corporate issue Flashcards
target capital structure
percentage of debt, preferred stock, and common equity that a firm is striving to maintain and that will maximize the firm’s stock price. Each firm has a target capital structure, and it should raise new capital in a manner that will keep the actual capital structure on target over time.
If the target capital structure is known, it should be used.
If not, market values of debt and stocks should be used to calculate weights. That is, the company’s current capital structure is assumed to represent the company’s target capital structure.
If this is not possible, then trends in the company’s capital structure or averages of comparable companies’ capital structures should be used as targets.
cost of debt
cost to the firm in terms of the interest rate that it pays for ordinary debt (rd) less the tax savings that are achieved. Interest on debt is tax-deductible and therefore to calculate the cost of debt the tax benefit is deducted.
Issues in Estimating the Cost of Debt
Fixed-rate debt versus floating-rate debt
Estimating the cost of floating-rate debt is difficult because the cost depends not only on the current yield but also on the future yields. The term structure of interest rates may be used to calculate an average rate.
Debt with option-like features
Be aware that some debt can have call or put options. (Valuing such debts is a topic for Level II candidates.)
Non-rated debt
The yields of a firm’s debt may not be available, or a firm may not have rated bonds.
Leases
If a company uses leasing as a source of capital, the cost of these leases should be included in the cost of capital (long-term debt).
Cost of Preferred Stock
The cost of preferred stock is calculated by dividing the dollar amount of the dividend (which is normally paid on an annual basis) by the preferred stock current price.
It is important to note that tax does not affect the calculation of the cost of preferred stock, since preferred dividends are not tax deductible.
Adjusted beta =
(2/3) (Unadjusted beta) + (1/3) (1.0)
beta estimation for public companies, thinly traded public companies, and nonpublic companies;
thinly traded
levered beta = beta ( 1 + D(1-T)/E)
unlevered beta = beta (
Total Leverage =
Operating Leverage x Financial Leverage
Operating Leverage =
Contribution / EBIT
Financial Leverage =
EBIT/EBT
capital allocation process
planning expenditures on assets (fixed assets) whose cash flows are expected to extend beyond one year. Managers analyze projects and decide which ones to include in the capital budget.
“Capital” refers to long-term assets.
The “budget” is a plan which details projected cash inflows and outflows during a future period.
NPV =
CF / (1 + K)^t
where cf is expected cash flow,
k is cost of capital
NPV represents
amount of present-value cash flows that a project can generate after repaying the invested capital (project cost) and the required rate of return on that capital. An NPV of zero signifies that the project’s cash flows are just sufficient to repay the invested capital and to provide the required rate of return on that capital. If a firm takes on a project with a positive NPV, the position of the stockholders is improved.
NPV decision rules
The higher the NPV, the better.
Reject if NPV is less than or equal to 0.
Internal rate of return, NPV =
CF / (1 + IRR) ^t
discount rate that forces a project’s NPV to equal zero.
IRR decision rules
The higher the IRR, the better.
Define the hurdle rate, which typically is the cost of capital.
Reject if IRR is less than or equal to the hurdle rate.
