Chapter 17 Flashcards
What is more risky? Debt or stock?
Stock.
What is proposition 1?
A firm cannot change the total value of its securities just by splitting its cash flows into different streams: the firm’s value is determined by its real assets, not by the securities it issues.
Why is maximizing stockholder value good form the firm as well?
In general, any increase or decrease in firm total value caused by a shift in capital structure accrues to the firm’s shareholders.
Why is stock considered a levered equity?
Stockholders face the benefits and costs of financial leverage, or gearing. Lever up = borrow more and pay proceeds to shareholders.
What is the law of conservation of value?
Value of an asset is preserved regardless of the claims against it.
How does increasing the leverage affect earnings per share and share price?
Increases the expected earnings per share but not the share price. Because change in expected earnings stream is exactly offset by a change in the rate at which the earnings are discounted.
How to calculate WACC?
expected return on assets = (proportion in debtexpected return on debt) + (proportion in equityexpected return on equity)
What is the expected return on equity for a levered firm?
expected return on equity = expected return on assets + (expected return on assets - expected return on debt) * debt-equity ratio
What is proposition 2?
The expected return on the common stock of a levered firm increases in proportion to the debt-equity ratio, expressed in market values; the rate of increase depends on the spread between rA and rD. rE = rA if the firm has no debt.
How to understand the extra risk associated with a levered firm?
When the firm is unlevered, the investors demand a return of rA, when the firm is levered, the investors require a premium of (rA-rD)*D/E to compensate for the extra risk.
Other implications of the debt-equity ratios?
The debt equity ratio does not affect the dollar risk borne by equity holders, but it does amplify the spread of percentage returns.
How does debt-equity ratio affect required return on the firm’s assets?
It does NOT. However, when increasing leverage, rD will increase due to the firm having a higher level of debt, and rE will increase due to the firm having a higher debt/equity ratio.
How is beta affected by capital structure?
The beta of the total package does not change. However, both the debt and the equity are now more risky, so the beta of the debt and equity will both increase.
