Capital Structure Flashcards
The mix of debt (long and short term) and equity (common stock and preferred) used to finance operations and growth is an entity’s:
Capital structure
An unsecured, short-term debt instrument issued by a corporation is a:
(It also matures in less than 270 days and must be used to finance current assets such as accounts receivable or inventory)
Commercial paper
Unsecured obligation of the issuing company is called a
Debenture
A bond issue that is unsecured and ranks behind senior creditors in the event of an issuer liquidation is a:
(These also command higher interest rates than debentures to allow for additional risk)
Subordinated debentures
Securities that pay interest only upon achievement of target income levels are:
Income bonds
These are characterized by high default risk and high return and also classified as “non investment grade” bonds. Frequently used to raise capital for acquisitions and leveraged buyouts.
Junk Bonds
A loan that is secured by residential or commercial real property. A trustee acts on behalf of bond holders to foreclose on these assets In the event of default.
Mortgage
For this type of lease, “lease expense” representing interest expense and the amortization of the ROU asset combined will be recorded on the income statement for every payment made:
Operating Lease
For this type of lease, interest expense and amortization expense are accounted for separately on the income statement:
Finance lease
An ROU asset and lease liability may not be recognized for leases if
Terms are less than 12 months
One of the OWNES criteria:
Ownership transfers at end of lease
Written purchase option that lessee is certain to exercise
Net present value of all lease payments is equal to or greater than the assets FV
Economic life of asset is primarily encompassed within lease term
Specialized asset such that it will not be used for anything following the lease
must be met in order to classify a lease as a:
Finance lease
If none of the OWNES criteria are met, the lease is classified as:
Operating lease
What shareholders have the lowest claim to firms asset if liquidation?
Common stock shareholders
Flexibility - no Tax deductibility - yes EPS dilution - no Increased financial risk - yes Security issuance costs - low Investor return - fixed
These characteristics defined what type of financing?
Debt
Flexibility - yes Tax deductibility - no EPS dilution - yes Increased financial risk - no Security issuance costs - high Investor return - variable
These characteristics defined what type of financing?
Equity
The average cost of all forms of financing used by a company is called the:
Weighted average cost of capital (WACC)
The lower the WACC, the higher the:
Firm value
What is the formula for WACC?
(Common Equity X Cost of CE) + (Preferred Stock X Cost of PS) + (Debt X (Interest rate x (1 - tax rate)))
What shareholders have the highest claim to firms asset if liquidation?
Debt holders
The higher the tax rate, the more incentive exists to use what sort of financing?
Debt
The cost of preferred stock is greater than the cost of debt because:
Dividends are not tax deductible and preferred stockholders assume more risk
Formula for calculating the cost of preferred stock is:
(Par X Rate) / Net proceeds of preferred stock
Proceeds should be net of flotation costs
Cost of Retained Earnings Formula (CAPM):
Risk free rate + (Beta X (Market Return - Risk free rate))
Discounted cash flow (DCF) formula:
(D1 / P0) + G
D1 = end of one year P0 = current price G = growth
The Bond Yield Plus Risk Premium (BYRP) formula:
Pretax cost of long-term debt + market risk premium
The average of the CAPM, DCF and BYRP can be used to estimate what?
The cost of retained earnings
The ratio of debt to equity that produces the lowest WACC is the:
Optimal cost of capital
Initially as debt increases, WACC does what? Then what happens as debt continues to rise?
Initially, WACC goes down, then WACC goes up
What happens to liquidity, risk of distress, and Return on Asset as current assets increase?
Liquidity goes up, risk of distress goes down, and ROA goes down
What happens to liquidity, risk of distress, and Return on Asset as non-current assets increase?
Liquidity goes down, risk of distress goes up, and ROA goes up
If debt increases, a company needs to be…
Liquid
An entity’s asset structure is influenced by and incidences its capital structure. With debt in the capital structure, cash (or cash equivalents) are needed to fund interest and principal payments when they come due.
What do lenders use to protect their interest by limiting or prohibiting the actions of borrowers that might negatively affect the position of the lenders?
Debt covenants
If a borrower’s capital structure has more equity, its financial leverage will be______ and its fixed obligations associated with debt will______. In a situation like this, loan covenants may not be difficult to maintain because there is _____ risk the borrower will be unable to make the interest and principal payments
Low, minimal, and less
When a borrower has a significant amount of debt and not much equity, loan covenants will increase because why?
There is more risk the borrower will be unable to make interest and principal payments the financial leverage will also be high
The payout rate is calculated by:
Dividends per share / EPS
Retention rate is calculated by:
1 - payout rate
The growth rate is calculated by:
(Return on assets X Retention Rate) / 1 - (Return on assets X Retention)
OR
Return on Equity X Retention = Growth Rate
Return on Sales is calculated by:
( Net Income - Interest Inc. + Interest Exp. + Tax Exp ) / Net Sales
If debt increases, what happens to risk, return on equity, and growth?
Risk goes up, ROE goes up, and Growth goes up
Return on investment is calculated by:
Net income / (Assets - Operating Liabilities)
Return on assets is calculated by:
Net income / average total assets
Return on equity is calculated by:
Net income / average total equity (or A - L)
What is an amplifier of risk and return (meaning it amplifies the good and bad)?
Leverage
What is the degree to which a company uses fixed operating costs rather than variable operating costs?
Operating leverage
Capital intensive industries have what level of operating leverage?
Labor intestine industries have what level of operating leverage?
Capital - high
Labor - low
As fixed costs increase, degree of leverage…
Increases
What are some implications of operating leverage?
A company with high pertains leverage must produce sufficient sales revenue to cover its high fixed operating costs. A company with high operating leverage will have greater risk but greater possible returns. When sales decline, a company with high operating leverage may struggle to cover its fixed costs.
What’s a formula used to calculate the degree of leverage?
% change EBIT / % change Sales
What is the degree to which a company uses debt rather than equity to finance the company?
Financial leverage
What are some implications of financial leverage?
Companies must have enough EBIT to cover the interest expense (Int. Exp = a fixed cost). Companies that are highly financially leveraged may be at risk of bankruptcy if they are unable to make payments on their debt. They also may be unable to find new lenders in the future.
A company that has debt in its capital structure is a:
Levered firm
A company that does not have debt in its capital structure is a:
Unleavened firm
To find the value of a levered firm use the calculation:
Value of unlevered firm + ((tax rate X (interest rate debt)) / interest rate)
The ability to meet long-term obligations is an entity’s:
Solvency
As the total debt ratio goes up, what happens to risk, degree of financial leverage, an the return on equity?
Risk goes up, DFL goes up, and ROE goes up
How to calculate total debt ratio:
Total liabilities / total assets
The lower the total debt ratio, the…
Greater the level of solvency and the greater the presumed ability to pay debts.
Risk goes down, but ROE also goes down.
How to calculate the debt to equity ratio:
Total liabilities / total equity
The lower the debt to equity ratio, the…
Lower the risk
To calculate the equity multiplier…
Total assets / total equity
How to calculate the time interest earned ratio…
EBIT / Interest Expense
When using the times interest earned ratio, as debt increases, what happens with interest expense and risk?
Interest expense increases and risk increases
