M2 Capital Structure: Part 2 Flashcards
What is the optimal cost of capital?
The ratio of debt to equity that produces the LOWEST WACC
Formula to calculate the growth rate
g = ROA * Retention / 1 - (ROA * Retention)
Retention = (1 - Dividend Payout)
Return on sales formula
ROS = Inc before int incom, int exp and taxes / sales (net)
NI
(Interest income)
+Interest expense
+Tax expense
Return on Investment Formula
ROI = Net Income / Avg Invested Capital
Avg invested capital = (Assets - operating leverage)
Return on Assets formula
ROA = Net Income / Average Total Assets
Return on equity formula
ROE = Net Income / Avg total equity
The degree to which a company uses fixed operating costs rather than variable operating costs
operating leverage (i.e. higher op leverage if fixed salaries over commissions)
Use of debt rather than equity
Financial Leverage
A company that has debt in its capital structure
Levered firm
Calculation for value of a levered firm
= value of an UNlevered firm * PV of Interest tax savings
PV of int tax savings = T * (rdebt * d) / r debt
Total debt ratio
Total L / total A
Debt to equity ratio
Total L / Total E
Equity Multiplier
Total A / Total E
Times Interest Earned Ratio
EBIT / Interest expense
the degree to which a firm uses fixed operating costs as opposed to variable operating costs
operating leverage
FC/VC
How to back into EBIT when you are given the tax rate?
X * (1-T) = earnings after tax
x = EBIT
*Also remember to add back the interest expense
What is the risk to having high operating leverage?
Must produce sufficient sales to cover the high fixed-operating costs
more risky but has higher potential for return
*firm with high op leverage, has higher fixed costs vs variable
A less risky entity would have a ___ debt ratio?
LOWER
Debt ratio = Total L / Total A
Basic EPS formula
NI - PD / WACSO
Calculate operating leverage?
% change in EBIT / % change in unit sales volume
Calculate financial leverage?
%change in EPS / % change in EBIT
Calculate combined leverage?
Degree of operating leverage * degree of financial leverage
OR
% change in EPS / % change in unit sales volume
from SIM writing: advantages and disadvantages of debt vs equity financing (bullet points)
Advantages -
-after-tax cost (interest expense deduction) - no tax deduction for equity
-debt holders must be paid interest before stockholders receive dividends so debt is “safer investment’ from investor perspective”
Disadvantages -
-less attractive to creditors (impact to debt to equity ratio, times interest earned, etc.)
-Fixed cost for the company whereas dividends are at discretion so debt interest pymts MUST be met to avoid default. can be more problematic in difficult economic environments where cash may be constrained
SIM MISTAKE!! - in calculating ratios, make sure to do what with the results if in percentage as opposed to decimals???
MOVE THE DECIMALS!
