Finance - Capital Structure - Overview and In-depth Flashcards
What is the optimal capital structure
It depends on:
1. Nature of the company and its asset
2. Amount of debt that is available to an entity and related cost
3. Impact on the company’s current cost of debt & equity as debt is added
- Private companies might face difficulty raising additional equity in cases where all current shareholders have provided all the equity capital they can afford
Explain what financial leverage is
Financial leverage - proportion of debt to proportion of equity that has been used to finance the company
Financial ratios - such as the debt-to-equity ratio or the debt-to-asset ratio, measure the degree of financial leverage
What is the difference between operating risk and business risk and explain operating leverage
Business risk - arises from the variability of the firm earnings due to the nature of the industry
Operating risk - is the volatility of earning due to the cast structure of the firm
Operating leverage - increase in volatility in operating income caused by fixed cost. Costs do not change based on the volume of sales of production
What are three factors of the probability of financial distress
- Debt is always paid first, lenders bear less risk than an investor in equity
- The cost of debt is always cheaper than the cost of equity for a specific entity
- Debt lenders assume that there are adequate operating cash flows and or there is enough collateral, they are comfortable lending at relatively low interest rate
Collateral - Asset pledge as security for payment of a debt, lender can seize the asset. The cost of debt is cheaper than the cost of equity interest, tax-deductible
What is the formula that relates to the cost of equity with change in debt
Re= Ru + D/E (Ru - Rd)(1-T)
Re - cost of equity
Ru - Cost of equity when the entity is unleveled - no debt
D/E - Debt to equity ratio for the company based on market value
Rd - entity cost of debt
T - tax rate
Financial risk-return - the added amount determined theoretically by the formula and represents the added risk to the equity
What is the impact on the value of the firm as capital structure change
- WACC calculation uses current market values of debt and equity to determine the weighting of debt and equity in the formula
Impact of coverage on the value of a company assuming no financial distress
VL = Vu +TD
VL - value of the levered firm
Levered - capital structure that has a mix of debt and equity
Vu - value of the firm in the unlevered state
T= The corporate tax rate
D= amount of borrowed debt
