chapter 13 - capital structure

Question 1

Total Risk = Business Risk + Financial Risk

Answer 1

remember this fr

business risk no control
financial risk control

Question 2

What is return on invested capital?
* Does it vary with changes in capital structure?
* Does ROE vary with changes in capital
structure?

Answer 2

ROIC measures the after-tax return that the company provides for all its investors.
Best measure of business risk

ROIC doesn’t vary with changes in capital structure.
The mix of debt, preferred stock, equity doesn’t matter

ROE and ROA does vary with capital structure

Question 3

What is business risk? What are some factors
that determine business risk?

Answer 3

depends on business factors such as competition, product obsolescence and operating leverage

companies usually do not have influence on business risk

If there were higher business risk, then the probability of financial distress would be greater at any debt level, so the optimal capital structure would have less debt.
If business risk decreases, the optimal capital structure would have more debt
Total risk = business risk + financial risk

Question 4

What is operating leverage?

Answer 4

Operating leverage
Fixed versus marginal cost
The use of fixed costs rather than marginal =variable costs.

Question 5

If a company mainly has high fixed costs, does it have high or low operating leverage?

Answer 5

If most costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage. HIGH business risk
Airlines: A great example of high operating leverage
Why they need financial assistance from the government
GM during financial crisis another example

Question 6

Does operating leverage create more or less
business risk?

Answer 6

More operating leverage leads to more business risk,

Question 7

What is the pro and con of using operating
leverage to increase risk?

Answer 7

More operating leverage leads to more business risk,
A small sales decline causes a big profit decline.
A small sales increase causes a big profit increase.

Question 8

What does a firm’s optimal capital structure
mean?

Answer 8

Optimal Capital Structure:
The capital structure (mix of debt, preferred, and common equity) at which P0 is maximized.

If there were higher business risk, then the probability of financial distress would be greater at any debt level, so the optimal capital structure would have less debt.
If business risk decreases, the optimal capital structure would have more debt
Total risk = business risk + financial risk

Question 9

What is financial leverage?

Answer 9

Financial leverage
The use of debt and preferred stock.
DEBT IS A FIXED COST, interest on debt
So financial leverage INCREASES fixed cost
More debt –> more fixed cost, more financial lev

Question 10

• Does financial leverage create more or less risk?
• How does leverage affect firm profitability and
  debt coverage?

Answer 10

So financial leverage INCREASES fixed cost
More debt –> more fixed cost, more financial lev

Question 11

Describe the sequence of events in a
recapitalization

Answer 11

Firm announces the recapitalization.
New debt is issued.
Proceeds are used to repurchase stock.
The number of shares repurchased is equal to the amount of debt issued divided by price per share.
$10 million in net income, 1 million in shares, $50 stock price BUY 500,000 of the shares
$10 in dividends per share
$10 million / 500,000 = $20 dividends per share

A recapitalization is when a firm decides to issue debt and use the debt to buyback shares
Remember, dividends and earnings matter on a per share basis
So, reducing the number of shares will boost dividends per share and earnings per share

Question 12

What effect does more debt have on a firm’s
cost of equity?

Answer 12

For most situations, the firm has too little debt
If the firm increases the amount of debt; WACC?
DEBT IS LESS EXPENSIVE THAN EQUITY;
HOWEVER, using more debt increases the cost of debt and the cost of equity
WACC goes down as you use more debt WHEN you have too little debt.
If you increase equity, WACC will go up
1) issue more debt 2) buyback shares 3) pay more dividends.

If the firm has too much debt;
Using more debt will cause the WACC to go up.
If you increase equity, WACC will go down.
Buyback debt, issue equity; pay fewer dividends.

We want to minimize WACC

Question 13

What is the difference between business risk
and financial risk?

Answer 13

business risk: depends on business factors such as competition, product obsolescence and operating leverage

financial risk: depends only on the types of stocks/bond issued

Question 14

What is the Hamada Equation?
* What does the Hamada equation try to quantify the tradeoff between?

Answer 14

bL = bU*[1 + (1 – T)(D/E)]

quantify the increased cost of equity due to financial leverage

Question 15

What are the two ways to find a firm’s optimal
capital structure?

Answer 15

The firm’s optimal capital structure can be determined two ways:
Minimizes WACC.
Maximizes stock price.

Question 16

How do we select the firm’s optimal capital
structure given either WACC or the stock price?

Answer 16

The firm’s optimal capital structure can be determined two ways:
Minimizes WACC.
Maximizes stock price.

Both methods yield the same results.
The right amount of debt, preferred stock, and equity (common stock) to maximize the stock price and/or minimize the WACC

Question 17

Understand the relationship between target
capital structure and the level of business risk

Answer 17

The target capital structure is the mix of debt, preferred stock, and common equity with which the firm intends to raise capital.

Question 18

Recapitalization (important)

Answer 18

• During a recapitalization, the firm issues debt
  and uses the debt to buyback stock
• EPS typically increases because earnings divided
  among fewer shares
• Cost of debt/equity (risk) increases
• Stock price may go up or down
   Depends on which factor is more important:
  increase in earnings or increase in risk
• Tempting when interest rates are low

Question 19

What are some factors that affect a firm’s target
capital structure?
* Know whether the target debt or equity amount
will increase or decrease depending on a change
in a given factor like an increase in sales
volatility

Answer 19

The target capital structure is the mix of debt, preferred stock, and common equity with which the firm intends to raise capital.

As the firm borrows more money, the firm increases its financial risk causing the firm’s bond rating to decrease and its cost of debt to increase.
More debt, pay more interest
10 m debt, 5%; 7% ; 500,000 vs 700,000
Downgraded, pay higher interest rate on new debt. More interest + higher interest rate.

Question 20

What is the Modigliani-Miller Irrelevance
Theory?
* Why do we care about this?

Answer 20

The graph shows MM’s tax benefit vs. bankruptcy cost theory.
Firms reap tax benefits of debt because they can deduct interest expense
Firms incur bankruptcy costs because firms that are near bankruptcy find it harder to operate
Example: may have to pay cash up front for all product, trade credit not provided.

Question 21

what are signaling effects in capital structure?

Answer 21

Signaling theory suggests firms should use less debt than MM suggest because the unused debt capacity helps avoid stock sales
Firms generally don’t like issuing equity
Issuing equity depresses firm stock price because of signaling effects
So firms use less debt to keep a spare capacity to issue debt

Assumptions:
Managers have better information about a firm’s long-run value than outside investors.
Managers act in the best interests of current stockholders.

What can managers be expected to do?
Issue stock if they think stock price is overvalued.
Issue debt if they think stock price is undervalued.
Buyback stock or issue debt.
As a result, investors view a stock offering negatively; managers think stock is overvalued.

Question 22

(What are signaling effects in capital structure?)
* What will management do if they believe that the stock is overvalued?
* What if undervalued?
* Why do investors view stock offerings as
negative for the firm’s future prospects?

Answer 22

• What will management do if they believe that the stock is overvalued?
  Issue stock if they think stock price is overvalued.
• What if undervalued?
  Issue debt if they think stock price is undervalued.
• Why do investors view stock offerings as
  negative for the firm’s future prospects?
  Buyback stock or issue debt.
  As a result, investors view a stock offering negatively; managers think stock is overvalued.