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### WACC

the weighted average of the firm's cost of equity, preferred stock, and after-tax debt is known as

### adjust, project

If the risk of an investment is different than the firm's risk then you must _____ the discount rate for the project based on the ________ risk

### greater

The beta of the common stock of a levered firm is ________ than the beta of the common stock of an unlevered firm

### beta, equity

Using the CAPM equation to calculate the cost of capital for a risky project assumes that using a firms ______ is the same measure of risk as the project AND that the firm is all _____ financed

### covariance, variance

The beta of a security is calculated by dividing the ________ of the security with the market by the _________ of the market

### market risk premium

the slope of an asset's security market line is the section of CAPM also know as the

### MM Proposition II (w/o taxes)

The proposition that the cost of equity is a positive linear function of capital structure is called

### MM Proposition I w/o taxes

illustrates: (1) The value of an unlevered firm equals that of a levered firm (2) one capital structure is as good as another (3) leverage does not affect the value of the firm, & (4) capital structure changes have no effect on stockholder's welfare

### MM Proposition I w/ taxes

illustrates how the value of the firm increases as total debt increases b/c of the interest tax shield

### covariance, market, correlated

Beta measures depend highly on the ___________ of the security with the _________ and how they are ____________

### SML, return, risk

A stock with an actual return that lies above the ______ line has yielded a higher ________ than expected for the level of _____ assumed

### capital structure, increases

A manager should attempt to maximize the value of the firm by changing the _________ __________ if and only if the value of the firm __________

### direct bankruptcy

The explicit costs, such as legal expenses, associated with corporate default are classified as ______ _________ costs

### technically insolvent

A firm is said to be __________ ___________ when it is unable to meet its financial obligations

### CML

displays the pricing relationship between the optimal portfolio and the standard deviation of the portfolio

### internally

The pecking order states how financing should be raised. In order to avoid asymmetric information problems and misinterpretation of whether mgmt. is sending a signal on security overvaluation the firm's first rule is to finance with _________ generated funds

### borrowing portfolio

type of portfolio involving investment of total capital plus borrowed funds in a risky asset (debt not assets)

### CML

the line from the risk free rate that is tangent to the efficient frontier is sometimes called the

### two fund seperation theorum

theorum that states: all investors, regardless of their risk preferences, will form optimal portfolios by combining only two assets; the risk-free asset and the tangency portfolio. The investor chooses the weights of risk-free asset and the tangency portfolio based on his risk preference

### more, less

A firm with a beta > 1 is ______ volatile than the market. A firm with a beta < 1 is ______ volatile than the market.

### CML, SML

______ holds for fully diversified portfolios without unsystematic risk, and does not hold for single securities which have idiosyncratic(unsystematic) risk. ______ is different in that it holds for any security and measures systematic risk with beta

### CAPM, SML

______ is the equation that puts a specific functional form on the relationship between a firm's beta and its expected return. Predicts that all assets lie on the ____.

### less, greater

The portfolio expected return is a weighted average of the asset returns, so it must be _____ than the largest asset return and _______ than the smallest asset return

### standard deviation, less, less

The ________ _________ can be ____ than that of every single asset in the portfolio. However, the portfolio beta cannot be ____ than the smallest beta because it is a weighted average of the individual asset betas

### cost of equity capital

From the SHAREHOLDER'S perspective, the ______________ is the return they expect to receive

### problems with cost of equity capital

betas may vary over time, sample size may be inadequate, betas are influenced by changing financial leverage & business risk, and the equity of the firm is not publicly traded

### solutions to cost of equity problems

beta variation and inadequate sample size can be mitigated by more sophisticated statistical techniques, betas being influenced by changing leverage & business risk can be reduced by adjusting for changes in business & financial risk, and the equity of the firm not being publicly traded can be solved by looking at average beta estimates of comparable firms

### estimating the cost of capital

(1) estimate equity beta (systematic risk) (2) estimate required ROR on equity, and (3) effects of leverage (results)

### measurement error

Estimating beta for similar firms can help reduce some of the __________ ______ in beta

### beta, project, equity

Using CAPM to calculate the cost of capital for a risky project assumes that using the firm's _____ is the same measure of risk as the ________ AND that the firm is all _______ financed

### ROE, ROA, leverage

Regarding cost of capital, the required _ _ _ will be higher than the required _ _ _ because of the effects of __________

### greater

All other things equal, the beta of the common stock of a levered firm is _______ than the common stock off an unlevered firm

### shareholders, increases

Capital structure changes benefit __________ if and only if the value of the firm ________

### M&M Proposition I (w/o taxes)

proposition stating that leverage cannot influence firm value, given a levered OR an unlevered firm, the investor can create the other himself (homemade leverage is most applicable here)

### M&M Proposition I (w/o taxes)

prop stating that in a world with no taxes, the firm value is unaffected by capital structure (homemade leverage is most applicable here)

### M&M Proposition II (w/o taxes)

prop stating that in a world with no taxes, leverage increases the risk and return to stockholders. ***It states that the required return on a firm's equity is positively related to the firm's debt-equity ratio

### M&M Proposition I

prop stating that the firm value increases with leverage (due to the interest tax shield)

### indirect costs

financial distress costs including agency costs as well costs incurred as a result of impaired ability to conduct business

### selfish strategy # 1

"take risks" strategy. e.g., suppose bonds are not due today. Manager can gamble with bondholders' money (S/he still controls the assets!)

### selfish strategy # 2

"underinvestment" strategy. e.g., stockholders of a firm with significant probability of bankruptcy often find that new investment helps the bondholders at the stockholders expense. In boom times the stockholder would benefit, but in a recession would likely make nothing (bankruptcy.) However, a bondholder wins in both cases without additional investment in either case.

### selfish strategy # 3

"milking the property" strategy whereby dividends are liquidated (paid out) and possible increases in perquisites to shareholders and/or mgmt. take place during a period where their is a probability of bankruptcy

### protective covenants, debt consolidation

Costs of debt can be reduced via _________ _________ and ______ ___________

### protective covenants

Limits on dividends, limits on sale of assets, minimum net working capital requirements, and limits on further borrowing are all examples of ___________ ______________ that can be implemented to reduce debt

### debt consolidation

A way of reducing debt whereby the number of debtor parties is minimized, effectively lowering contracting costs

### trade-off theory

the theory that capital structure is based on a trade-off between the tax advantage and the costs of financial distress

### pecking order theory

theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient

### internal financing, debt, new equity

According to the pecking order theory, ________ ___________ should be used first, followed by ________, and finally by ___ _______

### new equity, down, more, overpriced

In the pecking order theory, ____ _______ is issued last because the announcement of stock issue drives the stock price ________ b/c invetors believe managers are ______ likely to issue when shares are __________

### debt, equity

According to the pecking order theory, if external financing is required, firms issue _____ first and ______ as a last resort

### equity, lower

growth implies significant ______ financing, even in a world with low bankruptcy costs. Thus, high-growth firms will have _______ debt-equity ratios than low-growth firms

### how firms establish capital structure

low debt-asset ratios, changes in financial leverage affect firm's value (stock price increases with leverage and vice-versa), capital structures vary across industries, and firms behave as if they had a target debt-equity ratio

### factors in target d/e ratio

taxes (highly profitable firms should use more debt), types of assets (distress costs are significant and depend on asset type), uncertainty of operating income (uncertain operating income = greater chance of financial distress, and pecking order & financial slack (firms prefer to issue debt rather than equity if internal financing is insufficient... some slack is probably good)

### bankruptcy process

business failure, legal bankruptcy, technical insolvency, accounting insolvency, liquidation, and reorganization

### liquidation

Ch. 7 of the Federal Bankruptcy Reform Act of 1978, whereby trustee takes over assets, sells them , and distributes the proceeds according to the absolute priority rule. This is the complete termination of a firm as an ongoing business concern