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Corporate Finance FINAL

STUDY
PLAY
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