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BEC > 8 Corporate Capital Structure > Flashcards

8 Corporate Capital Structure Flashcards

1
Q

What is a bond?

A

A formal contract to pay an amount of money (par value, maturity amount, or face amount) to the holder at a certain date (maturity date). Also, most bonds provide for a series of cash interest payments based on a specified percentage (stated rate or coupon rate) of the face amount at specified intervals. The agreement is included in a legal document called an indenture.

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2
Q

What is a bond sinking fund?

A

The objective of the fund is to accumulate sufficient assets to pay the bond principal at maturity. The amounts transferred into this account earn revenues over time. Thus, the bond sinking fund accumulates money to provide the necessary funds to repay the bonds in the future.

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3
Q

What are the advantages of bond issuers?

A
  • interest paid on debt is tax deductible (referred to as a tax shield)
  • control of the firm is not shared with debtholders.
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4
Q

What disadvantages of bond issuers?

A
  • the payment of interest and principal on debt is legal obligation. If cash flow is insufficient, the firm could become insolvent.
  • the legal requirement to pay interest and principal increases a firm’s risk and reduces its retained earnings. Since shareholders demand increased retained earnings, they are less likely to invest in the firm, thus decreasing the share price.
  • bonds may require collateral, which is specific property pledged to a lender in case of default
  • the amount of debt financing available to the individual firm is limited. Generally accepted standards of the investment community usually require a certain debt-to-equity ratio. Beyond this limit, the cost of debt may rise rapidly, or debt may not be available.
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5
Q

What are the two types of bond maturities?

A
  1. term bond

2. serial bond

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6
Q

What is a term bond?

A

A term bond has a single maturity date at the end of its term.

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7
Q

What is a serial bond?

A

A serial bond matures in stated amounts at regular intervals.

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8
Q

What are variable (or floating) rate bonds?

A

Variable rate bonds pay interest that is dependent on market conditions. In other words, the interest rate of the bonds changes (or floats).

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9
Q

What are zero-coupon or deep-discount bonds?

A

Zero-coupon have no stated rate of interest and require no periodic cash payments. The interest component consists entirely of the bond’s discount.

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10
Q

What are commodity-backed bonds?

A

Bonds payable at prices related to commodity such as gold.

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11
Q

What are the two redemption provisions?

A
  • callable bonds

- convertible bonds

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12
Q

What are callable bonds?

A

Callable bonds may be repurchased by the issuer at a specified price before maturity. When interest rates are declining, the issuer can replace high-interest debt with low-interest debt. Callable bonds have higher interest rates than comparable noncallable bonds.

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13
Q

What are convertible bonds?

A

Bonds that 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 incentive to potential investors.

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14
Q

What is securitization?

A
  • mortgage bonds are backed by specific assets, usually real estate.
  • debentures are backed by the issuer’s credit, not specific assets.
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15
Q

What are the two types of bond ownership?

A
  • registered bonds - issued in the name of the holder. Only the registered holder may receive interest and principal payments.
  • bearer bonds - not individually registered. Interest and principal are paid to whoever presents the bond.
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16
Q

What is the priority of subordinated debentures?

A

Subordinated debentures and second mortgage bonds are junior securities with claims inferior to those of senior bonds.

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17
Q

What are repayment provisions?

A
  • income bonds pay interest contingent on the issuer’s profitability
  • revenue bonds are issued by governmental units and are payable from specific revenue sources.
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18
Q

What are bond ratings?

A

Credit-rating agencies judge the creditworthiness of bonds. The higher the rating, the more likely the firm will pay the interest and principal.

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19
Q

What are the three largest credit-rating agencies?

A

Moody’s, Standard & Poor’s, and Fitch

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20
Q

What are investment-grade bonds?

A

Safe investments that have the lowest yields. The highest rating assigned is AAA, and the lowest investment-grade bond is BBB. Some fiduciary organizations (such as banks and insurers) are allowed to invest in only investment-grade bonds.

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21
Q

What are noninvestment-grade bonds?

A

Also called speculative-grade, high-yield, or junk bonds, have high risk. The ratings range from BB+ to DDD.

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22
Q

How are bonds valued?

A

Bonds are valued at the present value of the cash flows from the bonds (principal at maturity and periodic interest) discounted at the market (effective) interest rate.

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23
Q

What does it mean is a bond is sold at par?

A

The stated rate equals the market rate at the time of sale.

present value = face amount

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24
Q

What does it mean if the bond’s stated rate is lower than the market rate?

A

Periodic interest payments are lower than those currently available. Thus, the bonds are sold for less than par value, at a discount, so that the effective interest rate equals the market rate.

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25
Q

What is the present value formula of the face amount of a bond?

A

present value = amount / (1 + interest rate)squared by # of years

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26
Q

What is the present value formula of the interest payments of a bond?

A

PV = interest amount / (1+r) squared by # of year, + interest amount / (1+r) squared 2, + interest amount / (1+r) squared 3, + interest amount / (1+r) squared 4, etc.

Each year is calculated and added to equal the PV of the total interest of the bond.

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27
Q

What does it mean if the bond’s stated rate is higher than the market rate?

A

Periodic interest payments are higher than those currently available. Thus, the bonds are sold for more than par value, at a premium, so that the effective interest rate equals the market rate.

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28
Q

What is leverage?

A

The relative amount of fixed cost in a firm’s cost structure. In other words, leverage is the amount of debt a firm has. Leverage creates risk because fixed costs must be paid, regardless of sales.

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29
Q

What makes up a firm’s total leverage?

A

operating leverage plus financial leverage

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30
Q

What is operating leverage?

A

The extent to which a firm’s costs of operating are fixed. A firm’s degree of operating leverage (DOL) is a ratio that measures the effect that given fixed operating costs have no earnings.

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31
Q

What is the degree of operating leverage (DOL) ratio?

A

DOL = % change in earnings before interest and taxes (EBIT) / % change in sales

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32
Q

What is financial leverage?

A

The degree of debt (fixed financial costs) in the firm’s financial structure. A firm’s degree of financial leverage (DFL) is a ratio that measures the effect that an amount of fixed financing costs has on earnings per share.

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33
Q

What is the degree of financial leverage (DFL) ratio?

A

DFL = % change in earnings per share (EPS) / % change in earnings before interest and taxes (EBIT)

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34
Q

What is the earnings per share calculation?

A

EPS = net income available to common shareholders / weighted-average common shares outstanding

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35
Q

What is net income available to common shareholders?

A

Net income less preferred dividends

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36
Q

Why would a firm with a high percentage of fixed financial costs accept more risk?

A

To increase earnings per share

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37
Q

What is the degree of total (combined) leverage (DTL) ratio?

A

DTL = DOL x DFL = (% change in EBIT / % change in sales) x (% change in EPS / % change in EBIT) = %change in EPS / % change in sales

Ex - if the firm’s EPS increases by 10% as a result of an increase in sales of 2%, the firm’s DTL is 5 (10% / 2%)

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38
Q

What does it mean if a firm has a higher DTL?

A

The firm provides a higher return to investors, but it is also more risky. The risk is due to a higher likelihood of default.

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39
Q

What is the value of a levered firm?

A

The value of a levered firm is the value of an unlevered firm plus the present value of the interest tax savings

40
Q

What is the calculation for interest tax savings?

A

interest tax savings = corporate tax rate x (rate of interest on the debt x amount of debt)

41
Q

What is the calculation for present value of the interest tax savings?

A

PV of the interest tax savings = corporate tax rate x (rate of interest on the debt x amount of debt) / Rate of interest on the debt (assuming the debt is permanent)

42
Q

What are examples of debt covenants?

A
  • limitations on issuing additional long-term or short-term debt
  • limitations on dividend payments
  • maintenance of certain financial ratios
  • maintenance of specific collateral that secures the debt
43
Q

What happens if a debtor violates a debt covenant?

A

The debt becomes due immediately

44
Q

What is market capitalization (market cap)?

A

Market capitalization refers to the market value of a company’s outstanding shares. It is equal to the shares of common stock outstanding times the fair market value per share.

45
Q

If a corporation issues common stock, what are the advantages?

A
  1. common stock does not require a fixed dividend. Dividends are paid from profits when available.
  2. common stock has no fixed maturity date for repayment of capital.
  3. the sale of common stock increases the creditworthiness of the firm by providing more capital (or money) for the corporation to use.
46
Q

If a corporation issues common stock, what are the disadvantages?

A
  1. cash dividends on common stock are not tax-deductible and are paid from after-tax-profits. This means common stockholders are double taxed: once on the corporate income and once individually on their personal dividend income. It also means that paying dividends does not decrease a corporation’s net income.
  2. new common stock sales dilute EPS available to current shareholders
  3. Underwriting costs - fees to issue new common stock are typically higher than debt.
  4. Too much equity may raise the average cost of capital of the firm above its optimal level
47
Q

How is common stock valued?

A

It’s based on dividend payout models

48
Q

When the dividend per share of common stock is constant and expected to be paid continuously, how is the price per share calculated?

A

current price per share = dividend per share (constant) / required rate of return

49
Q

What is the dividend growth model?

A

The dividend growth model assumes that dividends per share and price per share increase at the same constant rate (which can be positive or negative).

50
Q

How is price per share calculated using the dividend growth model?

A

current stock price per share = current dividends per share ( 1 + growth rate (constant) / (required rate of return (discount rate) - growth rate)

51
Q

How is the required rate of return (the cost of common stock) be calculated using the dividend growth model?

A

required rate of return = (dividends per share expected next year / current stock price per share) + growth rate

52
Q

What are the disadvantages of the dividend growth model?

A
  • assumes the dividend growth rate is constant and is always less than the required rate of return
  • cannot be used to value stock price if a company does not pay dividends
53
Q

Another way to calculate stock price is the dividend discount model. What is the calculation?

A

current stock price per share = {dividends expected next year / (1 + growth rate)squared by # of year} + {{dividends expected year 2/ (1 + growth rate)squared by # of year} +{dividends expected year 2/ (1 + growth rate)squared by # of year} , etc.

54
Q

What is preferred stock?

A

A hybrid of debt and equity. Preferred stock dividends are generally established in terms of issuance as a percentage of par value, making preferred stock dividends fixed payments. Preferred stock has priority over common stock in terms of dividend payment (preferred stock dividends must be paid before common stock dividends can be paid), but preferred stock dividends are not required payments. Also, preferred shareholders have priority over common shareholders in bankruptcy.

55
Q

If a corporation issues preferred stock, what are the advantages?

A
  1. preferred stock is equity and increases the creditworthiness of the firm
  2. control is still held by common shareholders. Preferred stock rarely has voting rights.
  3. superior earnings of the firm are usually still reserved for the common shareholders
  4. preferred stock does not require periodic payments. Thus, nonpayment dividends does not lead to bankruptcy.
56
Q

If a corporation issues preferred stock, what are the disadvantages?

A
  1. cash dividends on preferred stock are not tax-deductible and are paid from after-tax profits. The result is a substantially greater cost relative to bonds because preferred stockholders also enjoy the value of ownership, but bondholders do not.
  2. in periods of economic difficulty, accumulated unpaid dividends (dividends in arrears) may create managerial and financial problems for the firm
57
Q

What is the difference between participating and nonparticipating preferred stock?

A

participating preferred stock may receive common shareholder dividends on a pro-rata basis. Ex - a 8% participating preferred stock may pay a preferred dividend each year of 8% and, when the corporation is extremely profitable, receives an ordinary dividend equal to what the common shareholders receive. But, a nonparticipating preferred stock receives no further dividends than are required.

58
Q

How is preferred stock valued?

A

Preferred stock is valued in the same way as bonds, as the present value of the future cash flows. Future cash flows associated with the security are discounted at an investor’s required rate of return (market rate) used to value preferred stock.

59
Q

What are the future cash flows from preferred stock?

A

The estimated future annual dividends.

60
Q

What is the calculation of the value of preferred stock?

A

estimated future annual dividends = par value of preferred stock x preferred dividend rate

61
Q

What is the calculation of preferred stock price?

A

preferred stock price = estimated future annual dividends / investor’s required rate of return

62
Q

What is the dividend payout ratio?

A

The dividend payout ratio measures what portion of accrual-basis earnings was actually paid out to common shareholders in the form of dividends.

63
Q

What is the formula for dividend payout ratio?

A

dividend payout ratio = dividend per share / earnings per share = cash dividend / net income

64
Q

What is the dividend yield ratio?

A

The dividend yield ratio measures how much a company distributes to shareholders relative to its price per share.

65
Q

What is the formula for dividend yield ratio?

A

dividend yield = dividend per share / market price per share

66
Q

What is shareholder return?

A

Shareholder return measures the return on a purchase of stock.

67
Q

What is the calculation for shareholder return?

A

shareholder return = (ending stock price - beginning stock price + annual dividends per share) / beginning stock price

68
Q

What makes up a firm’s capital structure?

A

Financing sources, both short-term and long-term, debt and equity.

69
Q

What is solvency?

A

Solvency is a firm’s ability to pay its noncurrent obligations as they come due and to remain in business in the long run

70
Q

What is the times-interest-earned ratio?

A

The ability to service debt from current earnings. Part of the effective use of leverage.

71
Q

What is the formula for the times-interest-earned ratio?

A

times-interest-earned ratio = earnings before interest and taxes (EBIT) or income before interest expense and taxes / interest expense

72
Q

What are capital structure ratios?

A

Capital structure ratios report the relative proportions of debt and equity in a firm’s capital structure.

73
Q

What is the total debt ratio?

A

The total debt ratio (also called the debt to total assets ratio) reports the total debt burden carried by a firm per dollar of assets.

74
Q

What is the formula for total debt ratio (debt to total assets)

A

total debt ratio = total debt / total assets

75
Q

What is the total-debt-to-total-capital ratio?

A

The total-debt-to-total-capital ratio measures the percentage of the firm’s capital provided by creditors. Total capital includes equity and interest-bearing debt. When total debt to total capital is low, more of the firm’s capital is supplied by the shareholders. Thus, creditors prefer this ratio to be low to provide a cushion against losses.

76
Q

What is the formula for the total-debt-to-total-capital ratio?

A

total debt to total capital = total debt / total capital

77
Q

What is the debt-to-equity ratio?

A

A direct comparison of the firm’s debt with it’s equity. The debt-to-equity ratio reflects long-term debt-payment ability. A low ratio means a lower relative debt and less risk for creditors.

78
Q

What is the formula for the debt-to-equity ratio?

A

debt to equity = total debt / shareholders’ equity

79
Q

What is the long-term-debt-to-total-equity ratio?

A

Reports long-term debt per dollar of equity. A firm with a low ratio has a better chance of obtaining new debt financing at a favorable rate.

80
Q

What is the formula for the long-term-debt-to-total-equity ratio?

A

long-term debt to total equity = long-term debt / shareholders’ equity

81
Q

What happens if management does not provide the required rate of return to investors?

A

Investors sell their stock on the secondary market, causing the market value of the stock to drop. Creditors then demand higher rates on the firm’s debt.

82
Q

What is the firm’s cost of capital?

A

A firm’s cost of capital is the required rate of return by investors on the firm’s debt and equity (both preferred and common).

83
Q

What is the component cost of long-term debt?

A

The after-tax interest rate on the debt because interest payments are tax-deductible.

effective rate x (1 - marginal tax rate)

84
Q

How is the effective rate on debt calculated?

A
  • if debt is issued at face value, the effective rate equals the coupon rate
  • if debt is issued at a premium or discount, the effective rate equals the coupon payment divided by the issue price

Ex - coupon rate is 10%, bonds issued at premium price of 105 = (10 / 105) x (1 - marginal tax rate)
Ex - coupon rate is 10%, bonds issued at discount price of 95 = (10 / 95) x (1 - marginal tax rate)

85
Q

How is the component cost of preferred stock calculated?

A

calculated using the dividend yield ratio

preferred stock (old) = cash dividend on preferred stock / market price of preferred stock - flotation costs

86
Q

What are flotation costs?

A

Issuance costs, these reduce the net proceeds received, raising the cost of capital. The market price of preferred stock up on issuance equals the net proceeds (gross proceeds - flotation costs).

87
Q

What is the traditional (basic) formula for the component cost for common equity?

A

Common equity (basic) = next dividend per share / share price

88
Q

What is the component cost of retained earnings?

A

The rate of return required by common shareholders. Retained earnings (internal equity capital) already belong to the common shareholders. These earnings would be distributed to them as dividends if not retained.

89
Q

What is the advanced formula for the component cost for common equity?

A

The advanced formula combines the basic formula with the dividend growth model.

common equity (advanced) = (next dividend per share / share price) + dividend growth rate

90
Q

Besides the traditional and advanced formulas to calculate the cost of common equity, what is another method used?

A

The capital asset pricing model

91
Q

What is expected value?

A

A means of associating a dollar amount with each possible outcome of a probability distribution. The outcome yielding the highest expected value (which may or may not be the most likely one) is the optimal alternative.

92
Q

How is expected value calculated?

A

Expected value = probability (state of nature payoff 1) + probability (state of nature payoff 2) +probability (state of nature payoff 3) , etc.

  • the decision is under the manager’s control

state of nature = future event whose outcome the manager is attempting to predict
payoff = the financial result of the combination of the manager’s decision and the actual state of nature

93
Q

What is a criticism?

A

A criticism is that expected value is based on repetitive trials, but many business decisions ultimately involve only one event.

94
Q

What is weighted-average cost of capital (WACC)?

A

A firm’s WACC combines the three components of capital into one composite rate of return on the combined components of capital. The weights are based on the target capital structure, which is effectively expected-value analysis. Corporate management usually designates a capital structure, i.e., the proportion of each component of capital: long-term debt, preferred equity, and common equity.

95
Q

How is weighted-average cost of capital calculated?

A

Long-term debt = target weight x cost of capital = weighted cost
Preferred equity = target weight x cost of capital = weighted cost
Common equity = target weight x cost of capital = weighted cost

WACC = sum of all weighted costs

96
Q

What is the formula to calculate the WACC given no preferred equity?

A

has two components

debt = (value of debt / value of equity + value of debt) x cost of debt x (1 - corporate tax rate) 
equity = (value of equity / value of equity + value of debt) x cost of equity

WACC = sum of both

97
Q

What is the formula to calculate WACC when a firm has preferred equity?

A

has three components

debt = (value of debt / value of common equity + value of preferred equity +value of debt) x cost of debt x (1 - corporate tax rate)

common equity = (value of common equity / value of common equity + value of preferred equity + value of debt) x cost of common equity

preferred equity = (value of preferred equity / value of common equity + value of preferred equity + value of debt) x cost of preferred equity

WACC = sum of all three

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