Capital structure Flashcards
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Bond
A long-term debt instrument issued by a corporation or government
Indenture (legal agreement between bond issuer and bondholder)
Indenture
Mortgage securities (with collateral)
- Less yield required
Debenture (without collateral)
- More yield required
Seniority = rank of claiming
Mortgage bond > debenture > subordinated debt
- Least risk < Moderate risk < Highest risk
- Least yield < Moderate yield < Highest yield
Types of bond
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
- Long-term + Unsecured
- Secured by debtor’s earning power (financial statements)
Subordinated debentures
- Long-term + Unsecured + Lowest claim
- Liquidity priority: XXX > YYY > subordinated debt > equity
- Less yield < High yield < Highest yield
Income bonds
- Unsecured + Interest paid when profit earned
- XXX > income bond > subordinated debt > equity
Junk bonds
- Unsecured + high-risk + high yield
Mortgage bonds
- Secured by property
- Proceeds from disposing collateral to be paid to creditors
Lease
Lease: a contractual agreement to use the property with periodic lease payments
Lessee: a right-of-use (ROU) asset and a lease liability on the balance sheet. The ROU asset will be amortized, and the lease liability will be paid down over the life of the lease.
Exception: leases terms <= 12 months, classified as Operating Lease, no ROU assets and lease liabilities recognized
Operating lease: Periodic lease expense in I/S = interest expense + amortization of the ROU asset
Finance lease: interest expense and amortization expense record separately on I/S
If met one of below criteria, classified as a finance lease:
- Ownership transfer at the end of the lease.
- Written purchase option that the lessee is reasonably certain to exercise.
- Net present value of all lease payments and guaranteed residual value is equal to or substantially exceeds the underlying asset’s fair value.
- Economic life of the underlying asset is primarily encompassed within the term of the lease.
- Specialized asset, no expected alternative use to the lessor when the lease ends.
Preferred stock
Fixed dividend
Debt + common stock
Senior to common stock
Cumulative dividend
Participating dividend
NO voting right
Common stock
Ultimate ownership and risk
Shareholder’s liability = amount invested
Entitled to share income
Voting rights
Preemptive right
* New issue of common stock or convertible securities offered first to existing common shareholders
Cost of capital
The required rate of return on the various types of financing
Cost of debt
The required rate of return on investment of the lenders of a company.
Cost of preferred stock
The required rate of return on investment of the preferred shareholders
Kp = D / (P0 - F)
Cost of equity
The required rate of return on investment of the common shareholders of the company.
Three common methods for measurement
- Discounted cash flow (DCF)
Cost of retained earnings = D1/P0 +g
D1 = D0 * (1+g) - Capital asset pricing model (CAPM)
Cost of retained earnings = Risk-free rate + Risk premium
Risk premium = Beta * market risk premium = Beta * (market return - Risk-free rate) - Bond yield plus risk premium (BYRP)
Cost of retained earnings = pretax cost of L-T debt + market risk premium
WACC
The weighted average cost of capital is determined by weighting the cost of each specific type of capital by its proportion to the firm’s total capital structure.
The percentage equity and percentage debt in the capital structure is calculated using the market values of the outstanding debt and equity, if market values are available.
WACC = (E/V) Re + (P/V)Rp + (D/V) [Rd(1-T)]
Capital structure
The mix (or proportion) of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity
Optimal capital structure
The capital structure that minimizes the firm’s cost of capital and thereby maximizes the value of the firm
value of levered firm
= value of an unlevered firm + PV of the interest tax savings.
PV of interest tax savings = (T(rD)/r = T*D = tax * Amount of debt
Retention Ratio
Addition to R/Es divided by net income
retention ratio = 1- payout ratio
Growth rate (g) = (Return on asserts * Retention)/[1-(return on assets * retention)]
Financial leverage
Financial leverage is the degree to which a company uses debt rather than equity to finance the company.
Financial leverage added variability in earnings per share (EPS) and the risk of possible insolvency.
The presence of financial leverage is at the discretion of management.
motives for holding cash
precautionary motive
transaction motive
speculative motive
disadvantage of maintaining high levels of cash
The “negative arbitrage” effect (i.e., interest obligations exceed interest income from cash reserves).
Increased attractiveness as a takeover target.
Investor dissatisfaction with allocation of assets (i.e., failure to pay dividends)
Primary Methods of Increasing Cash Levels
Either speeding up cash inflows or slowing down cash outflows increases cash balances.
Credit Period
Credit period is the length of time buyers are given to pay for their purchases.
credit policy
Credit policy is one of the major determinants of demand for a firm’s products or services, along with price, product quality, and advertising. The credit policy of a company is typically established by a committee of senior company executives.
Credit standards
Credit standards refer to the required financial strength of credit customers. Extending credit to only financially strong customers minimizes uncollectible receivables, but also limits potential sales. Extending credit to a broader base of customers increases sales, but adds risk in that a greater percentage of receivables are likely to be written off.
Collection policy
Collection policy is measured by a company’s stringency or laxity in collecting delinquent accounts. This is also a balancing act between wanting to collect cash owed quickly versus maintaining positive relationships with customers.
Discounts
Discounts include the discount percentage and period. Offering discounts to customers who pay early may result in faster receivables collection, depending on the terms of the discount and the customer’s own cash needs and capacity to pay early.
Factoring
Factoring accounts receivable entails turning over the collection of accounts receivable to a third-party factor in exchange for a discounted short-term loan. Cash is collected from the factor immediately rather than from the customer according to the credit terms.
Types of inventory
Raw Materials: Inventory held for use in the production process.
Work-in-Process: Inventory in production but incomplete.
Finished Goods: Production inventory that is complete and ready for sale.
safety stock
Many companies maintain safety stock to ensure that manufacturing or customer supply requirements are met. The determination of safety stock depends on the following factors:
Reliability of sales forecasts
Possibility of customer dissatisfaction resulting from back orders
Stockout costs (the cost of running out of inventory), including loss of income, the cost of restoring goodwill with customers, and the cost of expedited shipping to meet customer demand
Lead time (the time that elapses from the placement to the receipt of an order)
Seasonal demands on inventory
reorder point
The reorder point is the inventory level at which a company should order or manufacture additional inventory to meet demand and to avoid incurring stockout costs. The reorder point can be calculated using the following formula:
reorder point = safety stock + (Lead time * sales during lead time)
EOQ
Two types of cost involved in EOQ
Ordering cost
* The costs of placing order, receiving and checking in goods
Carrying cost
* The cost of inventory storage, handling, and insurance, and opportunity cost over the period.
Purpose of EOQ: Minimize total ordering and carrying costs
Assumptions:
- Demand is known and is constant throughout the year. Not consider stockout costs, not count for costs of safety stock
- Carrying costs per unit and ordering costs per unit are fixed
EOQ = (2OS/C)^(1/2)
Supply Chain Operations Reference (SCOR) Model
There are four key management processes or core activities pertaining to SCOR: plan, source, make, and deliver
ordinary annuity
A series of equal payments or receipts occurring over a specified number of periods, payments or receipts occur at the end of each period.
annuity due
Payments or receipts occur at the beginning of each period.
Perpetuity
An ordinary annuity whose payments or receipt continue forever. PV = CF/i
DDM
Dividend discount model
Pt = Dt (1+G) / (R-G)
= Dt+1/ (R-G)
DCF
Discounted cash flow (DCF) analysis: determine the intrinsic value of an equity security by determining the present value of its expected future cash flows.
Step 1: Choose an appropriate model and forecast the security’s cash flows
- Dividend discount model (DDM) use the stock’s expected dividends as the relevant cash flows, e.g. Constant Growth DDM
- Free cash flow model: discount the cash flow left over by the firm after satisfying certain required obligations including working capital needs and fixed capital investment.
- Residual income model: the income left over after the firm satisfies the investor’s required return.
Step 2: Estimate the required return by selecting a discount rate methodology, such as CAPM.
Step 3: Apply to the appropriate DCF model to calculate the equity security’s intrinsic value and compare to its current market value.
