Flashcards on Finance Chapter 13
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How do you know if one capital structure is better than the other?
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If it results in a lower WACC
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A particular debt-equity ratio represents the _____ _____ _____ if it results in the lowest possible WACC
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optimal capital structure
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What does financial leverage refer to?
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It refers to the extent to which a firm relies on debt. The more debt financing a firm uses in its capital structure, the more financial leverage it employs
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If capital structure is 50%, then debt-equity ratio is ..
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1
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Financial leverage acts to magnify _____ and _____ to shareholders.
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gains and losses
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On a graph showing earnings per share (EPS) in relation to earnings before interest and taxes (EBIT), that does the slope of the line show? Also what is the break even point?
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The slope of the line shows sensitivity of EPS in regards to changes in EBIT. The breakeven point is where EPS is exactly the same for both capital structures.
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If EBIT is above the break even point, leverage is _____; if it is below, then leverage is ______
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beneficial ; not beneficial
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If under a proposed capital structure, the EPS and ROE are more sensitive than under another proposed capital structure, share holders are exposed to more risk with the ...
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proposed capital structure where the EPS and ROE are more sensitive to change
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What is homemade leverage?
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The use of personal borrowing to alter the degree of financial leverage
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To undo leverage, investors must ...
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loan out money
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Is there anything special about corporate borrowing?
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No, because investors can borrow or lend on their own
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What is the M&M proposition I?
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It states that the value of the firm is independent of its capital structure (i.e. it is completely irrelevant how a firm chooses to arrange its finances) [its all the same "pie" it just is sliced in different ways depending on how they divvy up capital]
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What is the M&M proposition II?
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It says that the cost of equity depends on three things: the required rate of return on the firm's assets R(A); the firm's cost of debt R(D); and the firm's debt-equity ratio, D/E (a firm's cost of equity capital is a positive linear function of its capital structure)
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Although changing the capital structure of the firm may not change the firm's ____ ____, it does cause important changes in the firm's ______ and ______
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total value ; debt ; equity
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As a firm increases its debt-equity ratio, the increase in leverage raises the risk of the _____ and therefore the ______ ______, or the ______ ___ ______
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equity ; required return ; cost of equity (RE)
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Does the WACC change if the debt-equity ratio changes?
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no
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The change in capital structure weights (E/V and D/V) is exactly offset by the change in the cost of equity (RsubE), so..
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the WACC stays the same
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M&M Proposition II shows that the firm's cost of equity can be broken down into ..
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two components: 1) RsubA, which is the required return on the firm's overall assets (this depends on the nature of the firm's operating assets) 2) (RsubA-RsubD)x(D/E) which is the financial risk of the firm's equity (this is determined by the firm's financial structure)
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What is business risk?
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It is the risk that is inherent in a firm's operations (the greater a firm's risk, the greater RsubA will be, and so the greater the firm's cost of equity)
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The required return on the firm's overall assets depends on ...
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the nature of the firm's operating activities
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The financial risk of a company depends on the firm's _____ _____
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financial structure
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The business risk of a firm depends on the ...
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systematic risk of a firm's assets
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As a firm begins to rely on debt financing, what happens to the required return on equity? Why?
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It rises, because the debt financing increases the risks borne by the stockholders
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The extra risk that arises from the use of debt financing is called the ..
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financial risk of the firm's equity
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The total systematic risk of the firm's equity has two parts:
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business risk and financial risk
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The first part of systematic risk, business risk, depends on the firm's _____ and ______ is is not effected by ______ ______. Given the firm's business risk (and its _____ __ _____), the second part, financial risk, is completely determined by ______ _______.
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assets ; operations ; capital structure ; cost of debt ; financial policy
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Why does the firm's cost of equity rise when it increases its use of financial leverage?
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Because the financial risk of the equity increases while the business risk remains the same
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Interest paid on debt is _____ _____
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tax deductible
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Failure to meet debt obligations can result in ______. This is not good for the firm, and it may be an added cost of ______ ______.
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bankruptcy ; debt financing
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Because the _____ _____ is generated by paying interest, it has the same risk as the _____.
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tax shield ; debt
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Once we include taxes, _____ _____ definitely matters.
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capital structure
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In the no-tax case, the value of a _____ _____ is equal to that of an _______ ______. This is ...
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leveraged firm ; unleveraged firm ; Proposition 1
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What are the 2 implications of Proposition 1 in the no-tax case?
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1) A firm's capital structure is irrelevant 2) A firm's WACC is the same, no matter what mixture of debt and equity is used to finance the firm
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In the no-tax case, Proposition 2 implies what 2 things?
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1) The cost of equity rises as the firm increases its use of debt financing 2) The risk of equity depends on the riskiness of a firm's operations (business risk) and the degree of financial leverage (financial risk). Business risk determines RsubA and financial risk is determined by D/E
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In the tax case, Proposition one says that the ..
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value of the leveraged firm is equal to the value of the unleveraged firm plus the present value of the interest tax shield
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What two things does Proposition 1 imply in the tax case?
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1) Debt financing is highly adventageous 2) A firm's WACC decreases as the firm relies more heavily on debt financing
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_____ _____ _____: The costs that are directly associated with bankruptcy, such as legal and administrative expenses.
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Direct bankruptcy costs
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_____ _____ _____: The cost of avoiding bankruptcy
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indirect bankruptcy costs
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Until the firm is legally bankrupt, the _______ control it.
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stockholders
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What are financial distress costs?
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direct and indirect bankruptcy costs
