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12 Cards in this Set
- Front
- Back
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Advantages to debt financing
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1. Interest paid on debt is tax-deductable
2. Return on debt is fixed, so stockholders do not have to share the firm's proits if it is extremely successful. |
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Disadvantages to debt financing
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1. Using more debt increases the firm's risk, which raises the cost of both debt and equity.
2. If the company falls on hard times and its operating income is not suffiient to cover interest charges, the stockholders will have to make up the shortfall; if they cannot the firm will go bankrupt. |
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Four primary factors that influence capital structure decisions
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1. Business risk (risk if company uses no debt compared to financial risk which is risk if company uses debt)
2. Tax position 3. Financial flexibility 4. Managerial conservatism or aggressiveness |
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Business risk depends on...
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1. Demand variability
2. Sales price variability 3. Input cost variability 4. Ability to adjust output prices for changes in input costs 5. Ability to develop new products in a timely, cost-effective manner 6. Foreign risk exposure 7. Extent to which fixed costs are fixed; operating leverage |
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Operating leverage
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The extent to which fixed costs are used in a firm's operation
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Operating breakeven
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The output quantity at which EBIT = 0
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Financial leverage
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The extent to which fixed-income securities (debt and preferred stock) are used in a firm's capital structure
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TIE ratio (times-interest-earned)
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Depends on the percentage of debt, the interest rate on the debt, and the company's profitability.
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Advantages to reinvestment and capital gains over dividends
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1. Taxes must by paid on dividends the year they are received, whereas taxes on capital gains are not paid until the stock is sold.
2. Due to TV effects, a dollar of taxes paid in the future has a lower effective cost than a dollar of taxes paid today. |
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Optimal dividend payout ratio is the function of these four factors
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1. Management's opinion on its investors' preferences for dividends versus capital gains
2. The firm's investment opportunities 3. Its target capital structure 4. Availability and cost of external capital |
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Residual dividend model
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Model in which the dividend paid is set equal to net income minus the amount of retained earnings necessary to finance the firm's optimal capital budget.
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Stock repurchase
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A transaction in which a firm buys back shares of its own stock, thereby decreasing shares outstanding, increasing EPS, and often, increasing the stock price
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