Leverage & Capital Structure

Flashcards about Leverage and Capital Structure

Leverage

The effects that fixed costs have on the returns that shareholders earn; higher leverage generally results in higher, but more volatile returns.

Fixed costs

Costs that do not rise and fall with changes in a firm’s sales. Firms have to pay these fixed costs whether business conditions are good or bad.

Capital structure

The mix of long-term debt and equity maintained by the firm.

Sources of Capital

All of the items on the right-hand side of the firm’s balance sheet, excluding current liabilities, are sources of capital.

Two components of total capital

Debt capital and Equity capital

Lenders

They take the least risk of any contributors of long-term capital; therefore Lenders demand relatively lower returns.

Equity Capital

Unlike debt capital, which the firm must eventually repay, equity capital remains invested in the firm indefinitely—it has no maturity date.

Two basic sources of equity capital

Preferred stock and common stock equity, which includes common stock and retained earnings.

Debt ratio

Total liabilities ÷ total assets

Times interest earned ratio

EBIT ÷ interest

Mortgage payment to Gross Income example

Mort. pay./Gross income = $1,400/$5,380 = 26%

Optimal capital structure range

Research suggests that there is an optimal capital structure range.

M and M theory

In 1958, Franco Modigliani and Merton H. Miller demonstrated algebraically that, assuming perfect markets, the capital structure that a firm chooses does not affect its value.

Benefit of debt financing

The major benefit of debt financing is the tax shield, which allows interest payments to be deducted in calculating taxable income.

Probability of Bankruptcy

The chance that a firm will become bankrupt because of an inability to meet its obligations as they come due depends largely on its level of both business risk and financial risk.

Business risk

The risk to the firm of being unable to cover its operating costs.

Financial risk

The risk to the firm of being unable to cover required financial obligations.

Asymmetric information

The situation in which managers of a firm have more information about operations and future prospects than do investors.

Pecking order

A hierarchy of financing that begins with retained earnings, which is followed by debt financing and finally external equity financing.

Signal

A financing action by management that is believed to reflect its view of the firm’s stock value; generally, debt financing is viewed as a positive signal that management believes the stock is “undervalued,” and a stock issue is viewed as a negative signal that management believes the stock is “overvalued.”

NOPAT

Net operating profits after taxes, which is the after-tax operating earnings available to the debt and equity holders, EBIT ´ (1 – T)

WACC

Weighted average cost of capital