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define: Business Risk
Risk if firm uses no debt. Any other business related factors: demand (unit sales); output prices; input costs TERM 2
when does a firm have high operating
leverage?
DEFINITION 2 if a high percentage of firm's costs are fixed and don't decline when demand falls. TERM 3
does high operating leverage affect business
risk
DEFINITION 3 YES it increases its business risk TERM 4
define: a) financial leverage b) operating
leverage
DEFINITION 4 a) extent of fixed income securities (debt and preferred stock)b) extent of fixed and variable costs used by a firm TERM 5
The higher the proportion of fixed costs
relative to variable costs
DEFINITION 5 the higher the operating leverage.
business risk depends on? financial risk
depends on?
Business risk: depends on business factors such as competition, operating leverage, etc. Financial risk: depends the amount of debt and preferred stock financing. TERM 7
define: financial risk
DEFINITION 7 additional risk of using more debt Additional risk concentrated on common stockholders when financial leverage is used. TERM 8
T/F: by increasing debt, you increase your
expected risk and your expected return
DEFINITION 8 True TERM 9
Why does leveraging increase your return?
DEFINITION 9 More cash goes to investors less taxes TERM 10
what are 4 Capital Structure Theories
DEFINITION 10 MM, trade-Off, Signaling, and Pecking Order
MM theory on "personal taxes"
proves
Presence of personal taxes reduces advantage of debt financing. Use of debt financing remains advantageous, but benefits are less. BUT firms should still use 100% debt. Tax rates of investors would adjust until there was no advantage to debt. TERM 17
T/F: according to MM Investors are willing to
accept debt over equity.
DEFINITION 17 False! Investors prefer equity, corporations prefer debt TERM 18
Tradeoff theory says
DEFINITION 18 Debt adds value bc it's tax deductible BUT it also brings costs (bankruptcy costs) Optimal capital structure= balance b/w bankruptcy costs and tax benefits At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. TERM 19
according to tradeoff theory, what's the
optimal capital structure
DEFINITION 19 An optimal capital structure exists at balance of bankruptcy costs and tax benefits. TERM 20
T/F: Firms that add additional equity sends a
positive signal to investors
DEFINITION 20 FALSE!!! sends a negative signal price is overvalued
T/F: Firms that add additional debt sends a
positive signal to investors
Somewhat true Mostly positive bc reflects stock price is undervalued but too much debt could give bad impression TERM 22
Signaling theory assumes
DEFINITION 22 Investors have asymmetrical info (managers have better information to forecast FCF's) MM says they have symmetrical info (or investors and managers have same information) TERM 23
Signaling theory
concludes
DEFINITION 23 That since managers have better info they will: Sell stock if stock is overvalued. Sell bonds if stock is undervalued. TERM 24
pecking order theory
DEFINITION 24 Firms pay capital costs through internally generated funds (RE) first, because there are no flotation costs or negative signals. Then debt (because it has lower flotation costs than equity and no negative signals.) As a last (final) resort, firms then issue equity. TERM 25
T/F: Firms should issue dividends if they issue
a lot of debt.
DEFINITION 25 FALSE
define: underinvestment
High debt increases risk of financial distress and therefore, managers may avoid positive NPVs projects TERM 32
Having too much debt (or leverage) causes
management to be
DEFINITION 32 Risk averse OR very risky (Hail Mary pass) TERM 33
by increasing debt, you ____ your expected
return
DEFINITION 33 Increase (Vegas example) TERM 34
a) formula: tax shield b) which part is the
annual tax shield? c/d) what does each
variable mean?
DEFINITION 34 a) CFL = CFU + rdDT b) RdDT c) CFL=CF to Firm L; CFU= CF to Firm U; Rd=cost of debt; d) D= total amount of debt; T= tax shield TERM 35
formula: perpetuity
DEFINITION 35 PMT/r
T/F: more debt= more tax shield
TRUE
TERM 37
in real life why if the MM theory wrong?
DEFINITION 37 it ignores bankruptcy costs and other stutch TERM 38
T/F: value of firm will peak at equilibrium
point but if you keep using debt after that
point, value of firm will increase.
DEFINITION 38 FALSE!!! Value of firm will decrease as you move right on the graph and use more debt. TERM 39
impact on capital structure depends on effect
of debt on:
DEFINITION 39 WACC FCF TERM 40
with debt's interest expense being tax
deductible, what 3 benefits result?
DEFINITION 40 Reduces taxes paid Reduces AT Return on Debt Frees up more cash
As weight on debt increases,
risk
increases TERM 47
As weight on debt increases, cost/return of
equity
DEFINITION 47 increases because shareholders require a higher rate TERM 48
As weight on debt increases,
taxes
DEFINITION 48 decrease TERM 49
As weight on debt increases, risk of
bankruptcy
DEFINITION 49 increases TERM 50
As risk of bankruptcy increases, AT cost of
debt
DEFINITION 50 decreases
what are the direct and indirect costs of
"bankruptcy"
Direct: legal fees, "fire"sales Indirect: lost customers, employees looking for jobs, lower productivity, reduced credit TERM 52
As risk of bankruptcy increases, free cash flow
and NOPAT
DEFINITION 52 both decrease TERM 53
As risk of bankruptcy increases, agency costs
DEFINITION 53 decrease this is good- managers will have more pressure to perform so they wont be flying off in their corporate jets TERM 54
a) Wd also called b) We also called c)
Relationship?
DEFINITION 54 a) low cost debt b) high cost equityc) common sense: As Wd increases, We decreases TERM 55
whats a firms "optimal" capital structure
DEFINITION 55 mix of debt and equity that maximizes firms value (stock price)
T/F: if there are only corporate taxes, M and
M showed that a firm's value increases as it
adds debt
True TERM 62
how can companies avoid issueing new
stock?
DEFINITION 62 Reserve borrowing capacity using less debt TERM 63
T/F: firms owners may use large amounts of
debt to constrain managers
DEFINITION 63 True Why? bankrupcy costs forces managers to be more careful TERM 64
T/F: High debt ratio raises threat of
bankruptcy
DEFINITION 64 True
