5-2. Cost of Capital and Financing Strategy Flashcards
What is the rate of return required by each financing source? How is it determined?
Cost of capital of each source.
By other opportunities with comparable risk available to investors; it is the investor’s opportunity cost.
Higher the perceived risk = Higher return required.
What are factors affective cost of capital?
- Macroeconomic conditions; market conditions and expectations about the interest rate, tax rate, and inflation rate
- Past performance of the firm: the greater the firm risk, the higher the cost of capital
- Amount of financing: the larger the absolute amount of financing sought, the higher the cost
- Relative level of debt financing: the higher the proportion go financing sought though debt, relative to equity, the higher the cost of debt capital
- Debt maturity: the longer the maturity, the higher the cost of that debt
- Debt security: the greater the value of collateral, the lower the cost of debt
If the market rate increases, what happens to cost of capital?
Increase.
Which one is most risky (and therefore, higher cost of capital) and least risky; LT corporate bonds, pref.stock, com. stock, com. stock in small firms?
Least: LT corporate bond
Pref. Stock
Com. Stock
Most: Com. stock in a small firm
Financing Strategies: What is hedging principle of financing also called? What is it?
Principle of self-liquidating debt.
Calls for matching cash flows from assets with cash requirements needed to finance those assets.
Financing Strategies: LT assets should be financed with what? ST assets should be financed with what?
LT: with LT financing.
ST: with ST financing.
Financing Strategies: What is the optimum capital structure objective?
To structure the capital mix to achieve the set or sets of capital sources that results in the lowest composite cost of capital for the firm.
Financing Strategies: How is the general business risk measured?
The variability of the firm’s expected operating Earnings Before Interest and Taxes (EBIT)
Financing Strategies: What should a firm with higher business risk (= higher variability in EBIT) do?
Use less debt financing than firms with a steady EBIT
Financing Strategies: The higher the tax rate faced by a firm, what happens to tax savings by use of debt?
Greater the amount of tax saved by use of debt financing.