Ch11 Capital Structure Flashcards
Optimal capital structure
Mix of debt and equity that minimize cost of financing, thus minimizing cost of capital and maximizing value
Cost of capital represents the return that capital provider require on their invested funds
Cost of capital (WACC) = Return on invested funds
Lowest WACC = Optimal capital structure
Financial leverage
D/E ratio
D/Asset ratio
The proportion of debt / proportion of equity
The higher the financial leverage, the greater risk for investors
Higher ROI on debt, higher return on shares
Two aspects influencing debt availability
- nature of the operations and assets
- volatility of operating cash flows (stable)
- amount and type of assets owned (tangible assets) - level of probability of financial distress
Financial distress
- failur to meet current cash obligations
- legal proceedings: company’s creditors arrangement act / bankruptcy and insolvency act
debtors factor risks into higher interest rate when they assess an entity cannot generate enough cash flows to cover required payments, or amount of tanbible assets not enough to secure the debt
Cost of financial distress
- direct costs: legal and accounting fees
- indirect costs: loss of customers, reputation, and employees
Financial risk
Risk to equity investors when debt is added
Re - Ru (unlevered cost of equity - cost of equity)
M&M Proposition I
VL = Vu + TD
VL value of the levered firm
Vu value of the unlevered firm (no debt, all equity financed)
T tax rate
D amount of borrowed debt
M&M Proposition II
Re = Ru + D/E (Ru - Rd) (1 - T)
* only applicable when probability of financial distress is 0
used to assess how the cost of equity changes with debt when no financial distress exists
Ru is the cost of equity when the entity is “unlevered” (no debt)
Target capital structure
where WACC is the lowest
