Capital Structure Pt. 1 Flashcards
T/F: an entity’s capital structure is the mix of debt and equity used to finance operations and growth
True; debt includes short and long term while equity includes common and preferred
Common forms of short and long term debt
short: short-term notes payable, commercial paper, and line-of-credit arrangements
long: long-term notes payable, debentures, bonds, and finance leases
What is commercial paper?
an unsecured, short-term debt instrument issued by a corporation; it matures in 270 days or less (usually around the 30 day mark); the proceeds must be used to finance current assets or to meet short-term obligations
What are debentures?
an unsecured obligation of the issuing company; in the event of default, the holder of a debenture has the status of a general creditor; risks associated with debentures may be mitigated by a negative-pledge clause that stops a company from pledging assets to additional debt
What are subordinated debentures?
a bond issue that is unsecured and ranks behind senior creditors in the event of an issuer liquidation; it commands higher interest rates than debentures to allow for additional risk
What are income bonds?
securities that pay interest only upon achievement of target income levels; they represent a risky bond that typically is only used in reorganizations
What are junk bonds?
they are characterized by high default risk and high return; they are classified as “noninvestment grade” bonds by the major credit rating agencies given their more likely default on principal and/or interest payments by the issuer; they are frequently used to raise capital for acquisitions and leveraged buyouts
What are mortgage bonds?
a loan that is secured by residential or commercial real property; mortgages are usually pooled together and issued as mortgage bonds with bondholders protected from default by a lien on the pooled real property assets; a distinguishing feature is that trustees act on behalf of bondholders to foreclose on mortgage assets in the event of default
What is leasing?
a contractual agreement in which the owner of an asset, the lessor, allows another party, the lessee, to use the property in exchange for periodic lease payments
a lessee will classify a lease on its books as either an operating lease or a finance lease; both types will result in the lessee recording 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
What is equity financing?
it involves the issuance of equity securities (common stock and preferred stock) that represent different forms of ownership of the company; a distinguishing feature of equity securities is the rights of shareholders to a firm’s assets in a bankruptcy (liquidation) are less than that of both secured and unsecured bondholders
T/F: 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
True; the mixture of debt and equity financing that produces the lowest WACC maximizes the value of the firm
What is weighted average cost of capital (WACC)?
the average cost of debt and equity financing associated with a firm’s existed assets and operations
Formula: WACC = (E/V)(Re) + (P/V)(Rp) + (D/V)[Rd(1-T)]
E = common stock equity
P = preferred stock equity
D = debt
T = corporate tax rate
R = required rate of return of the various components (aka cost)
V = summed market values of the individual components of the firm’s capital structure
How is the weighted average interest rate calculated?
weighted average interest rate = effective annual interest payments / debt outstanding
How is the after-tax cost of debt calculated?
after-tax cost of debt = pretax cost of debt * (1 - tax rate)
T/F: debt carries the lowest cost of capital and the interest is tax deductible
True; the higher the tax rate, the more incentive exists to use debt financing
