Financial Leverage and Capital Structure Policy

Flashcards on key vocabulary related to financial leverage and capital structure.

Capital Restructuring

Involves changing the amount of leverage a firm has without changing the firm’s assets.

Financial Leverage

When a firm increases the amount of debt financing, it increases the fixed interest expense.

Break-Even EBIT

EBIT level where EPS is the same under both the current and proposed capital structures.

Modigliani and Miller Theory of Capital Structure

States that the value of the firm is determined by the cash flows to the firm and the risk of the assets.

Case I (Capital Structure Theory)

No corporate or personal taxes and no bankruptcy costs.

Case II (Capital Structure Theory)

Corporate taxes, but no personal taxes and no bankruptcy costs.

Case III (Capital Structure Theory)

Corporate taxes, but no personal taxes, and bankruptcy costs.

Proposition I (Case I)

The value of the firm is NOT affected by changes in the capital structure.

Proposition II (Case I)

The WACC of the firm is NOT affected by capital structure.

Financial Risk

Additional return required by stockholders to compensate for the risk of leverage.

Interest Tax Shield

Tax rate times interest payment.

Proposition I (Case II)

The value of the firm increases by the present value of the annual interest tax shield.

Bankruptcy Costs (Direct)

Legal and administrative costs, ultimately cause bondholders to incur additional losses.

Bankruptcy Costs (Indirect)

Larger than direct costs, but more difficult to measure and estimate.

Business Failure

Business has terminated with a loss to creditors.

Legal Bankruptcy

Petition federal court for bankruptcy.

Technical Insolvency

Firm is unable to meet debt obligations.

Accounting Insolvency

Book value of equity is negative.

Liquidation

Trustee takes over assets, sells them, and distributes the proceeds according to the absolute priority rule (Chapter 7).

Reorganization

Restructure the corporation with a provision to repay creditors (Chapter 11).