BEC 2 Flashcards
What do capital structures deal with?
How a corporation should raise money.
What is debt financing? What is the fixed cost of debt financing?
Using short ot long-term debt in a capital structure. Interest is the fixed cost.
What is commercial paper? When does it mature? What must its proceeds be used to do?
- Unsecured, short-term debt instrument ossied by a corporation.
- Commercial paper matures in 270 days or less.
- Must be used to finance current assets.
What are debentures? What status does a debenture have in the event of a default?
- An unsecrued obligation of the issuing company.
- In the event of a default, the holder of a debenture has the status of a general creditor?
What is a subbordinate debenture? Do they command higher or lower interest rates than debentures?
- Same as a debenture and is unsecured, but it ranks behind the senior creditors in the event of a liquidation. -Subbordinate debentures command higher interest rates that debentures to allow for additional risk.
What are income bonds? When are they typically used?
- Securities that pay interest only uppon achievement of target income levels.
- Typically only used in reorganizations.
What are junk bonds? What are they also called? When are they typically used?
- High default risk, high return bonds.
- noninvestment grade bonds
- Used to raise capital for acquisitions and leveraged buyouts.
What are mortgage bonds? What is a distinguishing feature of mortgage bonds?
- Loans secured by residential or commercial real property.
- A distinguishing feature of mortgage bonds is that trustees act on behalf of bondholders to foreclose on mortgage asset in the event of default.
What is an operating lease? Will companies who use operating leases have better or worse financial ratios? Why?
- when property is leased over an insignificant portion of the asset’s useful life with no obligation (or opportunity) to assume ownership of the property.
- Better financial ratios.
- Because liabilities are lower (debt off the b/s) and, in the early years of the lease, rent expense is lower than the combined depreciation expense and interest expense reported under a capital lease.
What is a capital lease? Who uses them? Why?
- Analogous to a lessee buying an asset and financing it with debt.
- Generally used by firms who want to report higher periodic operating cash flows.
- Because the principal portion of the capital lease payment is reported as a financing cash outflow, while the entire rent payment under an operating lease is reported as an operating cash outflow.
In order to classify as a capital lease, a lessee must meet one of the following four criteria.
OWNS
- Ownership transfer @ end of lease.
- Written option for bargain purchase.
- Ninety (90) percent of lease property FV less than or equal to PV of lease payments.
- Seventy-fve (75) percent or more of the asset’s economic life is committed in the lease term.
What is equity financing? What is one of its distinguishing features>
- Involves the issuance of equity (stock) securities that represent different forms of ownership in the company.
- The rights of shareholder’s to a firm’s assets in a bankruptcy are less than that of both secured and unsecured bondholders.
What is preferred stock? What does it require?
- Preferred stock is a hybrid security with features similar to both debt and equity.
- Offer or require a fixed dividend payment (similar to coupon payments made on debt instruments).
- Like equity because the timing of the dividend payment is up to the discretion of the Board and dividend payments are not tax deductible.
What is the participating feature of preferred stock?
- Preferred shares may participate in declared dividends along with common shareholders to the extent that undistributed dividends exist after satisfying both preferred dividend requirements and common shareholder requirements at the preferred dividend rate.
Do preferred shareholders receive voting rights?
- Rarely.
What is common stock? What two things do common stockholders receive?
- Basic equity ownership of a corporation.
- Voting rights and (optional) dividends.
Who has the lowest claim to a firm’s assets in the event of liquidation?
- common stockholders.
What is WACC? What is it often used as? What does the lowest possible WACC indicate?
- WACC is the weighted average cost of all forms of financing used by a company.
- often used as a hurdle rate.
- The theoretical optima capital structure is a mix of financing and instruments that produces the lowest WACC.
How is WACC calculated?
WACC = (Cost of equity X % equity in capital structure) + (weighted ave cost of debt X debt in capital structure).
Cost of debt is calculated on what basis?
- An after-tax basis.
Calculate pretax cost of debt.
Weighted ave int rate = effective annual int pmts / debt outstanding
Calculate after tax cost of debt.
After tax cost of debt = pretax cost of debt X (1- Tax rate).
Is the cost of preferred debt > the cost of debt? If so, why?
- Yes
- Because dividends are not tax deductible and preferred stockholders assume more risk.
Calculate cost of preferred stock.
Cost of preferred stock = preferred stock dividends / net proceeds of preferred stock.
Think Outflows/Inflows
Calculate net proceeds of preferred stock
Proceeds net of flotation (issuance) costs.
What is great, the cost of retained earnings (common equity) or the cost of preferred equity?
- The cost of common equity.
- Because common equity is last in line @ liquidation and assumes more risk.
What are the three common methods of computing the cost of retained earnings?
Capital assey pricing model (CAPM), discounted cash flow (DCF), bond yield plus risk premium (BYRP).
calculate cost of retained earnings using CAPM.
Cost of retained earnings = risk-free rate + [Beta x (Market return - Risk-free rate)]
Calculate cost of retained earnings using DCF.
Cost of retained earning s = D0/P0 + g
Where:
P0 = current market value or price of the outstanding common stock.
D1 = The dividend per share expected at the end of one year.
g = The constant rate of growth in dividends.
Calculate cost of retained earnings using BYRP.
Cost of retained earnings = pretax cost of long-term debt + market risk premium.
