Study Unit 7 Flashcards
Indenture
document that states terms of bond agreement
may require issuer to establish and maintain bond sinking fund
-objectives of pmts into fund is to segregate and accumulate assets to pay bond principal at maturity
Advantages and disadvantages of bond to issuer
Advantages
interest paid on debt is deductible
maintain ctrl of firm
Disadvantages
pmt of interest and debt are legal obligations; if not enough cash flow to pay could become insolvent
legal req raises firm’s risk level; s/h demand higher cap rates on r/e, decreasing mkt price of stock
require collateral (restricts assets)
debt financing limited; cost of debt may rise rapidly
Maturity Pattern Bonds
term- single maturity date at end of term
serial- matures in stated amnt at regular intervals
Valuation Bonds
Variable (floating) rate- pay interest based on mkt conditions
zero-coupon or deep discount - no stated rate of interest, no periodic cash pmt, interest is the bond’s discount
commodity backed- payable at prices related to a commodity (i.e. gold)
Redemption Provisions
Callable- able of issuer to repurchase at specific price before maturity (good when interest rates fall b/c issuer an replace high interest debt with lower interest rate); pay higher yield than non callable
Convertible-convert into equity security of issuer
Call provisions
provisions on a bond allowing issuer to repurchase and retire bonds early
Value proposition of callable bonds
favorable for issuer b/c can retire & pay debt earlier
-no more interest pmts
unfavorable for investor bc amnt rec’d when not retired is more than premium company pay to retire
Securitization
Mtg bonds- backed by assets (real estate)
Debentures- backed by borrower’s general credit not specific collateral
Ownership
Registered bonds- issued in name of holder; only holder receives interest and principal pmts
bearer bonds- not individually registered; interest and principal paid to whomever presents bond
Priority
Subordinated debentures- junior securities with claims inferior to sr bonds
Repayment provisions
income bonds- pay interest contingent on issuer’s profitability
revenue bonds- issued by govt and payable from specific revenue sources
Bond discount vs premium
discount- stated rate (coupon) mkt rate
-investor pay more bc interest pmts are higher than available for mkt
Leverage
relative amnt of FC in firm’s overall cost structure
-creates risk bc FC must be covered regardless of sales level
Operating Leverage
firms’ cost of operating are fixed rather than variable
degree of op leverage (DOL) measures effect given level of fixed operating costs has on firm earnings
DOL=% change in earnings before interest & taxes (EBIT)/% change in sales
- help find best level of operating leverage to maximize EBIT
- firm w/ high FC more risky than firm w/ more VC
Financial leverage
degree of debt (fixed financial costs) in the financial structure
degree of financial leverage (DFL)
DFL=% change in EPS/ % change in EBIT
high % of fixed financial costs, firm takes more risk to increase its EPS
Degree of total (combined) leverage
DTL= DOL * DFL
high DTL has higher return for investors, but is more risky
Disadvantages of issuers of common stock
cash dividends aren’t tax deductibe; paid out of after tax profits
new c/s sales dilute EPS to existing s/h
underwriting costs higher
too much equity raises avg cost of capital above optimal level
Preemptive rights
common shareholder have right to purchase adtl stock issuance in proportion to current ownership %
Dividend payout model for constant dividend
Price per share now = divident per share (constant)/req rate of return
P(0)=D/r
when dividend is constant & expected to be paid continuousy
Constant growth model
dividend discount model
P(0)=D(0) (1+g) / r-g
P(0)=D(1)/r-g
preferred stock
hybrid of debt & equity; has fixed charge, pmts not obligation
Advantages of issuers of preferred stock
builds creditworthiness (form of equity)
control held by common s/h (no voting rights)
superior earning of firm reserved for common s/h
doesn’t req periodic pmts; failure to pay doesn’t lead to bankruptcy
Disadvantages to issuers of preferred stock
cash dividend aren’t tax deductible
during rough economy, accumulated unpaid div create managerial and financial problems
Future dividends of preferred stock
D=par value of preferred * preferred div rate
preferred stock price P(p)
P(p)= D(p)/r
IPO (advantages & disadvantages)
advantage
- raise $
- establish value in mkt
- increase liquidity of firm’s stock
disadvantage
- cost of reporting req
- access to firm’s operating data by competitors
- access to net worth by s/h
- limitation on self-dealing by corporate insiders
- pressure from outside s/h for earnings growth
- stock prices don’t accurately reflect NW
- loss of control by mgt
- increased s/h service costs
Types of leases
sale leaseback- alternative for raising capital; allow firms to acquire capital from sale of asset while retaining use
service or operating- both financing and maint services
financial- don’t provide maint, noncancelable and fully amortize cost of lease over term of basic lease contract (installment purchases)
Capital lease
essentially the purchase of an asset
4 part test (meet at least 1)
-Bargain purchase option
-Lease term is at least 7% of useful economic life
-Title transfered at end of lease
-Minimum lease pmt (PV MLP =90% or more of FV of leased property)
Operating lease
off B/S
rental contract
no entry recorded, expense as incurred
Cost of capital used to discount FCF of LT projects
investments w/ RoR higher than cost of capital increase the value of the firm (s/h wealth)
Risk for Investors
firm not legally obligated to pay return
if firm liquidates, creditors have priority
3 components of financing structure
LT debt, preferred equity, common equity (r/e included)
RoR demanded is component cost for that form of capital
Component cost for LT, preferred stock, common equity
LT
-Effective rate * (1-Marginal TR)
P.Stock (use dividend yield ratio)
-cash dividend on p stock/mkt price of p stock
mkt price = net proceeds from issuance (gross proceeds-flotation costs)
flotation costs reduce net proceeds rec’d and raise cost of capital
-alternative component cost= cash dividend on p stock/p stock mkt price-issuance cost
component cost of r/e is same for c/s
-cash dividend/mkt price
WACC
composite RoR on its combined components of capital with weights based on target capital structure
WACC= E/V *R(E) +D/V*R(D) * (1-T) R(E)=cost of equity R(D)=cost of debt E=mkt value of firm's equity D=mkt value of firm's debt T=Corp TR V=D+E=Capital used to generate profits
Optimal cap structure
minimize WACC
don’t focus just on increasing EPS
can’t ID this point, find optimal range
Modigliani-Miller theore
no optimal cap structure
doesn’t matter if finance w/ all debt, all equity, or equity and debt bc no consequence to s/h wealth
-any increase in expected return from debt is offset by increase in RoR on equity from the risk
-debt to equity ratio not useful to s/h
