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31 Cards in this Set
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MM theory ->Capital structureis irrelevant. Original concept: 1/3 |
Begins with the assumption of zero taxes. MM prove, under a very restrictive set of assumptions, that a firm’s value is unaffected by its financing mix:VL = VU. Any increase in roe resulting from financial leverage is exactly offset by the increase in risk (i.e., rs), so WACC is constant. |
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MM theory includes corporate tax
2/3 |
Corporate tax laws allow interest to bededucted, which reduces taxes paid by levered firms. Therefore, more CF goes to investors andless to taxes when leverage is used. In other words, the debt “shields” someof the firm’s CF from taxes. Under this theory the firms value increases continuously as more and more debt is used |
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What type of financing do corporate taxes favor ? Personal taxes? |
Corporatetaxes favor debt financing since corporations can deduct interest expenses. Personaltaxes favor equity financing, since no gain is reported until stock is sold,and long-term gains are taxed at a lower rate. -- concluded that debt financing is still advantageous, but as beneficial as under corp taxes. |
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Trade-off theory -> |
MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used. At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these costs and benefits. |
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Signaling theory - |
MM assumed that investors and managers have the same information. But managers often have better information. Thus, they would sell stock if stoc kis overvalued, and sell bonds if stock is undervalued. Investors understand this, so view new stock sales as a negative signal. |
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Pecking ordertheory - |
Firms use internally generated funds first, because there are no flotationcosts or negative signals. If more funds are needed, firms then issue debtbecause it has lower flotation costs than equity and not negative signals. Ifmore funds are needed, firms then issue equity. |
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Over investmentagency problem |
One agency problem is that managers can use corporate funds for nonvaluemaximizing purposes. The use of financial leverage bonds “free cashflow,” and forces discipline on managers to avoid perks and non-valueadding acquisitions. |
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Underinvestmentagency problem |
A second agency problem is the potential for “underinvestment”. Debt increases risk of financial distress. Therefore, managers may avoid risky projects even if they have positive NPVs. |
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What should firms dow with |
Firms with many investment opportunities should maintain reserve borrowing capacity, especially if they have problems with asymmetric information (which would cause equity issues to be costly). |
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Market timingtheory - |
They issue equity when the market is “high” and after big stock price runups. They issue debt when the stock market is “low” and when interes trates are “low.” They issue short-term debt when the term structure is upward sloping and long-term debt when it is relatively flat. |
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What is current yield? |
The current yield is the annual interest payment divided by the bond's current price. The currentyield provides information regarding the amount of cash income that a bond will generate in agiven year. However, it does not account for any capital gains or losses that will be realized if thebond is held to maturity or call. |
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What should the returns(earn) be equal to for investors of premium, discount, and par value bonds |
YTC on premium bonds, but YTM on discount and par value bonds |
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What is the formula for required rate of return on a debt security? |
rd = r* + IP + DRP + LP + MRP.
rd = Required rate of return on a debt security. r* = Real risk-free rate. IP = Inflation premium. DRP = Default risk premium LP = Liquidity premium MRP = Maturity risk premium ( |
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What is the default risk premium |
(The default risk premium (DRP) is a premium based on theprobability that theissuer will default on the loan, and it is measured by the difference between the interest rate on aU.S. treasury bond and a corporate bond of equal maturity and marketability - similar liquidityrisk |
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What is the Liquidity Premium? |
LP = Liquidity premium (A liquid asset is one that can be sold at a predictable price on shortnotice; a liquidity premium is added to the rate of interest on securities that are not liquid) |
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What is the Maturity Risk Premium |
MRP = Maturity risk premium (The maturity risk premium (MRP) is a premium which reflectsinterest rate risk;longer-term securities have more interest rate risk (the risk of capital loss due to rising interestrates) than do shorter-term securities, and the MRP is added to reflect this risk.). |
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What is interest rate risk? |
the risk of a decline in a bond's price due to an increase in interest rates.Price sensitivity to interest rates is greater (1) the longer the maturity and (2) the smaller thecoupon payment. Thus, if two bonds have the same coupon, the bond with the longer maturitywill have more interest rate sensitivity, and if two bonds have the same maturity, the one with thesmaller coupon payment will have more interest rate sensitivity. |
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What is total corporate value? |
The sum of value operations and value of non-operating assets. Some company's also have growth options. Debt holders have first claim, then preferred stockholders, and then anything else remaining belongs to stockholders. |
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What is the formula for the present value of expected free cash flows when discounted at the WACC? Value of operations at time 0: |
Vop(0)=(FCF0*(1+g)) / (WACC-g) free cash flow 1 divided by WACC-growth rate |
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What does IRR measures and What does it mean when IRR>cost of capital and vice versa |
It measures a projects profitability in the rate of return sense: If a project’s IRR equals its cost of capital, then its cash flows are just sufficient to provide investors with their required rates of return. An IRR greater than r implies an economic profit, which accrues to the firm’s shareholders, while an IRR less than r indicates an economic loss, or a project that will not earn enough to cover its cost of capital. |
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What is Modified internal rate of return (MIRR), how is it calculated. |
similar to the regular IRR, except it is based on the assumption that cash flows are reinvested at the WACC. To find MIRR, calculate the PV of the outflows and the FV of the inflows and then find the discount rate that equates the two. Or, you can solve using Excel's MIRR function |
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How do you calculate profitability index(PI) |
The present value of all future cash flows divided by the initial cost. It measures the pv per dollar of investment. |
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What is internal rate of return (IRR) |
The internal rate of return is defined as the discount rate that equates the present value of a project's cash inflows to its outflows. It is the discount rate that forces the PV of the inflows to equal the initial cost |
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What is the difference when using the NPV function to IRR function |
With the IRR you must specify all cash flows, including the time zero cash flow. With the NPV function you only specify the future cash flows, but subtract the initial CF after the fact. |
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How to calculate the crossover rate of two projects? |
Find the differential in CF by subtracting year 1 project A CF1 by Project B CF1 and repeating. Then you find the irr of those values. |
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How to calculate Payback period? only if all cf are equal |
Initial cost/cash inflow peryear |
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How to calculate discounted payback period? this can also be followed for calculating regular payback periods of projects with non consistent cf, just skip discounting step. |
1. Get pv of CFs 2.Initial cost - pv of CF1= remainder 1 3. remainder 1- pv of CF2= remainder 2 --repeat until remainder is negative 4. year before negative remainder + (last pos. remainder/ Pv of cf of following year) |
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If two projects are independent, Project B has a shorter payback period than Project A, but both are paid back before maturity, which project or projects should be selected. |
Since the projects are independent and are both paid back prior to maturity, then you would select both projects to take on. If they were mutually exclusive you would select the one that is paid back fastest. |
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What is the decision making process when comparing two mutually exclusive projects based on their NPVs and must decide which one to select. |
Select the higher of the two NPVs |
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How do you compare projects with different maturities? |
you must you use the equivalent annual annuity (EAA) approach by using the pmt function within excel. be sure to to put in npv negative at the pv value |
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What is the replacement chain approach for determining the projects extended NPVs. |
You take on both projects, sum all cf from each period, there will be at least one period with an inflow and outflow, then use npv function. |
