Brainscape's Knowledge GenomeTM

Browse over 1 million classes created by top students, professors, publishers, and experts.


See full index

Fin 301 > Final exam - Chapter 11 > Flashcards

Final exam - Chapter 11 Flashcards

1
Q

 Does the debt and equity mix matter for the firm
value?
ttt

A

Yes, as
If the financing mix matters for the firm value, we
would choose the capital structure that maximizes
stockholders’ wealth.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

 Does there exist the optimal financing mix of debt and Equity?
ttt

A

Yes
An optimal capital structure exists that just balances
the additional gain from leverage against the added financial distress cost.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

 The effect of financial leverage on cash flows and
cost of equity.
ttt

A

 When we increase the amount of debt financing,
we increase the fixed interest expenses.
 If we have a really good year, then we pay our
fixed costs and we have more left over for our
stockholders
 If we have a really bad year, we still have to pay
our fixed costs and we have less left over for our
stockholders
 Leverage amplifies the variation in both EPS and
ROE
- Stock would be riskier

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

 The impact of taxes and bankruptcy on capital
structure choice.
ttt

A 
Therefore, when a firm adds debt, it
reduces tax obligations, all else being
equal
The reduction in taxes increases the cash
flow to the firm (Can be viewed as a
Government subsidy)
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

Choosing a financing mix of debt and equity

A

(Capital Structure)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

 Primary firm’s goal

A

Maximize stockholder wealth

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

 If the financing mix matters for the firm value, we would choose the capital structure

A

that maximizes stockholders’ wealth.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

 We maximize the stockholders’ wealth by maximizing

A

the firm value given a level of debts.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

Firm Value

A

is the market value of assets
Or
sum of the market values of debt & equity

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

Capital restructuring involves

A

“changing the amount of leverage” a firm has without changing the firm’s assets

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

How to do Capital restructruing?

A

Increase leverage by issuing debt and repurchasing
outstanding shares of stock.
Decrease leverage by issuing new shares and retiring
outstanding debt

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

We want to see how changes in capital structure

affect the value of the firm, ____ ____ ____ ____

A

all else being equal

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

Since we want to see the effect of capital
restructuring on the firm value, we assume that
firm’s investment opportunity is _____.

A

fixed

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

What does the effect of capital restructuring (everything is fixed) imply?

A

no new net capital spending and no new NWC.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

unlevered firm

A

(100% equity financing company)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

unlevered firm formula for CFFA

A

Operating cash flow

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

What are 2 things that unlevered firms entail?

A
  1. The firm value is the present value of all future CFFA’s

2. All future CFFA’s are expected to be constant like a perpetuity because of no new investment opportunity.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q

What are the 2 Unrealistic Assumptions for now.

A

We assume
1) No Corporate Taxes
2) interest rate is constant regardless of the size of debt. (Under what condition would the interest rate be constant ?)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
19
Q

unlevered

CFFA becomes the

A

(=Net
Income in this
case)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
20
Q

 How does leverage (debt) affect the EPS and

ROE of a firm? (4)

A

 When we increase the amount of debt financing,
we increase the fixed interest expenses.
 If we have a really good year, then we pay our
fixed costs and we have more left over for our
stockholders
 If we have a really bad year, we still have to pay
our fixed costs and we have less left over for our
stockholders
 Leverage amplifies the variation in both EPS and
Ultimately, Stock would become riskier.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
21
Q

Modigliani and Miller Theory of Capital

Structure

A 
Proposition I – Firm value
The value of the firm is NOT affected by
changes in the capital structure
Proposition II – WACC
The WACC of the firm is NOT affected by
change in the capital structure
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
22
Q 
Proposition I – Firm value
The value of the firm is NOT affected by
changes in the capital structure
Proposition II – WACC
The WACC of the firm is NOT affected by
change in the capital structure
A

Modigliani and Miller Theory of Capital

Structure

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
23
Q

Cost of Equity
The variability of RA
is the firm’s ___ _____,
i.e., the risk of the firm’s assets

A

business risk

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
24
Q

The variability of (RA
– RD)(D/E) is the firm’s
________ _____, i.e., the additional return
required by stockholders to compensate for the
risk of leverage

A

Financial risk

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
25
Q

____ ___ ____ (__) increases as leverage

increases.

A

Cost of Equity (RE)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
26
Q

Therefore, the systematic risk of the stock

depends on: (2)

A
  1. Systematic risk of the assets, B^lowera , (Business
    risk)
  2. Level of leverage, D/E, (Financial risk)
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
27
Q 
Assumptions used: How realistic?
1. No Corporate Taxes
2. interest rate is constant regardless
of the size of debt.
How realistic?
A

Not realistic

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
28
Q

What are these known as?

Assumptions used:
1. No Corporate Taxes
2. interest rate is constant regardless
of the size of debt.

A

These are known as the “Perfect Market”

assumptions

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
29
Q

Now we formalize the Capital
Structure Theory Under Three
Special Cases

A 
Case I – Assumptions (We have already discussed this case)
------No corporate taxes
------No bankruptcy costs
Case II – Assumptions
------Corporate taxes
------No bankruptcy costs
Case III – Assumptions
------Corporate taxes
------Bankruptcy costs
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
30
Q

Interest payment is __ ______

A

tax deductible

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
31
Q

Therefore, when a firm adds debt, it leads to

A

Therefore, when a firm adds debt, it reduces tax obligations, all else being equal

32
Q

The reduction in taxes increases the cash

flow to the firm (Can be viewed as a ____ ______)

A

Government subsidy

33
Q

Interest Tax Shield

Formula

A

Tax rate times interest payment

T^lower C X (R^lower D * D)

34
Q

The interest tax shield every year will increase the firm value

A

by the PV of all

future interest tax shields

35
Q

Interest Tax Shield
Firm Value
Formula

A

V^L = V ^ U + DxT^lowerC

Value of unlevered firm + PV (annual tax shield)

36
Q

(R^lower D * D)

A

Interest payment

37
Q

Interest payment formula

A

(R^lower D * D)

38
Q

Firm Value future CFFA’s of unlevered firm =

A

CFFA^U
/
WAAC

39
Q

Firm Value future CFFA’s of unlevered firm =

What does it do?

A

Increase in debt -> decreases WACC

40
Q

The value of the firm increases by the present

value of the

A

annual interest tax shields

41
Q

Value of levered firm =

A

value of unlevered firm + PV

of interest tax shield

42
Q

Value of equity =

A

Value of the firm – Value of debt

43
Q

“Maximize firm value” is equivalent to

A

“Minimize weighted average cost of capital”.

44
Q

 The WACC decreases as D/E increases

A

because of decrease in the after-tax cost of debt

45
Q

(3) Bankruptcy Costs

A
  1. Direct costs
  2. Financial distress cost
  3. Indirect bankruptcy costs
46
Q

Bankruptcy Costs

Direct costs

A

Direct costs
Legal and administrative costs (accountant &
lawyer fee)
Ultimately cause bondholders to incur additional
losses
Disincentive to debt financing

47
Q

Bankruptcy Costs

Indirect bankruptcy costs

A

Larger than direct costs, but more difficult to measure
and estimate
Stockholders wish to avoid a formal bankruptcy filing
Bondholders want to keep existing assets intact so
they can at least receive that money
Assets lose value as management spends time
worrying about avoiding bankruptcy instead of running the business
Also have lost sales, interrupted operations and loss of valuable employees

48
Q

Bankruptcy Costs

Financial distress cost

A

Significant problems in meeting debt obligations
Most firms that experience financial distress do
not ultimately file for bankruptcy

49
Q

(4) Bankruptcy related terms

A

Business failure
Legal bankruptcy
Technical insolvency
Accounting insolvency

50
Q

Business failure –

A

business is terminated

with a loss to creditors

51
Q

Legal bankruptcy –

A

petition federal court

for bankruptcy

52
Q

Technical insolvency –

A

firm is unable to

meet debt obligations

53
Q

Accounting insolvency –

A

book value of

equity is negative

54
Q

Liquidation

A

Trustee takes over assets, sells them and
distributes the proceeds according to the
absolute priority rule

55
Q

Reorganization

A

Restructure the corporation with a provision to repay creditors

56
Q

 As the D/E ratio increases, (leads to)

A

the probability of

bankruptcy increases

57
Q

 This increased probability will increase the

A

expected bankruptcy costs

58
Q

Case III: Non-zero bankruptcy costs
 Thus the expected pizza size (CFFA) available
to creditors and shareholders ______.

A

shrinks

59
Q

 If the firm increases the debt,

A

the expected pizza

size for all future period would get smaller.

60
Q

Case III: Non-zero bankruptcy costs

The creditor would not be comfortable to charge
the _____ interest rate any more.

A

same

61
Q

Case III: Non-zero bankruptcy costs

 This implies the interest is ____ ____ ______

A

no longer constant.

62
Q

Case III: Non-zero bankruptcy costs
As the debt level increases, the additional value
of the ____ _____ ____ will be offset by the expected bankruptcy cost at some point.

A

interest tax shield

63
Q

 At this point, the value of the firm will start to
decrease and the WACC will start to ______ as
more debt is added because markets require
higher interest rate due to increase in default
chance (expected ____ ____ _____).

A

increase

financial distress costs

64
Q

According to the static theory, .

A

the gain from tax shield on debt is offset by

financial distress costs

65
Q

An optimal capital structure

A

exists that just balances

the additional gain from leverage against the added financial distress cost.

66
Q

In Sum

 Case I – no taxes and no bankruptcy costs

A

No optimal capital structure

67
Q

In Sum
 Case II – corporate taxes but no bankruptcy
costs

A

Optimal capital structure is 99.9999% debt
Each additional dollar of debt increases the cash
flow of the firm

68
Q

In Sum

 Case III – corporate taxes and bankruptcy costs

A

Optimal capital structure is part debt and part equity
Occurs where the benefit from an additional dollar of
debt is just offset by the increase in expected
bankruptcy costs

69
Q

The tax benefit is only important if the firm

has a ____ _____ _____

A

large tax liability

70
Q

Risk of financial distress
The greater the risk of financial distress, the
less debt will be ______ for the firm

A

optimal

71
Q

Capital structure does differ by _____

A

industries

72
Q

Two Important Decisions to be made by

Financial Managers.

A
  1. Investment Decision (Capital Budgeting decision)

2. Financing decision

73
Q

It is generally considered incorrect to
deduct the interest charges associated
with a particular project for two reasons:

A
  1. Profitability of the project should be
    independent of financing decision.
  2. The cost of capital (discount rate) already
    incorporates the cost of funds used to finance a
    project.
74
Q

Capital Structure definition:

A

Choosing a financing mix of debt and equity

75
Q

 Leverage amplifies the variation in both

A

EPS and ROE

76
Q

Cost of Equity formula (R^lower E)

A

RE = RA + (RA – RD)(D/E)

77
Q

What increases as leverage

increases.

A

Cost of Equity

Fin 301 (9 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2024 Bold Learning Solutions. Terms and Conditions