M1 Capital Structure: Part 1 Flashcards
Definition: The mix of debt (LT and ST) and equity (common and preferred) used to finance operations and growth
Capital Structure
Type of financing that includes short-term notes payable, commercial paper, and LOC arrangements; LT notes payable, debentures, bonds and finance leases
Debt financing
type of debt financing definition: unsecured, ST debt instrument issued by a corporation that matures in 270 days or less and typically matures in 30 days
Commercial Paper
The proceeds MUST be used to finance current assets such as AR or inventory or to meet ST obligations
type of debt financing definition: an unsecured obligation of the issuing company
Debenture
Holder has the status of a general creditor
type of debt financing definition: a bond issue that is unsecured and ranks behind senior creditors in the event of an issuer liquidation; command higher interest rates to allow for additional risk
Subordinated Debenture
type of debt financing definition: represent securities that pay interest only upon achievement of target income levels
Income Bonds
type of debt financing definition: high default risk and high return; classified as “noninvestment” grade bonds by the major credit rating agencies given their more likely default on principal and interest payments by the issuer
Junk bonds
(used to raise capital for acquisitions and leveraged buyouts)
type of debt financing definition: loan that is secured by residential or commercial real property; trustees act on behalf of bondholders to foreclose on mortgage assets in the event of default
Mortgage Bonds
type of debt financing definition: represents a contractual agreement in which the owner of an asset allows another party to use the property in exchange for periodic lease payments
Leasing
Lease new rules: Two types of leases and they result in the lessee recording what on the balance sheet?
Operating Lease
Financing Lease
Lessee must record a right-of-use (ROU) asset and a lease liability on the balance sheet
(ROU asset is amortized and the lease liability is paid down over the life of the lease)
Lease rules: For an operating lease, what is recorded and how on the income statement?
Lease Expense (represents interest and the amortization) on the income statement for every payment made
Lease rules: For a finance lease, what is recorded and how on the income statement?
Interest Expense AND Amortization Expense accounted for SEPARATELY on the income statement
Lease rules: what is the exception to the presentation rules?
A lessee can make an accounting policy election to NOT recognize ROU assets and lease liabilities for leases with terms of 12 months or less
Lease rules: In order for a lease to be classified as a finance lease, what are the five criteria that it has to meet at least one of? (mnemonic)
OWNES
O = Ownership transfer at end of lease
W = Written purchase option that the lessee is reasonably certain to exercise
N = Net present value of all lease payments and guaranteed residual value is equal to or substantially excees the underlying asset’s fair value
E = Economic life of the underlying asset is primarily encompassed within the term of the lease
S = Specialized asset such that it will not have an expected alternative use to the lessor when the lease ends
*or if Short Term (12 months or less) = operating lease
Financing that involves the issuance of stock securities that represent different forms of ownership of the company; the rights of shareholders to a firm’s assets in a bankruptcy are less than that of both secured and unsecured bondholders
Equity Financing
Type of equity financing that is a hybrid equity security having features similar to both debt and equity; require a fixed dividend payment to their holders but the dividend payment is at the discretion of the BOD and not tax deductible
Preferred Stock
Type of equity financing that represents the basic equity ownership security of a corporation; includes voting rights with optional dividend payments by the issuer; has the lowest claim to a firm’s assets in a liquidation
Common Stock
Definition: the average cost of all forms of financing used by a company; often used internally as a hurdle rate for capital investment decisions
Weighted Average Cost of Capital (WACC)
Weighted Average Cost of Debt Computation (AKA Pretax Cost of Debt)
Effective annual interest payments / Debt outstanding
After Tax Cost of Debt Computation
Pretax Cost of Debt * (1 - Tax Rate)
Cost of Preferred Stock Computation
Preferred Stock Dividends / NET proceeds of preferred stock
*NET PROCEEDS - subtract out and issuance or flotation costs
Cost of Retained Earnings: The cost of equity capital obtained through retained earnings is equal to the rate of return required by the firm’s common stockholders. A firm should earn at least …
As much on any earnings retained and reinvested in the business as stockholders could have earned on alternative investments of equivalent risk
Three Methods of Computing the Cost of Retained Earnings
1.) Capital Asset Pricing Model (CAPM)
2.) Discounted Cash Flow (DCF)
3.) Bond Yield Plus Risk Premium (BYPR)
Capital Asset Pricing Model Formula (CAPM)
Risk free rate + [Beta * (Market Rate - Risk Free Rate) ]
From CAPM, what is the formula for the market risk premium (MRP)
Market Rate - Risk Free Rate
Discounted Cash Flow (DCF) Formula
D1 / P0 + Growth Rate
D1 is the future dividend per share:
D0 (dividend today) * (1 + Growth)
If growth rate isn’t given:
ROE (Net Income / Equity) * (1 - dividend payout)
Bond Yield Plus Risk Premium (BYRP) Formula
Pretax cost of long-term debt + Market risk premium
Pretax cost of LTD = effective annual interest payments
/ debt outstanding
Market risk premium = Market Rate - Risk Free Rate
definition: Rate of return on assets that covers the costs associated with the funds employed
cost of capital
What type of bond is most likely to maintain a constant market value?
Floating-Rate
What is another way of saying “risk-free rate” in CAPM formula
Bond Yield
Market rate of interest calculation?
Risk Free rate + Inflation premium
Pretax cost of debt formula?
effective annual interest payments / debt outstanding
OR stated effective interest rate (Market rate, YTM, etc.)
Formula for market capitalization
Number of common shares outstanding * FMV per share
From Sim #2: How to calculate value of equity using Sector PE
Net Income * P/E Multiplier (given)
From Sims: How to calculate total market value of bonds
Par value * current market value /per 1,000 bond
From Sim #2: What is the value of equity using the dividend discount model (DDM)?
Current dividends D0 * (1+ growth rate) /
Cost of equity - growth
What is the Weighted Average Cost of Capital (WACC) Formula?
A = L + PE + CE
L = interest rate AFTER tax so interest rate (1-T)
P = weighted % an then 8.4 percent is decimal
C = “”
What is the beta coefficient’s formula in the CAPM formula?
% change in stock price / % change in market price
What is the capital asset pricing model formula? (CPM)
R = RF + b (RM-RF)
R = required return rate on equity
RF = risk-free rate earned on US Treas bonds
b = Beta coefficient
RM = expected market return (earnings)
OR Cost of retained earnings =
RF rate + [ beta * (market return - RF rate)]
Market return - RF rate = Market risk premium
Formula for debt ratio?
total debt / total assets
*if not given, use equation to figure out missing piece A = L + E
times interest earned ratio
EBIT / Int exp
In laymen terms, WACC is really what?
Hurdle rate whether company will take on a project (if lower, then wouldn’t accept the project)
*objective may be to lower/minimize WACC so you can be more attractive and take on more projects
