Capital Structure Flashcards
EBIT for non-debt
before tax cost of financing * desired NI
Capital structure maximizing firm value
minimizes after tax WACC assuming operating income is independent of capital structure
Operating income dependent on capital structure
if your ability to service debt influences customer decisions
E.g. customers avoiding an airline because their inability to pay debt could lead to them not honoring their ticket
Debt for equity substitution
we increase debt and decrease equity by the same amount
How to reduce equity
pay cash dividend
repurchase shares
How to increase debt
issue bonds
takeout a loan
Traditional Position
WACC can be minimized for moderate amounts of debt because the cost of equity does not rise fast enough to offset cheap debt
This is NOT true for large amounts of debt
Traditional position can vary by industry and there is NO KNOWN optimal amount
Why is K-e always above K-i
bondholders get paid before stockholders so debt is less risky and bondholders require less of a return
Why does K-i have upward slope
more debt = more risk of default
as debt increases bondholders need a better return
Why does k-e slope upward
more debt we issue equity becomes riskier because stockholder payoff decreases
WACC-AT = K-e
at 0 debt avg cost of financing is the cost of equity b/c there’s no debt
WACC-AT = K-i
at 100% debt we have 0 equity
WACC-ATSlope
slopes down due to interest cost and back up due to additional impact of debt
Interest Cost (WACC-AT)
average cost of financing decreases as we replace equity and cheap debt increases
Impact of Additional Debt (WACC-AT)
makes remaining common stock riskier and this overwhelms the coupon and brings WACC-AT curve back up
