Exam 3 Flashcards
the cost of using debt financing net of the tax savings due to the deductibility of interest expense.
after-tax cost of debt
a legal proceeding involving a business that is unable to fulfill its contractually required debt obligations. The process begins with a petition, either filed by the debtor or creditors. After the petition is filed the debtor’s assets are evaluated and a court decides which assets, if any, will be liquidated, which debts will be paid or forgiven, and which parties will control the firm when the proceedings are concluded.
bankruptcy
he costs a firm incurs when it files for protection from its creditors. These include lost sales, suppliers changing the terms of their contracts, difficulty in retaining and attracting talented employees, managerial distraction as well as legal and administrative expenditures.
bankruptcy costs
the volatility of cash flows generated by a firm’s assets. Since different firms have different assets, the business risk may be unique to a given firm or industry.
business risk
the fraction of the financing that is raised from lenders to fund the firm’s assets. It is denoted by the variable wD.
capital structure weight of debt
the fraction of the financing that is raised from owners to fund the firm’s assets. It is denoted by the variable wE.
capital structure weight of equity
the percentage of money raised from each source of capital, which in this class is stockholders and bondholders. The capital structure weights must some to one in order to account for all the financing.
capital structure weights
the minimum required rate of return by a bondholder to provide capital to a firm. This opportunity cost can be estimated by calculating the yield-to-maturity of a firm’s bonds that are currently trading in secondary markets.
cost of debt
the minimum required rate of return by a shareholder to provide capital to a firm. This opportunity cost can be estimated by using the Capital Asset Pricing Model (CAPM). Dividends paid to shareholders are not tax deductible, so the cost of equity and the after-tax cost of equity are one and the same.
cost of equity
a situation where the firm either is close to bankruptcy or enters bankruptcy
financial distress
when the firm gets close to bankruptcy without entering it, it will suffer from lost sales, suppliers changing the terms of their contracts, difficulty in retaining and attracting talented employees, and managerial distraction.
financial distress costs
the additional volatility that a manager imposes upon the shareholders by levering up. Increasing the D/E ratio takes the existing business risk and magnifies it from the perspective of the owners. This is because increasing leverage puts payments to the bondholders ahead of those to the residual claimants, the shareholders, in all states of the world, thus making their position riskier.
financial risk
The tax savings due to the deductibility on interest expense. The interest tax shield allows the manager to reduce the cash flow from the firm that goes to pay government taxes and use the savings to increase payments to the capital providers, the bondholders and stockholders.
interest tax shield
The extent to which debt is used to finance the assets of the firm. The manager tries to pick the leverage that will maximize the value of the firm.
leverage
decreasing the use of debt relative to equity to finance a firm’s assets. This is achieved by issuing stock in the primary markets and using the proceeds to repurchase bonds in the secondary market. Though no assets change in the transaction, the firm’s debt-to-equity ratio is reduced. In terms of a balance sheet, the assets on the left-hand side remain fixed while the claims on those asset represented by the right-hand side change.
levering down
increasing the use of debt relative to equity to finance a firm’s assets. This is achieved by issuing debt, typically bonds, in the primary markets and using the proceeds to repurchase shares of stock in the secondary market. Though no assets change in the transaction, the firm’s debt-to-equity ratio increases. In terms of a balance sheet, the assets on the left-hand side remain fixed while the claims on those asset represented by the right-hand side change.
levering up
the overall return that a set of assets must generate to compensate the capital providers for their opportunity costs, account for taxes, and account for the fraction of the funding coming from each of the capital providers. It is also known as the required return, discount rate, weighted average cost of capital, and WACC.
return on assets
the value of the firm is maximized when the marginal benefit from another dollar of debt due to the interest tax shield equals that dollar of debt’s marginal cost due to expected financial distress.
Static Theory of Capital Structure
a firm that is financed with 100% equity and thereby no debt
unlevered
a measure of volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
beta
the equation of the security market line (SML) showing the relationship between expected return and beta.
capital asset pricing model (CAPM)
the minimum required rate of return on an investment.
cost of capital
a term used interchangeably with asset-specific risk. A risk that is unique to an asset meaning that it can be reduced by holding a portfolio of assets that are uncorrelated.
diversifiable risk
the process of spreading investments across more than a single asset. Diversification reduces unsystematic risk by investing in a variety of assets
diversification
