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BEC Financial Management Flashcards > Financial/Capital Structure > Flashcards

Financial/Capital Structure Flashcards

1
Q

What is more inclusive, capital structure or financial structure?

A

Financial structure, which includes current and non-current liabilities as well as owners’ equity. Capital structure does not include current liabilities, only long-term debt and owners’ equity.

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2
Q

Describe the components of a firm’s financial structure.

A

All elements of liabilities (current and non-current) and owners’ equity of a firm constitute its financial structure.

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3
Q

What are financing options?

A

The alternative ways that funding may be obtained to carry out capital projects and other undertakings of an entity.

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4
Q

Describe the components of a firm’s capital structure.

A

All elements of long-term debt and owners’ equity.

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5
Q

Describe the concept of short-term financing.

A

Short-term financing involves:
1 - Obtaining funding through obligations (debt) that must be repaid within one year (current liabilities), or
2 - The use of current assets to obtain funding.

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6
Q

Identify at least five forms of short-term financing.

A
  1. Trade accounts payable
  2. Accrued accounts payable
  3. Short-term notes
  4. Lines of credit, revolving credit or letter of credit
  5. Commercial paper
  6. Pledging accounts receivable
  7. Factoring accounts receivable
  8. Inventory secured loans
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7
Q

What are the disadvantages of using short-term notes for short-term financing purposes?

A
  • Poor credit rating = High interest rate
  • Requires satisfaction in the short term
  • May require compensating balance or security
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8
Q

What is the meaning of cash discount terms of “2/10, n/30”?

A

The term “2/10, n/30” is a typical credit term.

  • The first digit (2) is the percentage discount offered by the seller.
  • The second digit (10) is the number of days within which the discount is available.
  • n/30 indicates that if the buyer does not pay the (full) invoice amount within the 10 days to qualify for the discount, then the net amount is due within 30 days after the sales invoice date.
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9
Q

Define “compensating balance.”

A

An amount that a borrower may be required to maintain in a demand deposit account with a lender as a condition of receiving a loan or other bank services.

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10
Q

List the advantages of using short-term payables (for financing purposes).

A
  • Ease of use
  • Flexible
  • Usually interest free
  • Usually no security required
  • Discounts may be offered for early payment
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11
Q

List the advantages of short-term notes (for financing purposes).

A
  • Commonly available for creditworthy firms
  • Flexible - amounts and periods (within one year) can be varied
  • Generally, no collateral required
  • Provide cash
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12
Q

List the disadvantages of using short-term payables (for financing purposes)

A
  • Require payment in the short term
  • Use-specific
  • Lost discounts increase cost
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13
Q

Describe trade accounts payable (also called trade credit) as a means of short-term financing.

A

Defers payment for goods or services provided by suppliers in the normal course of business. May carry the offer of a cash discount for early payment of obligation.

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14
Q

Why are cash discounts offered on trade accounts?

A

Cash discounts are offered to encourage early payment of amounts due on trade accounts.

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15
Q

Define “commercial paper.”

A

Short-term unsecured promissory notes sold by large, highly creditworthy firms as a form of short-term financing (i.e., 270 days or less).

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16
Q

Identify the advantages of commercial paper for financing purposes.

A
  • Large amounts can be obtained.
  • Interest rate generally lower than other short-term sources.
  • No collateral is required.
  • Provides cash for general use.
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17
Q

Identify the disadvantages of standby credit for financing purposes.

A
  • Poor credit rating = High interest rate
  • Usually involves a fee
  • Compensating balance may be required
  • Requires satisfaction in the short term
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18
Q

Identify the advantages of standby credit for financing purposes.

A
  • Commonly available for creditworthy firms
  • Highly flexible (debt is incurred only when needed)
  • No collateral required
  • May provide cash for general use
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19
Q

Define “letter of credit.”

A

A conditional commitment by a bank to pay a third party in accordance with specified terms and commitments (e.g., bank payment to a supplier upon proof that goods have been shipped to bank client).

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20
Q

Define a “revolving credit agreement.”

A

A revolving line of credit is a legal agreement between a borrower and a financial institution whereby the financial institution agrees to provide an amount of credit to the borrower. The line of credit may be borrowed, repaid, and then re-borrowed in a “revolving” or recurring manner.

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21
Q

Define “line of credit.”

A

An informal agreement between a borrower and a financial institution whereby the financial institution agrees to a maximum amount of credit that it will extend to the borrower at any one time. It is not legally binding on financial institution.

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22
Q

Distinguish between factoring accounts receivable “with recourse” and “without recourse.”

A
  • If accounts receivable are factored “without recourse,” the factor (buyer) bears the risk associated with collectability (unless fraud is involved).
  • It accounts receivable are factored are factored “with resource”, the factor (buyer) has resource against the selling firm for some or all of the risk associated with uncollectability.
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23
Q

Describe the user of an inventory-secured loan for short-term financing.

A

A firm pledges part or all of its inventory as collateral for a short-term loan.

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24
Q

Define “pledging of accounts receivable.”

A

The use of trade accounts receivable as collateral for a short-term, usually from a commercial bank or finance company.

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25
Q

Define “factoring of accounts receivable.”

A

The sale of trade accounts receivable to a commercial bank or other financial institution, called a “factor.” Sale may be “with recourse” or “without recourse.”

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26
Q

Describe a “floating loan agreement.”

A

The borrower gives a lien against all of its inventory to the lender but retains control of its inventory, which it continuously sells and replaces.

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27
Q

Identify the disadvantages of using inventory-secured loans for short-term financing.

A
  • It is not available for all inventory.
  • Pledged inventory may not be available when needed.
  • It is more costly than certain other forms of short-term financing.
  • It requires repayment in the short term.
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28
Q

Describe “long-term financing.”

A

Financing provided by those sources of capital funding that do not mature within one year (e.g., long-term notes, financial leases, bonds, preferred stock and common stock).

29
Q

Identify major forms of long-term financing.

A
  • Long-term notes
  • Financial (capital) leases
  • Bonds
  • Preferred stock
  • Common stock
  • Retained earnings
30
Q

Describe the concept of long-term financing.

A

Long-term financing involves obtaining funding through sources for which repayment is not due within one year, including sources that do not require any “repayment” (e.g., common or preferred stock). These sources of funding constitute the capital structure of a firm.

31
Q

Describe the use of long-term notes for long-term financing purposes.

A

Long-term notes are used for borrowings normally of from 1 to 10 years, but some may be of longer duration. Such borrowings usually require collateral and may have restrictive covenants but often permit repayment in installments over some period of time.

32
Q

Identify the advantages of leasing for long-term financing purposes.

A
  • Limited immediate cash outlay
  • Possible lower cost than purchasing
  • Possible scheduling of payments to coincide with cash flows
  • Debt (lease payments) is specific to amount needed.
33
Q

Identify the disadvantages of long-term notes for financing purposes.

A
  • Poor credit rating results in higher interest rate, greater security requirements, and more restrictive covenants.
  • Violation of restrictive covenants can trigger serious consequences.
34
Q

Define a net lease.

A

Lessee (using party) assumes the cost associated with ownership during the life of the lease, including maintenance, taxes, insurance, and so on.

35
Q

Define “long-term financing.”

A

Financing provided by those sources of capital funding that do not mature within one year (e.g., long-term notes, financial leases, bonds, preferred stock and common stock).

36
Q

Identify the disadvantages of leasing for long-term financing purposes.

A
  • Not all assets available for leasing.
  • Lease terms may prove different from the period of asset usefulness.
  • This method is often chosen over buying for noneconomic reasons (e.g., convenience).
37
Q

Define a net-net lease.

A

Lessee (using party) assumes not only the cost associated with ownership during the life of the lease, including maintenance, taxes, insurance, and so on, but also obligation for a residual value at the end of the lease.

38
Q

Describe the calculation of the current yield on a bond.

A

The ratio of annual interest payments to the current market price of the bond. It is computed as:
Annual interest payment / Current market price

39
Q

Define “bond maturity.”

A

The time at which the issuer repays the par value to the bondholders.

40
Q

Define “bond indenture.”

A

The bond contract, which sets forth such terms as face amount of bond, coupon or stated interest rate, maturity date, and so on.

41
Q

How is the selling price of a bond determined?

A

As the sum of the PV of future cash flows from:

  1. Periodic interest x PV of an annuity
  2. Maturity face value x PV of $1.

Both discounted using market rate of interest.

42
Q

Describe the yield to maturity for bonds (also called the expected rate of return).

A

The rate of return required by investors as implied by the current market price of the bonds; determined as the discount rate that equates present value of cash flows from the bonds with the current price of the bonds.

43
Q

Define “market rate risk.”

A

The risk of loss in the market value of outstanding bonds and other fixed rate instruments as a result of an increase in the market rate of interest during the life of the outstanding instrument. If the market rate of interest increases after an instrument is issued, the market value of the instrument will decrease.

44
Q

Define “bonds.”

A

Long-term promissory notes wherein the borrower, in return for buyers’/lenders’ funds, promises to pay the bondholders a fixed amount of interest each year and to repay the face value of the note at maturity.

45
Q

How is the cost of bond financing calculated?

A

The cost of financing with bonds is calculated as: Cost = Interest rate x (1.0 - marginal tax rate)

46
Q

How is the currently expected rate of return on preferred stock (PSER) determined?

A

PSER = Annual preferred dividend / Market price of preferred stock

Note: This expected rate of return is the current cost of outstanding preferred stock capital.

47
Q

Define “preferred stock.”

A

Ownership interest in a corporation that has certain preferences over common stock; often described as having characteristics of both bonds and common stock.

48
Q

Distinguish between cumulative preferred stock and noncumulative preferred stock.

A
  • With cumulative preferred stock, the dividend preference amount not paid in any year accumulates and must be paid before common dividends are paid.
  • With noncumulative preferred stock, the dividend preference amount not paid in any year does not accumulate; it is “lost” to the preferred stakeholder for that period.
49
Q

List the advantages of using preferred stock (for long-term financing).

A
  • No legally required periodic payments (i.e., dividends)
  • Lower cost of capital than common stock
  • Does not dilute common stock voting strength
  • No maturity date
  • No security required
50
Q

How is the theoretical value of a share of preferred stock (PSV) determined?

A

PSV = Annual preferred dividend / Investors’ required rate of return

Note:

  • The annual dividend is assumed to exist in perpetuity.
  • The investors’ required rate of return is a “discount rate.”
51
Q

Distinguish between convertible preferred stock and nonconvertible preferred stock.

A
  • With convertible preferred stock, preferred shareholders can exchange (convert) preferred stock for common stock according to a specified exchange plan.
  • With nonconvertible preferred stock, preferred shareholders cannot exchange (convert) their preferred stock to common stock.
52
Q

Define “callable preferred stock.”

A

The issuing firm has the right to buy back the preferred stock, normally at a premium.

53
Q

Distinguish between participating preferred stock and nonparticipating preferred stock.

A
  • With participating preferred stock, preferred shareholders can “participate” with common shareholders in receiving dividends in excess of the preferred preference rate.
  • With nonparticipating preferred stock, preferred shareholders cannot “participate” with common shareholders in receiving dividends in excess of the preferred preference rate; each period they receive only their preference rate of dividends.
54
Q

How is the cost of financing with newly issued preferred stock calculated?

A

The cost of financing with newly issued preferred stock is calculated as:
Annual dividend amount / Net proceeds from issue

Net proceeds from issue would be after deducting flotation costs.

55
Q

Identify the advantages of using common stock for long-term financing.

A
  • No legally required periodic payments (i.e., dividends)
  • No maturity date
  • No security required
56
Q

Describe the preemptive right of common stock.

A

The right of first refusal to acquire a proportionate share of any new common stock issued by a corporation.

57
Q

Describe the limited liability of common stock.

A

Common shareholders’ liability is limited to their investment in a corporation.

58
Q

Identify the disadvantages of using common stock for long-term financing.

A
  • Higher cost of capital than other sources
  • Dividends paid are not tax deductible
  • Additional shares issued dilute ownership and earnings per share
59
Q

How is the theoretical value determined for a share of common stock (CSV) that is to be held for multiple periods?

A

CSV = Dividend in 1st year / (Investors’ required rate of return - Dividend growth rate)

Note: Dividends are assumed to grow at a constant rate indefinitely.

60
Q

How is the expected return on currently outstanding common stock determined?

A

The expected return on currently outstanding common stock is calculated as:

CSER = (1st year Dividend / Market Price) + Growth Rate

The expected return is the current cost of financing with outstanding common stock.

61
Q

How is the cost of financing with newly issued common stock determined?

A

The cost of financing with newly issued common stock is calculated as:

(Annual Dividend Amount / Net Proceeds from Issue) + Growth Rate

Net proceeds from issue would be after deducting flotation costs.

62
Q

Define “operating leverage” and show how it is computed.

A

Operating leverage measures the degree to which a firm incurs fixed cost in its operations. Computed as: % change in operating income / % change in unit volume.

63
Q

Define “financial leverage” and show how it is computed.

A

Financial leverage measures the degree to which a firm uses debt financing. Computed as: % change in EPS / % change in EBIT.

64
Q

What macroeconomic conditions affect the cost of capital.

A

Market conditions and expectations concerning economic factors such as interest rates, tax rates, and inflation/deflation rates.

65
Q

What are some factors that influence the cost of capital to a firm?

A
  • Macroeconomic conditions (e.g., interest rates, tax rates, and inflation/deflation rates, etc.)
  • Past performance of the firm
  • Amount of total financing used
  • Relative level of debt financing
  • Length of debt maturity
  • Relative level of collateral provided
66
Q

Define the hedging principle of financing (also called the principle of self-liquidating debt).

A

Principle that focuses on matching cash flows from assets with the cash requirements needed to satisfy the related financing. Thus, long-term assets should be financed with long-term sources of capital, and short-term assets should be financed with short-term sources of financing.

67
Q

Generally, how do the costs compare of financing using long-term debt, preferred stock, and common stock?

A

Generally, the cost of long-term debt is lower than the cost of either preferred stock or common stock, and the cost of preferred stock is lower than the cost of common stock. However, as the level of long-term debt increase relative to equity, the cost of marginal debt increases due to the increased risk of default.

68
Q

What is the objective of optimum capital structure?

A

To minimize a firm’s aggregate cost of capital financing by using an optimum mix of debt and equity components; to achieve the lowest possible weight average cost of capital.

69
Q

Define “business risk.”

A

The risk of loss or other unfavorable outcome that results as variability in operating results increases; the higher the variability in a firm’s expected operating earnings, the greater the business risk (i.e., the increased chance that it may not be able to meet its debt obligations).

BEC Financial Management Flashcards (20 decks)

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