure of a firm?

Answer 1

Financial structure refers to how a firm finances its total assets, including all liabilities and invested capital.

Question 2

What is the capital structure of a firm?

Answer 2

Capital structure refers to how a firm finances its invested capital, focusing on the proportion of financing through debt and equity.

Question 3

How do financial structure and capital structure differ?

Answer 3

Financial structure includes all of a firm’s liabilities, while capital structure focuses on long-term financing sources, particularly the mix of debt and equity used to finance invested capital.

Question 4

What is the debt-to-equity ratio?

Answer 4

The debt-to-equity ratio is the ratio of interest-bearing debt to shareholders’ equity plus minority interest, reflecting the firm’s leverage.

Question 5

Why is the debt-to-equity ratio important?

Answer 5

The debt-to-equity ratio indicates a firm’s financial leverage, showing how much debt is used to finance assets compared to equity.

A higher ratio suggests higher leverage and potential financial risk.

Question 6

What does the market-to-book (M/B) ratio represent?

Answer 6

The market-to-book (M/B) ratio is the market price per share divided by the book value per share, indicating the market’s valuation of a firm’s equity relative to its book value.

Question 7

How does the market-to-book (M/B) ratio impact financing decisions?

Answer 7

A higher M/B ratio suggests that the market values the firm more than its book value, which can influence management’s decisions regarding equity financing and overall capital structure.

Question 8

How has the debt-to-equity ratio changed over time for Canadian firms?

Answer 8

The debt-to-equity ratio for Canadian firms peaked in the early 1990s and has generally declined, indicating a trend towards less leverage and reliance on equity financing.

Question 9

What is the role of the Chief Financial Officer (CFO) in managing capital structure?

Answer 9

The CFO is responsible for optimizing the firm’s capital structure to enhance equity market value, ensuring that financing decisions align with shareholders’ interests and the firm’s cost of capital.

Question 10

How are the financial structure and capital structure related to a firm’s balance sheet?

Answer 10

The financial structure encompasses all liabilities and equity used to finance total assets, while capital structure focuses on the proportion of debt and equity financing for long-term investments.

Question 11

What is the basic perpetuity valuation equation?

Answer 11

S = X / k_e

Where:
- S = Value of the perpetuity
- X = Forecast earnings
- k_e = Investors’ required rate of return for equity

Question 12

How do you calculate the value of a perpetuity?

Answer 12

To find the value of a perpetuity, divide the forecast earnings (X) by the investors’ required rate of return (k_e):

S = X / k_e

Question 13

What is the formula for the investors’ required rate of return using the valuation equation?

Answer 13

k_e = X / S

Where:
- k_e = Investors’ required rate of return
- X = Forecast earnings
- S = Market price or value of the security

Question 14

What is the earnings yield?

Answer 14

Earnings yield is the estimate of the investors’ required rate of return, also known as the cost of equity capital.

It is calculated as forecast earnings divided by market price.

Question 15

Why are perpetuities often used in finance?

Answer 15

Perpetuities are easy to value because they provide constant payments indefinitely.

The valuation equation can be rearranged to solve for different variables, helping assess various financial scenarios.

Question 16

How can the valuation equation be used to determine forecast earnings?

Answer 16

The valuation equation can be rearranged to solve for forecast earnings:

X = k_e × S

Where:
- X = Forecast earnings
- k_e = Investors’ required rate of return
- S = Market price or value of the security

Question 17

How do regulators use the valuation equation in setting prices for utilities?

Answer 17

Regulators use the valuation equation to set prices that allow utilities to earn a specific return.

They adjust pricing to ensure the utility’s earnings meet investors’ required returns while considering cost structures.

Question 18

What does the valuation equation reveal about a firm’s market value with a mix of debt and equity?

Answer 18

The valuation equation helps determine if a firm can meet investors’ expectations based on its earnings, cost of debt, and equity returns.

If earnings don’t cover these costs, the firm’s market value may fall.

Question 19

How do you calculate the total earnings required for a firm using both debt and equity?

Answer 19

Total earnings required is the sum of interest on debt and the return to shareholders:

Total Earnings = (k_d × Debt) + (k_e × Equity)

Where:
- k_d = Required return on debt
- k_e = Required return on equity
- Debt = Market value of debt
- Equity = Market value of equity

Question 20

How does the earnings yield relate to dividend yield?

Answer 20

Earnings yield includes both current earnings and potential growth, unlike dividend yield, which only considers cash payouts.

It reflects a more comprehensive view of a firm’s expected return.

Question 21

What is a forecast income statement?

Answer 21

A forecast income statement projects a firm’s expected revenues, expenses, and profits over a specific period, helping assess financial performance and set pricing for regulated industries.

Question 22

How is Earnings Per Share (EPS) calculated?

Answer 22

EPS = Net Income / Number of Shares

Where:
- EPS = Earnings per share
- Net Income = Total profit after taxes
- Number of Shares = Total outstanding shares

Question 23

What is the formula for Return on Equity (ROE)?

Answer 23

ROE = Net Income / Equity

Where:
- ROE = Return on equity
- Net Income = Profit after taxes
- Equity = Book value of shareholders’ equity

Question 24

How is the Asset Turnover Ratio calculated, and what does it represent?

Answer 24

Asset Turnover Ratio = Sales / Total Assets

This ratio measures the efficiency of a firm’s use of its assets to generate sales, indicating how well a company uses its resources.

Question 25

What is the Return on Assets (ROA) formula?

Answer 25

ROA = Net Income / Total Assets

Where:
- ROA = Return on assets
- Net Income = Profit after taxes
- Total Assets = Sum of all assets owned by the firm

Question 26

What does the Return on Invested Capital (ROIC) measure?

Answer 26

ROIC measures a firm’s efficiency in allocating capital to profitable investments, calculated as earnings before interest and taxes (EBIT) divided by the book value of invested capital.

Question 27

How is the share price (P) related to ROE and the Market-to-Book (M/B) ratio?

Answer 27

P = (ROE × BVPS) / k_e

Where:
- P = Share price
- ROE = Return on equity
- BVPS = Book value per share
- k_e = Required rate of return for equity

Question 28

What is the basic relationship driving the Market-to-Book (M/B) ratio?

Answer 28

The M/B ratio is driven by the relationship: P / BVPS = ROE / k_e

Where:
- P = Share price
- BVPS = Book value per share
- ROE = Return on equity
- k_e = Required rate of return for equity

Question 29

Why might the earnings yield not be an adequate measure of the required return on equity?

Answer 29

Earnings yield might not be adequate because it doesn’t account for growth opportunities, inflation, or changing economic conditions that can affect future earnings.

Question 30

How are ROE and the required rate of return (k_e) related to a firm’s growth opportunities and M/B ratio?

Answer 30

A higher ROE relative to k_e indicates good growth opportunities, leading to a higher M/B ratio, as investors are willing to pay more for shares with higher expected returns.