Section 3A Flashcards
Larson Corp. issued $20 million of long-term debt in the current year. What is a major advantage to Larson with the debt issuance?
The reduced earnings per share possible through financial leverage
The relatively low after-tax cost due to the interest deduction
The increased financial risk resulting from the use of the debt
The reduction of Larson’s control over the company
The relatively low after-tax cost due to the interest deduction
Interest expense is deductible for income tax purposes, while dividends on equity are not deductible. This reduces the after-tax cost of issuing debt as compared to issuing equity.
Advantages of long-term debt financing
Ownership of the company is not shared with the debt holder. T/F
No matter how profitable an organization is, the bond holder will still only receive the same semi-annual interest payments over the life of the bond. Operating income in excess of the bond interest goes to the equity holder. T/F
The interest on the loan is a fixed amount that can be budgeted, or in the case of a variable interest rate, the interest for a particular period can be adequately estimated. t/f
The interest paid on the debt is a not tax-deductible expense; the tax shield lowers the effective after-tax cost of the debt. t/f
Raising debt capital is less complicated than issuing either preferred or common stock. T/F
Some debt issues have call provisions that supply flexibility to the issuing firm. T/F
True
True
True
False - it is tax-deductible
True
True
Disadvantages of long-term debt financing
Long-term debt frequently has various restrictive covenants that can dramatically limit choices available to management. T/F
If interest rates fall, a firm could be locked into a high interest rate T/F
Long-term debt has a maturity date at which time the principal needs to be repaid. Interest payments are a fixed cost that increase the breakeven point of the firm. Interest must be paid whether a profit is made or not Debt increases the financial leverage (risk) of the company, and the higher the leverage, the less flexibility a company has for raising future financing.
True
True
true
true
true
According to the hedging approach to financing, seasonal variations in current assets should be financed with:
common stock.
long-term debt.
retained earnings.
short-term debt.
RATIOS/FORMULAS
Cost OF PREFERRED STOCK COST OF DEBT COST OF RETAINED EARNINGS COST OF EQUITY WEIGHTED AVG COST OF CAPITAL
short-term debt.
Cost OF PREFERRED STOCK
(Dividend/(Mkt price(1-flotation cost))+divid growth rate
COST OF DEBT
Principal amount of debt x (1-marginal tax rate)
COST OF RETAINED EARNINGS
krm = (Dividend / Price of stock) + Growth rate in divid
COST OF EQUITY
(dividend/price)+growth %
MKT VALUE OF STOCK
(Divdiend/(current price - underprice - flotation) + expected annual growth rate)
As discussed earlier, financial leverage is created through the use of ___
Financial structure (use of debt and equity) is influenced by:
- Mgmt’s __toward risk
- Industry Norm
- Anticipated future ___rate
- Lenders’ __toward the industry
Whenever additional long-term funds are needed, management can choose between debt and equity. Long-term debt is likely to be used when:
- Sales and profits are estimated to be __
- anticipated profits are enough to make good use of__
- control through __privelige is important
- Existing capital structure has a low use of debt t/f
- Requirements/covenants of debt are not difficult t/f
debt.
attitude
True
growth
attitude
stable/increase leverage voting True True
FINANCING APPROACHES
Current assets can be further divided into:
___assets that would include assets that would fluctuate with the business cycle
___assets that would include assets that are more permanent in nature in that they are carried even at the low points of the business cycle such as the minimum accounts receivable and inventory levels during the lowest part of the business cycle.
temporary current
permanent current
FINANCING APPROACHES
The ___ to financing short-term debt uses permanent assets to finance all of the permanent operating assets requirements and also some of the seasonal needs.
…..__(accounts payable) is used to finance the remaining seasonal needs
The \_\_\_approach to financing matches assets to liability maturities. .........The difficulty with \_\_\_is that imperfect estimates are used in determining the lives of assets The \_\_\_to financing short-term debt would be to finance part of the permanent current assets with spontaneous credit such as accounts payable.
conservative approach
Spontaneous credit
maturity matching
maturity matching
aggressive approach
The right side of the balance sheet represents the sources of funds used to finance a company. These sources are:
(1) short-term debt.
(2) long-term debt.
(3) preferred stock.
(4) common stock.
(5) retained earnings.
When considering each of the above types of financing, management must consider:
(1) cost.
(2) risk.
(3) the lender's point of view of the
investment alternatives.
YEP
____is the risk that receivables will not be collected in full on a timely basis. Increased risk includes costs related to bad debt losses, higher receivable balances resulting in higher carrying costs, higher customer investigation fees, and collection costs.
This risk can be evaluated by looking into the customer’s:
- Character
- Capacity
- Capital Position
- Collateral
- General Economic Conditions
Credit risk
____is the risk that the borrower will be unable to make interest and/or principal payments as scheduled on the obligation.
\_\_\_are considered to be default risk free.
Default risk
U.S. Treasury bonds
A company is trying to determine the cost of capital for a major expansion project. A survey of commercial lenders indicates that cost of debt is currently 8% based on the company’s debt ratio of 40%. The company complies with this requirement and has determined that a stock issuance would require a 10% return in order to attract investors. Which of the following is the company’s cost of capital?
9.2%
WACC = (.40 × .08) + (.60 × .10)
= .032 + .06
= .092, or 9.2%
he company’s cost of capital (COC) is 9.2%. In the COC computation, the COC is weighted for the cost of debt (40%) and the cost of equity (100% − 40% = 60%).
According to the pecking order theory, which of the following will companies prefer to use first?
Adjusting dividend policy
Internal financing
Outside financing
Debt financing
Internal financing
The ___indicates that the order of financing of a company (or project) follows the path of least effort.
This path follows this order
- Internal Financing
- . __policy will be adapted to financing needs
- Outside financing with the ___ security, then __ securities, then __ securities
pecking order theory
True
Dividend
cheapest, hybrid, equity
Items that management may wish to consider when making capital structure decisions would include the following:
- ___Flexibility
- ___Position
- ____Rate
- ___Comparison
- ___Funds
- Risk
- ___Value
Finacial Tax Interest Industry Internal True Stock
Optimal capital structure
Finance theory indicates that the goal for a firm should be to __its weighted-average cost of capital.
Provide a ___ for debt
Find an optimal range of ____ ratio
minimize
tax shield
debt-to-equity
Key elements in making capital structure decisions include the following:
___A firm whose sales are stable can take on more debt than a firm with unstable sales.
____Firms with assets that are suitable to be pledged as security for a loan can use debt more heavily than firms with special purpose assets.
___Firms with less operating leverage are better able to employ financial leverage.
___: Faster-growing companies are more likely to rely more heavily on debt.
___: Firms with high profitability are better able to support more of their financing needs with internally generated funds.
___: The higher a firm’s marginal tax rate, the greater the advantages of using debt.
___: Management can exercise judgment as to the appropriate capital structure.
Sales stability: Asset structure: Growth rate Profitability Taxes Management attitude
A company with a combined federal and state tax rate of 30% has the following capital structure:
Weight Instrument Cost of Capital
—— ————— —————
40% Bonds 10%
50% Common stock 10%
10% Preferred stock 20%
What is the weighted-average after-tax cost of capital for this company?
9.8%
The cost of debt is the before-tax rate. Since interest expense is a tax-deductible item, thus providing a depreciation shield, an after-tax cost must first be determined:
After tax cost of debt = 10% x (1-30%)= 7%
Capital Item Weight Cost Weighting Factor
Debt 40% 7% 2.8%
Preferred Stock 10% 20% 2.0%
Common Stock 50% 10% 5.0%
—- —-
100% WACC 9.8%
Sen Corp., a publicly traded, mid-cap company, wanted to obtain $30 million in new capital to expand its Iowa plant. Cost of capital was a factor in making the decision. Sen Corp. could either issue new preferred stock or new debentures. Sen Corp.’s underwriter estimated that preferred stock should have an annual dividend payout of $6 and an issue price of $103 per share. The debentures should have a coupon interest rate of 9% and an issue price of $101. Sen Corp.’s marginal income tax rate was 40%. Which of the following approaches describes Sen Corp.’s best strategy?
Sen Corp. should issue the debentures since the after-tax cost of debt (5.40%) would be less than the cost of equity (5.83%).
Sen Corp. should issue the debentures since the after-tax cost of debt (5.40%) would be less than the cost of equity (6.0%).
Sen Corp. should issue the preferred stock because the cost of equity (6.0%) is less than the cost of debt (9.0%).
Sen Corp. should issue the preferred stock because the cost of equity (5.83%) is less than the cost of debt (9.0%).
Sen Corp. should issue the debentures since the after-tax cost of debt (5.40%) would be less than the cost of equity (5.83%).
The cost of debt for the issuing firm is based upon the required rate of return for debt holders (9%) and the marginal tax rate (40%) for the issuing company
To calculate the annual cost of debt, multiply the after-tax interest rate of the debt by the principal amount of the debt, or 9% × (1 − .40) = .054 (5.40%), rounded.
The cost of preferred stock is calculated by dividing the annual return (interest payment) by the net issuance price for the preferred stock, or $6 ÷ $103 = 5.83%, rounded.
Most analysts use the (___) to estimate the required return on a firm’s cost of equity. ‘
The capital asset pricing model uses the beta coefficient, the market risk premium, and the risk-free ra
capital asset pricing model
Additional data:
The long-term debt was originally issued at par ($1,000/bond) and is currently trading at $1,250 per bond.
Martin Corporation can now issue debt at 150 basis points over U.S. Treasury bonds.
The current risk-free rate (U.S. Treasury bonds) is 7%.
Martin’s common stock is currently selling at $32 per share.
The expected market return is currently 15%.
The beta value for Martin is 1.25.
Martin’s effective corporate income tax rate is 40%.
Martin Corporation’s current net cost of debt for issuing new debt is:
The problem provides the information that Martin Corporation can now issue debt at 150 basis points over U.S. Treasury bonds and that U.S. Treasury bonds have a current rate of 7%. This means Martin Corporation can now issue debt at 8.5% or………… 7.0% plus 1.50% (150 basis points). Because interest is tax deductible, the cost of debt is less than the interest rate and equals the interest rate times 1 minus the tax rate. Cost of debt = 8.5% × (1 - .40) = 5.1%.
Which of the following statements is correct regarding corporate debt and equity securities?
Both debt and equity security holders have an ownership interest in the corporation.
Both debt and equity securities have an obligation to pay income.
Neither
Debt is a form of financing that increases the liabilities of a corporation, whereas equity securities are an ownership interest.
Due to the contractual nature of debt, the debt holder is obligated to pay the agreed-upon interest.
Dividends are equal to $5, and the current share price is $50. Dividends are expected to grow at 2% forever. According to the dividend growth model, what is the investor’s required rate of return?
12.2%
he Gordon growth model is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. It is a popular and straightforward variant of a dividend discount model (DDM).
The formula is
Current stock price = Value of next year’s dividend ÷ (Rate of return (ROR) – Dividend growth rate).
$50 = ($5.00 × 1.02) ÷ (ROR − .02) $50 × (ROR − .02) = $5.10 50ROR − $1.00 = $5.10 50ROR = $6.10 ROR = .122 = 12.2%
The cost of debt most frequently is measured as:
actual interest rate.
actual interest rate adjusted for inflation.
actual interest rate plus a risk premium.
actual interest rate minus tax savings.
actual interest rate minus tax savings.
Dividends paid on stock are not deductible in computing taxable income, so there is no income tax savings when dividends are paid.
____refers to the extent to which debt and preferred stock (fixed income securities) are used in the capital structure.
…………The larger the percentage of debt and preferred stock that is used for financing, the greater the risk that the company will not earn enough to cover the fixed interest and preferred dividend payments. T/F
____) is the percentage change in earnings available to common stockholders related to a given percentage change in EBIT.
Financial leverage
true
Degree of financial leverage (DFL
A corporation obtains a loan of $200,000 at an annual rate of 12%. The corporation must keep a compensating balance of 20% of any amount borrowed on deposit at the bank, but normally does not have a cash balance account with the bank. What is the effective cost of the loan?
15%
A 20% compensating balance means the corporation must keep 20% of the amount borrowed ($40,000) in an account at the bank while the loan is outstanding.
This reduces the principal available for use by the corporation to $160,000 (the $200,000 loan less the $40,000 compensating balance).
However, the bank charges interest on the full $200,000 at 12%, or $24,000 per year.
The effective rate of interest is the interest cost incurred ($24,000) divided by the available principal ($160,000), or 15%.
COMPENSATING BALANCES
A compensating balance is a cash balance \_\_\_to be held in an account by a bank in order to obtain a loan or to avoid paying directly for certain bank services.
required
The overall cost of capital is the:
rate of return on assets that covers the costs associated with the funds employed.
average rate of return a firm earns on its assets.
minimum rate a firm must earn on high risk projects.
maximum rate of return on assets.
rate of return on assets that covers the costs associated with the funds employed.
he overall cost of capital is the rate of return on assets that covers the costs associated with the funds employed.
Which of the following quantitative factors, when compared to its industry average, could be an indicator of potential corporate failure?
High cash flow to total liabilities
High retained earnings to total assets
High fixed cost to total cost structure
High fixed assets to noncurrent liabilities
High fixed cost to total cost structure
The higher the fixed costs, the greater the risk that the breakeven point will not be reached given a drop in sales. When fixed costs are high, a small drop in sales can result in a loss for the period.
Which of the following factors is inherent in a firm’s operations if it utilizes only equity financing?
Financial risk
Business risk
Interest rate risk
Marginal risk
Business risk
Business risk is the uncertainty associated with the ability to forecast EBIT (earnings before interest and taxes) due to such things as sales variability and operating leverage. This risk is inherent in equity financing.
Both financial risk and interest rate risk deal with the concept of financial leverage and the cost of debt, and since the firm only utilizes equity financing, these risk types do not apply.
