Issues with WACC and Capital Structure Policy

Flashcards covering key vocabulary, formulas, and theories regarding the Weighted Average Cost of Capital (WACC), Capital Asset Pricing Model (CAPM), and various Capital Structure theories from Lecture 4.

Cost of Capital

The minimum acceptable hurdle rate or benchmark rate of return that a firm's projects must earn to be accepted; viewed as the required rate of return or opportunity cost by investors.

Weighted Average Cost of Capital (WACC)

The weighted average of the cost of debt and the cost of equity, calculated as $WACC = k_{d}(1 - t_{e})\frac{D}{V} + k_{e}\frac{E}{V}$. It represents the overall return the firm must earn on its existing assets to maintain the value of its securities.

Cost of Debt ($k_{d}$)

The market interest rate the firm has to pay on its long-term borrowing today, typically calculated as the Risk-Free Rate plus a Default Spread.

Interest Coverage Ratio

A financial ratio calculated as $\frac{\text{EBIT}}{\text{Interest Expenses}}$; it is commonly used to estimate a synthetic rating for a firm.

Effective Corporate Tax Rate ($t_{e}$)

The tax rate used in WACC calculations which, under an imputation system, is lower than the statutory rate ($t_{c}$) and calculated as $t_{e} = t_{c}(1 - \text{λ})$, where $\text{λ}$ is the proportion of corporate tax claimed by shareholders.

Imputation Tax System

A tax system utilized in countries like Canada, Australia, and New Zealand where corporate tax is reimbursed to resident shareholders as tax credits (franking credits) attached to dividends.

Cost of Equity ($k_{e}$)

The expected return required by shareholders, which can be estimated using the Capital Asset Pricing Model (CAPM) or the Dividend Discount Model (Gordon Growth Model).

Beta ($\beta$)

A measure used in CAPM that reflects how the underlying stock moves with the market; it represents the correlation or diversification measure of risk.

Levered Beta ($\beta_{L}$)

The stock beta of a firm with leverage that captures both business risk and financial risk, calculated as $\beta_{L} = \beta_{U}(1 + (1 - t_{e})\frac{D}{E})$.

Unlevered Beta ($\beta_{U}$)

Also known as asset beta, it reflects only the business risk of the firm and is the beta of a firm as if it were all-equity financed.

Debt to Capital Ratio

A common measure of capital structure, also known as the leverage ratio, calculated as $\frac{\text{Debt}}{\text{Debt} + \text{Equity}}$.

Modigliani-Miller ‘Irrelevance’ Theorem

The proposition that in perfect markets (no taxes, transaction costs, agency costs, or asymmetric information), the value of the firm is independent of its capital structure ($V_{L} = V_{U}$).

Trade-off Theory

The theory that the optimal target capital structure is determined by balancing the tax benefits of debt against the expected costs of financial distress.

Debt Tax Shield

The increase in firm value resulting from the tax-deductibility of interest payments; for a perpetuity with corporate taxes, the present value equals $t_{c} \times D$.

Expected Costs of Financial Distress

Calculated as the product of the probability of distress and the costs incurred if in distress; these costs include both direct costs (legal/court fees) and indirect costs (lost customers, reputation damage).

Pecking Order Theory

A theory primarily based on asymmetric information suggesting that firms prefer internal funds first, then debt, and then external equity as a last resort.

Asymmetric Information

The situation where management has more information about the firm's prospects than the market, leading the market to look for signals from management when capital is raised.

Hybrid Securities

Securities that display characteristics of both debt and equity, such as convertible notes, convertible bonds, and preference shares.

Free Cash Flow (FCF)

Cash flow in excess of that needed to fund all positive NPV projects; leverage can be used to reduce the problem of managers wasting these funds on "empire building" or pet projects.

Asset Specificity

The distinction between general-use assets (easier to realize value) and firm-specific assets; firms with more general-use or tangible assets can typically support higher leverage.