Chapter 10 Flashcards
Lower cost of capital maximizes the value of the firm in 2 ways:
- lower discount rate yields higher present value of existing cash flows.
- firm value goes up because it can implement more projects at a lower cost of capital.
financial leverage:
Share of debt in capital structure of the firm.
Financial leverage can be calculated in 2 ways:
- debt-to-equity ratio = debt/MCAP
- weight of debt = debt/firm value
If debt-to-equity ratio is 1:2 then weight of debt is?
1/(1+2)= 1/3
- the two equations are directly related.
The choice of share of debt is referred to as:
Capital structure decision
What are the three explanations to rationalize firms capital structure choices?
Static trade-off theory, pecking order theory, and market timing (path dependency).
Static trade-off theory rationalizes modest debt ratios through what equation?
Firm value = value of unlevered firm + tax shield - bankruptcy cost
Larger tax shield pushes firm value ____
up
Higher costs of financial distress _______ firm value
lower
V(levered) = ?
V(unlevered) + tax shield - bankruptcy cost
Companies in industries with marketable tangible assets will have ___________ due to ___________
larger share in capital structure, lower bankruptcy cost
Companies with a high share of research and development spending tend to _________ to avoid additional ____________
borrow less (less debt), disclosures regarding their products
Regulated firms will have _________
Higher levels of debt.
Firms operating in fast-paced environments require __________ and operate at _________ that minimizes ____ in static trade-off theory.
a higher degree of financial flexibility, below-optimal share of debt, WACC
Pecking order theory revolves around:
The concept of information asymmetry (unequal distribution of information)
In pecking order theory 3 sources of financing are used:
- reinvested earnings
- debt
- new equity
Market timing suggests that:
Firm managers take into account market conditions to raise capital. They issue equity when stock valuations are high, or debt when interest rates are low.
Path dependency is viewed as:
market timing over long periods of time.
High share of marketable tangible assets and low level of research and development suggest:
Higher level of leverage relative to other industries.
Sharp increase in retained earnings coupled with decrease in the number of shares outstanding point to:
Pecking order explanation.
