82 terms

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

systematic

The beta of a security provides an estimate of the __________ risk of the security

greater

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

beta

regression analysis can be used to estimate ______

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

systematic, 1

the ________ risk of the market is measured by a beta of

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

unlevered cost of capital

the cost of capital for a firm with no debt in its capital structure

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 __________

MM Proposition I w/ no tax

The concept of homemade leverage is most associated with

direct bankruptcy

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

liquidation

The complete termination of a firm as a going business concern is called ____________

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

lending portfolio

type of portfolio containing risk-free and risky Assets (assets not liablities)

borrowing portfolio

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

risk-free

A __________ asset has zero variance and zero covariance with any other asset

CML

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

tangency portfolio

the unique portfolio of risky assets that is also on the CML is 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

systematic risk

Also, known as market risk, the risk that cannot be diversified away

beta

a measure of how an individual security's returns vary with market returns

1

the beta of the market portfolio is

more, less

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

SML

the graph of the linear CAPM relationship

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)

beta, systematic

The _____ of a security provides an estimate of the _________ risk of the security

measurement error

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

market risk premium

(Rm-Rf)=

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

WACC

______ is used to calculate the cost of capital when a firm uses leverage.

ROE, ROA, leverage

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

WACC

the required return on assets is also known as

WACC

the weighted average of the firm's cost of equity, preferred stock & after-tax debt

greater

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

value

Regarding capital structure, the sum of the value of the firm's debt and the firm's equity

big

A firm should pick the debt-equity ratio that makes the pie as ____ as possible

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 II

prop stating that leverage increases the risk and return to stockholders

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)

homemade leverage

the use of borrowing on the personal level as opposed to the corporate level

direct costs

financial distress costs including legal and administrative costs

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

business failure

when a business has terminated with a loss to creditors

legal bankruptcy

when a business has to petition federal court for bankruptcy

technical insolvency

when a firm is unable to meet financial/debt obligations

accounting insolvency

when a businesses book value of equity is negative

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

reorganization

Ch. 11 of the Federal Bankruptcy Reform Act of 1978, whereby the corporation is restructured with a provision to repay its creditors