Capital Structure Flashcards
T/F: an entity’s capital structure is the mix of debt (long and short term) and equity (common and preferred) used to finance operations and growth
True; types of debt financing are as follows:
commercial paper - unsecured debt issued by a corporation and maturing in 270 days or less; proceeds used to finance current assets or to meet short-term obligations
debentures - unsecured debt issued by a corporation
subordinated debentures - unsecured debt ranking behind senior creditors in the event of an issuing company liquidation; these carry higher interest rates than debentures
income bonds - pay interest upon the achievement of target income levels
junk bonds - noninvestment grade bonds characterized by high default risk and high returns
mortgage bonds - pooled mortgages (loan secured by real property) with bondholders protected from default by liens on real property assets; trustees foreclose on mortgage assets in the event of default
lease - contractual agreement in which the owner of an asset (lessor) allows another party (lessee) to use the property/asset in exchange for periodic lease payments; it will generally result in the lessee recording a right-of-use (ROU) asset and lease liability on the balance sheet; a lessee will record “lease expense” on the income statement for an operating lease and interest and amortization expense on the income statement for finance leases
types of equity financing are as follows:
preferred stock - it is a hybrid equity security that has features similar to both debt and equity; preferred shares offer or require a fixed dividend payment to their holders, which is similar to coupon payments made on debt instruments; they are like equity because the timing of the dividend payment is at the discretion of the board of directors (not mandatory) and the dividend payments are not tax deductible
common stock - this represents the basic equity ownership security of a corporation; common stock includes voting rights with optional dividend payments by the issuer; most common stock is issued with a stated par value; when the common stock is issued at a given market price, the proceeds received by the issuer are separated between the common stock account and the APIC account; a negative feature of common equity is that common shareholders have the lowest claim to a firm’s assets in a liquidation
What is weighted average cost of capital (WACC)?
the WACC is the average cost of all forms of financing used by a company; it is often used internally as a hurdle rate for capital investment decisions; the theoretical optimal capital structure is the mix of financing instruments that produces the lowest WACC
the value of a firm can be computed as the present value of the cash flow it produces, discounted by the costs of capital used to finance it; the mixture of debt and equity financing that produces the lowest WACC maximizes the value of the firm
WACC = (e/v)(r) + (p/v)(r) + (d/v)[r(1-t)]
V = the summed market values of the individual components of the firms capital structure: common stock equity (E), preferred stock equity (P), and debt (D)
R = the required rate of return of the various components
T = the corporate tax rate
What is weighted average cost of debt?
the relevant cost of long-term debt is the after-tax cost of raising long-term funds through borrowing; sources of long-term debt generally include the issuance of bonds or long-term loans; debt costs are generally stated as the interest rate of the various debt instruments; in some cases, debt costs are stated according to basis points above U.S. treasury bond rates (where 1 basis point is equal to one-hundredth of 1% or 0.01%); the weighted average interest rate is calculated by dividing a company’s total interest obligations on an annual basis by the debt outstanding
weighted average interest rate = effective annual interest payments / debt outstanding
pretax cost of debt represents the cost of debt before considering the tax shielding effects of the debt; because interest on debt is tax deductible, the tax savings reduces the actual cost of the debt; the formula is below:
after-tax cost of debt = pretax cost of debt * (1 - tax rate)
debt carries the lowest cost of capital and the interest is tax deductible; the higher the tax rate, the more incentive exists to use debt financing
Cost of preferred stock
the cost of preferred stock is the dividends paid to preferred stockholders; after-tax considerations are irrelevant with equity securities because dividends are not tax deductible
cost of preferred stock = preferred stock dividends / net proceeds of preferred stock
preferred stock dividends can be stated as a dollar amount or as a percentage (ex. a 5% preferred stock pays an annual dividend of 5% of par value, if dividends are declared by the corporation)
the net proceeds from a preferred stock issuance can be calculated as the proceeds net of flotation/issuance costs
Cost of retained earnings
the cost of equity capital obtained through retained earnings is equal to the rate of return required by the firm’s common stockholders; a firm should earn at least as much on any earnings retained and reinvested in the business as stockholders could have earned on alternative investments of equivalent risk
there are 3 common methods of computing the cost of retained earnings: capital asset pricing model (CAPM), discounted cash flow (DCF), and bond yield plus risk premium (BYRP)
each method is a valid method of calculating the cost of retained earnings; the average of the three cost amounts could be used as the estimate of the cost of retained earnings if there is sufficient consistency in the results of the three methods
Capital asset pricing model (CAPM)
the beta coefficient is a numerical representation of the volatility of the stock relative to the volatility of the overall market; a beta equal to 1 means the stock is as volatile as the market and a beta greater (less) than 1 means the stock is more (less) volatile than the market
cost of retained earnings = risk-free rate + risk premium
risk-free rate + (beta * market risk premium)
risk-free rate + [beta * (market return - risk-free rate)]
Discounted cash flow (DCF)
the expected growth rate may be based on projections of past growth rates, a retention growth model, or analysts’ forecasts
cost of retained earnings = d/p + g
D = the dividend per share expected at the end of one year
P = the current market value or price of the outstanding common stock
G = the constant rate of growth in dividends
Bond yield plus risk premium (BYRP)
risks are associated with both the individual firm and the state of the economy; risk premiums depend on non-diversifiable risk
cost of retained earnings = pretax cost of long-term debt + market risk premium
What is optimal capital structure?
the optimal cost of capital is the ratio of debt to equity that produces the lowest WACC; required rates of return demanded by debt and equity holders fluctuate as the ratio of debt to equity changes; at some point as debt to equity increases, leverage becomes more pronounced and debtors will demand a greater return for the high level of default risk; in addition, equity holders also will require a greater return due to the negative effect of high leverage on their potential future cash flows
Loan covenants and capital structure
lenders use debt covenants to protect their interest by limiting or prohibiting the actions of borrowers that might negatively affect the position of the lenders
Growth rate
the growth rate associated with a company’s earnings is a key component of financial valuation; a company’s annual earnings are allocated between dividend payments to shareholders and retained earnings
growth rate = (return on assets * retention) / (1 - [return on assets * retention])
where: retention (the retention ratio) is equal to the addition to retained earnings divided by net income; this also can be thought of as the portion of net income not paid out in the form of dividends to stockholders
Profitability
a key financial measure of success for a company is profitability; measures of profitability include return on sales (ROS), return on investment (ROI), return on assets (ROA), and return on equity (ROE)
ROS = income before interest income, interest expense, and taxes / net sales
ROI = net income / average invested capital
ROA = net income / average total assets
ROE = net income / average total equity
Operating leverage
it is the degree to which a company uses fixed operating costs rather than variable operating costs; capital-intensive industries often have high operating leverage, whereas labor-intensive industries generally have low operating leverage
a company with high operating leverage must produce sufficient sales revenue to cover its high fixed-operating costs; high operating leverage is beneficial when sales revenue is high; a high contribution margin indicates high operating leverage
a company with high operating leverage will have greater risk but greater possible returns; there is risk because the variability of profits is greater with higher operating leverage
when sales decline, a company with high operating leverage may struggle to cover its fixed costs; however, beyond the breakeven point, a company with higher fixed costs will retain a higher percentage of additional revenues as operating income (earnings before interest and taxes or EBIT)
Financial leverage
when making financing decisions, a firm can choose to issue debt or equity; when debt is issued, the firm generally must pay fixed interest costs; equity issuances do not result in an increase in fixed costs because dividend payments are not required; financial leverage is the degree wo which a company uses debt rather than equity to finance the company
a company that issues debt must produce sufficient operating income (EBIT) to cover its fixed interest costs; however, once fixed interest costs are covered, additional EBIT will go straight to net income and EPS; a higher degree of financial leverage implies that a relatively small change in earnings before interest and taxes (increase or decrease) will have a greater effect on profits and shareholder value; another benefit of financial leverage is that interest costs are tax deductible, whereas dividends are not
companies that are highly 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
Value of a levered firm
a levered firm is a company that has debt in its capital structure, whereas an unlevered firm has only equity (and no debt) in its structure; the formula for calculating the value of a levered firm, assuming that the debt is permanent, is shown below:
value of a levered firm = value of an unlevered firm + present value of the interest tax savings
present value of interest tax savings = t * (r *d / r
T = corporate tax rate
R = interest rate on debt
D = amount of debt
a firm that uses debt benefits from the tax deductibility of the interest payments; these cumulative tax savings, discounted to today’s dollars, represent the difference between the value of a firm with no debt and a firm with debt in its capital structure
