Bec9 - Capital Structure

Front 1

What is capital structure?

Back 1

The firm's mix of debt and equity.

Front 2

Name the three types of debt.

Back 2

1. private debt
2. public debt
3. Eurobonds

Front 3

Name the two forms of private debt.

Back 3

1. long-term loans from financial institutions
2. private placement of unregistered bonds sold directly to accredited investors

Front 4

Is private or public debt more expensive?

Back 4

Public debt is typically more expensive than public debt.

Front 5

Describe public debt.

Back 5

Offerings of SEC registered bonds directly to investors.

Front 6

Describe a Eurobond.

Back 6

A bond payable in the borrower's currency but sold outside the borrower's country.

Front 7

How does the cost of issuance of Eurobonds compare to other forms of debt?

Back 7

The cost of issuance is less because the registration and disclosure requirements are less stringent.

Front 8

What is the effect of a debt covenant?

Back 8

It restricts the actions of management.

Front 9

Name the five security provisions that come with debt.

Back 9

1. mortgage bonds
2. ollateral trust bonds
3. debentures
4. subordinated debentures
5. income bonds

Front 10

How is a mortgage bond secured?

Back 10

It is secured with the pledge of property.

Front 11

How is a collateral trust bond secured?

Back 11

It is secured by financial assets.

Front 12

How is a debenture secured?

Back 12

It is unsecured.

Front 13

How is a subordinated debenture secured?

Back 13

It is unsecured with subordinated claims.

Front 14

Describe an income bond.

Back 14

Interest payments contingent on earnings.

Front 15

Name the five methods of payment for bonds.

Back 15

1. serial payments
2. sinking fund provisions
3. conversion
4. redeemable
5. call feature

Front 16

Describe serial payment of bonds.

Back 16

Paid in installments.

Front 17

Describe sinking fund provisions of bonds.

Back 17

Firm makes payments to sinking fund to liquidate bonds.

Front 18

Describe conversion of bonds.

Back 18

Convertible to common stock.

Front 19

Describe redeemable bonds.

Back 19

May be redeemed at the holder's option.

Front 20

Describe a call feature of bonds.

Back 20

Firm may force redemption.

Front 21

Name the three types of bond yields.

Back 21

1. coupon rate
2. current yield
3. yield to maturity

Front 22

What is the coupon rate?

Back 22

The stated interest rate that the bond pays.

Front 23

What is the current yield?

Back 23

The stated interest payment divided by the current price of the bond.

Front 24

What is the yield to maturity?

Back 24

The interest rate that equates the future interest payments and maturity payment into the current market price.

Front 25

Name six advantages of debt financing.

Back 25

1. interest is tax-deductible
2. fixed obligation
3. in periods of inflation, debt is paid back in dollars with less purchasing power
4. owners do not give up control
5. debtors do not participate in excess earnings
6. debt is less costly than equity

Front 26

Name three disadvantages of debt financing.

Back 26

1. interest and principal obligations must be paid regardless of the financial position of the firm
2. debt covenants restrict management's actions
3. excessive debt increases the risk of equity

Front 27

Name six advantages of leasing.

Back 27

1. a firm may be able to lease when it does not have the ability to purchase
2. less stringent provisions
3. no down payment may be required
4. creditor claims of certain types of leases are restricted in bankruptcy
5. the cost of a lease may be reduced if the lessor retains the tax benefits
6. operating leases do not require recognition of the liability

Front 28

Name two advantages of common stock.

Back 28

1. the firm has no fixed obligations
2. increased equity reduces the risk of debt which reduces the firm's cost of borrowing

Front 29

Name five advantages of common stock.

Back 29

1. issuance costs are greater than for debt
2. ownership and control is given up
3. dividends are not tax-deductible
4. shareholders demand a higher rate of return
5. issuance of too much common stock increases the cost of capital

Front 30

Name four advantages of preferred stock.

Back 30

1. No fixed obligation to pay dividends.
2. Increased equity reduces the cost of debt.
3. Common stockholders do not give up control.
4. Preferred stockholders do not generally participate in superior earnings.

Front 31

Name three disadvantages of preferred stock.

Back 31

1. Issuance of costs are greater than for debt.
2. Dividends are not tax deductible.
3. Dividends in arrears accumulated over time may create a burden on the firm.

Front 32

How does a firm decide whether to go public?

Back 32

Balance the additional compliance costs with the advantage of creating a liquid investment for its owners.

Front 33

What does operating leverage measure?

Back 33

The degree to which a firm builds fixed costs into its operations.

Front 34

What does financial leverage measure?

Back 34

The extent to which the firm uses debt financing.

Front 35

What is the cost of debt?

Back 35

The interest of the loan adjusted for the fact that interest is deductible.

Front 36

What is the cost of preferred equity?

Back 36

The preferred dividend amount divided by the issue price of the stock.

Front 37

What is the value is the cost of common equity?

Back 37

It is greater than that of debt or preferred equity.

Front 38

Name the two ways in which common equity is raised.

Back 38

1. retained earnings
2. issuing new common stock

Front 39

Which is the more expensive way to raise equity?

Back 39

By issuing new stock because of floatation costs (costs of issuance).

Front 40

Name four methods for estimating the cost of common equity.

Back 40

1. capital asset pricing model (CAPM)
2. arbitrage pricing model
3. bond-yield-plus approach
4. dividend-yield-plus-growth-rate approach

Front 41

Describe the arbitrage pricing model.

Back 41

Similar to the CAPM but the arbitrage pricing model uses a series of systematic risk factors instead of only one.

Front 42

Describe the bond-yield-plus approach.

Back 42

Involves adding a risk premium of 3 to 5% to the interest rate on the firm's long-term debt.

Front 43

Describe the dividend-yield-plus-growth-rate approach.

Back 43

Estimates the cost of equity by considering investors' expected yield on their investment.

Front 44

Describe the weighted-average cost of capital (WACC).

Back 44

Calculated by weighting each component of capital by its percentage of the total.