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Definitions and insights into key concepts related to business risk and capital structure, including operating leverage, financial leverage, tax shields, and the impact of debt on business and financial risk. It also covers various capital structure theories and their assumptions.
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Risk if firm uses no debt. Any other business related factors: demand (unit sales); output prices; input costs TERM 2
DEFINITION 2 if a high percentage of firm's costs are fixed and don't decline when demand falls. TERM 3
DEFINITION 3 YES it increases its business risk TERM 4
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
DEFINITION 5 the higher the operating leverage.
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
DEFINITION 7 additional risk of using more debt Additional risk concentrated on common stockholders when financial leverage is used. TERM 8
DEFINITION 8 True TERM 9
DEFINITION 9 More cash goes to investors less taxes TERM 10
DEFINITION 10 MM, trade-Off, Signaling, and Pecking Order
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
DEFINITION 17 False! Investors prefer equity, corporations prefer debt TERM 18
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
DEFINITION 19 An optimal capital structure exists at balance of bankruptcy costs and tax benefits. TERM 20
DEFINITION 20 FALSE!!! sends a negative signal price is overvalued
Somewhat true Mostly positive bc reflects stock price is undervalued but too much debt could give bad impression TERM 22
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
DEFINITION 23 That since managers have better info they will: Sell stock if stock is overvalued. Sell bonds if stock is undervalued. TERM 24
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
DEFINITION 25 FALSE
High debt increases risk of financial distress and therefore, managers may avoid positive NPVs projects TERM 32
DEFINITION 32 Risk averse OR very risky (Hail Mary pass) TERM 33
DEFINITION 33 Increase (Vegas example) TERM 34
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
DEFINITION 35 PMT/r
TERM 37
DEFINITION 37 it ignores bankruptcy costs and other stutch TERM 38
DEFINITION 38 FALSE!!! Value of firm will decrease as you move right on the graph and use more debt. TERM 39
DEFINITION 39 WACC FCF TERM 40
DEFINITION 40 Reduces taxes paid Reduces AT Return on Debt Frees up more cash
increases TERM 47
DEFINITION 47 increases because shareholders require a higher rate TERM 48
DEFINITION 48 decrease TERM 49
DEFINITION 49 increases TERM 50
DEFINITION 50 decreases
Direct: legal fees, "fire"sales Indirect: lost customers, employees looking for jobs, lower productivity, reduced credit TERM 52
DEFINITION 52 both decrease TERM 53
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
DEFINITION 54 a) low cost debt b) high cost equityc) common sense: As Wd increases, We decreases TERM 55
DEFINITION 55 mix of debt and equity that maximizes firms value (stock price)
True TERM 62
DEFINITION 62 Reserve borrowing capacity using less debt TERM 63
DEFINITION 63 True Why? bankrupcy costs forces managers to be more careful TERM 64
DEFINITION 64 True