Capital Structure Pt. 2 Flashcards
What is the optimal cost of capital?
the ratio of debt to equity that produces the lowest WACC
Loan covenants and capital structure
if a borrower’s capital structure is heavily weighted toward equity, its financial leverage will be low and its fixed obligations associated with debt will be relatively minimal
when a borrower has a significant amount of outstanding debt relative to equity, loan covenants will typically increase and become more stringent because there is more risk for the lender
What is the growth rate?
it is associated with a company’s earnings and is a key component of financial valuation; a company’s annual earnings are allocated between dividend payments to shareholders and retained earnings
Calculation: 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
Influence of capital structure
an entity’s capital structure influences its growth rate; the retention ratio is influenced by the level of equity; dividends paid to shareholders increase the dividend payout ratio and decrease the retention ratio and the overall growth rate
What are some ways to measure profitability?
return on sales (ROS): income before interest income, interest expense, and taxes / net sales
return on investment (ROI): net income / average invested capital
return on assets (ROA): net income / average total assets
return on equity (ROE): net income / average total equity
T/F: the higher an entity’s debt, the greater the impact of interest expense on net income
True; dividend payments affect these ratios in the sense that dividend payments reduce assets and retained earnings (equity)
T/F: leverage is a significant consideration as a factor in designing capital structure
True; financial managers must consider both operating leverage and financial leverage
What is operating leverage?
the degree to which a company uses fixed operating costs rather than variable operating costs; capital-intensive industries (hospital) often have high operating leverage while labor-intensive industries (big box retailer) generally have low operating leverage
a company with high operating leverage must produce sufficient sales revenue to cover its high fixed costs; it will also have greater risk but greater possible returns; if sales decline, it may become difficult to cover its fixed costs
What is 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 to which a company uses debt rather than equity to finance the company
a company that issues debt must produce sufficient operation 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 EBIT (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
What is a levered firm?
a company that has debt in its capital structure, whereas an unlevered firm has only equity; a firm that uses debt benefits from tax deductibility of the interest payments; below is the formula for calculating the value of a levered firm, assuming the debt is permanent
value of a levered firm = value of an unlevered firm + present value of the interest tax savings
present value of interest tax savings = [corporate tax rate * (interest rate on debt * amount of debt)] / interest rate on debt
What are some ways that solvency can be measured?
solvency is a company’s ability to meet its long-term obligations
total debt ratio = total liabilities / total assets…it provides indications related to an organization’s long-term debt-paying ability; the lower the ratio, the greater the level of solvency and the greater the presumed ability to pay debts
debt-to-equity ratio = total liabilities / total equity…relates the two major categories of capital structure to each other and indicates the degree of leverage used; the lower the ratio, the lower the risk involved
equity multiplier = total assets / total equity…on the BS, total assets = total assets + total equity; a greater percentage of debt utilized by the firm results in more assets allocated to debt relative to equity and a higher equity multiplier
times interest earned ratio = EBIT / interest expense…measures the ability of the company to pay its interest charges as they come due; it is a measure of long-term solvency
