5-2. Cost of Capital and Financing Strategy Flashcards

1
Q

What is the rate of return required by each financing source? How is it determined?

A

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.

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2
Q

What are factors affective cost of capital?

A
  • 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
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3
Q

If the market rate increases, what happens to cost of capital?

A

Increase.

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4
Q

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?

A

Least: LT corporate bond
Pref. Stock
Com. Stock
Most: Com. stock in a small firm

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5
Q

Financing Strategies: What is hedging principle of financing also called? What is it?

A

Principle of self-liquidating debt.

Calls for matching cash flows from assets with cash requirements needed to finance those assets.

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6
Q

Financing Strategies: LT assets should be financed with what? ST assets should be financed with what?

A

LT: with LT financing.
ST: with ST financing.

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7
Q

Financing Strategies: What is the optimum capital structure objective?

A

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.

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8
Q

Financing Strategies: How is the general business risk measured?

A

The variability of the firm’s expected operating Earnings Before Interest and Taxes (EBIT)

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9
Q

Financing Strategies: What should a firm with higher business risk (= higher variability in EBIT) do?

A

Use less debt financing than firms with a steady EBIT

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10
Q

Financing Strategies: The higher the tax rate faced by a firm, what happens to tax savings by use of debt?

A

Greater the amount of tax saved by use of debt financing.

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