Capital Structure Part 1 Flashcards
A bond will sell at a ______________ when the stated coupon rate on the bond is greater than the market interest rate on the bond at a given date.
premium
Which of the following types of bonds is most likely to maintain a constant market value?
Floating-rate bond
What bonds would automatically adjust the return on a financial instrument to produce a constant market value for that instrument. No premium or discount would be required since market changes would be accounted for through the interest rate?
Floating-rate
What bonds have, in effect, a fixed stated rate of return that would require assignment of a premium or discount to the underlying security to produce a market rate of interest if that market yield is different from the stated rate?
Zero-coupon
What financial product typically does NOT have an active secondary market?
Commercial Paper
Generally, what is the time frame for maturity on commercial paper?
Less than 270 days
The following are characteristics/advantages of which market?
-Avoids the expense of maintaining a compensating balance with a commercial
bank.
-Provides a broad distribution for borrowing.
-Accrues a benefit to the borrower because its name becomes more widely
known
The commercial paper market
What is a risk reward ratio, assuming standard deviation is a good measure of risk?
Mean return / Standard Deviation
Note: the higher the number, the better.
What is the formula for market capitalization?
number of common shares outstanding X fair market value per share
Note: Bonds are NOT part of this calculation!!!!
Which of the rate is most commonly compared to the internal rate of return to evaluate whether to make an investment?
The weighted-average cost of capital (WACC)
NOTE: The weighted-average cost of capital is frequently used as the hurdle rate within capital budgeting techniques. Investments that provide a return that exceeds the weighted-average cost of capital should continuously add to the value of the firm.
What is the rate of return required to cover the cost of resources employed?
“The overall cost of capital” a.k.a. “hurdle rate”
What can be used as a measure of the overall cost of capital, because it factors the company’s proportion of its cost of debt and its cost of equity?
The weighted-average cost of capital (WACC)
The optimal capitalization for an organization is usually determined by?
The lowest weighted-average cost of capital (WACC)
_________________ does not require any payment, it does not mature and, because it increases equity while having no effect on debt, it decreases the debt equity ratio and increases the credit-worthiness of the firm.
Common stock
What is the after tax WACC formula?
Calculate investment structure percentage.
Using: debt/total = debt percentage & equity/total = equity percentage (common and preferred separately if needed)
Multiply each times their respective cost of investment.
For debt only, account for tax effect and use the after tax #.
Add the two percentages together to derive the Weighted-average cost of capital (WACC).
Which portion of the WACC formula needs to be accounted for by the marginal tax rate (multiplied by 1 - tax rate)
DEBT
note. common and preferred stock are not subject to “tax effect” in the WACC calculation.
Cost of debt is measured as?
Cost of debt minus tax savings
What is typically the cheapest source of new capital (after tax)?
Bonds aka Debt
NOTE: Preferred stock does NOT have any tax advantage
When calculating net cost of debt, does the calculation use the “coupon rate” or “effective interest rate”?
Effective interest rate
When calculating annual/semi-annual disbursements of bonds/debentures, does the calculation use the “coupon rate” or “effective interest rate”?
Coupon rate
What is the formula for calculating the cost of preferred stock?
Dividend paid / Net Proceeds = Cost of preferred shares
Dividend paid = (par value x dividend %)
Net proceeds = pref stk sold price - flotation cost
Note: Flotation cost is the cost of issuing the stock, and therefore is subtracted from the sale price of the preferred stock.
What is the formula by which BETA measures inherent volatility/risk?
% change in stock price divided by % change in overall market price.
What does beta measure in the CAPM?
The volatility of a stock relative to the market
What is the CAPM formula?
R = RF + B (RM - RF)
R = Required rate of return on equity
RF = Risk-free rate earned on US treasury Bonds
B = Beta coefficient
RM = Expected Market Return
Cost of retained earnings = Risk Free Rate + [Beta x (Market return - Risk Free Rate)]
A capital investment whose rate of return is ______________ than the rate of return associated with the firm’s beta factor will increase the value of the firm.
Greater
Note: If the cap investment return is less than the beta factor return, the value of the firm will decrease.
Which of the following assumptions applies to the basic theory underlying the capital asset pricing model?
A single risk-free rate exists.
The market rate of interest on a one year US treasury bill is comprised of which two rates added together?
Risk Free Rate of Return + Inflation Premium = market rate of interest in a one year US treasury bill rate
Which of the following factors would not be relevant when determining the risk premium on a specific security?
A. Length of maturity.
B. Relative liquidity.
C. Relative seniority.
D. Earnings per share.
Choice “D” is correct. The risk premium on a security in essence compensates an
investor for the risk associated with the security’s cash flows. Earnings per share (EPS) is calculated by taking net income and dividing it by the number of common shares of stock outstanding. There is no additional risk component factored into the risk premium as a result of the EPS calculation.
______________________ is a factor in the risk premium, as the longer
the time period is until the security matures, the higher the risk associated with the investor receiving his/her cash flows.
Length of maturity
____________________ is a key component of the risk premium as the investor must be compensated for the extent to which a security can be sold without risking loss of principal.
Liquidity
Note: Higher (lower) liquidity will cause the risk premium to decrease (increase).
__________________ is an important factor with respect to risk premium, because the more senior the security is, the less risk associated with future cash flows for the investor
Relative Seniority
The three elements needed to estimate the cost of equity capital are:
- Current dividends per share (D)
- Expected growth rate in dividends (g)
- Current market price per share of common stock (P)
Cost of equity capital formula
R = (D1 / P0 ) + g
What is the cost of equity capital formula?
R = (D1 / P0 ) + g
Important step:
To obtain D1, Multiply D0 x (1+g)
Variable definitions:
D = current dividends per share
P = Current market price per share
g = expected growth rate in dividends
Using the discounted cash flow method, estimate the cost of retained earnings for a firm with a stock price of $30.00, an estimated dividend at the end of the first year of $3.00 per share, and an expected growth rate of 10 percent.
K = D/P + G
$3 dividend next period / $30 stock price + 10% growth
10% + 10% = 20% cost of retained earnings
What is the CAPM formula?
E = R + B * (M-R)
E = expected return on an asset
R = Risk-free rate (treasury bond)
B = Beta Coefficient
M = Market Rate of Return
