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20 terms

FIN 600 - CH 16

What is business risk? What is financial risk? Suppose Firm A has greater business risk than Firm B. Is it true that Firm A also has a higher cost of equity capital?
"Business risk is the equity risk arising from the nature of the firm's operating activity, and is directly related to the systematic risk of the firm's assets. Financial risk is the equity risk that is due entirely to the firm's chosen capital structure. As financial leverage, or the use of debt financing, increases, so does financial risk and, hence, the overall risk of the equity. Thus, Firm B could have a higher cost of equity if it uses greater leverage."
Is there an easily identifiable debt-equity ratio that will maximize the value of a firm? Why or why not?
"Because many relevant factors such as bankruptcy costs, tax asymmetries, and agency costs cannot easily be identified or quantified, it's practically impossible to determine the precise debt-equity ratio that maximizes the value of the firm. However, if the firm's cost of new debt suddenly becomes much more expensive, it's probably true that the firm is too highly leveraged."
What types of industries tend to use greater financial leverage?
"The more capital intensive industries, such as airlines, cable television, and electric utilities, tend to use greater financial leverage. The general tendency is for firms with identifiable, tangible assets and relatively more predictable future earnings to use more debt financing. These are typically the firms with the greatest need for external financing and the greatest likelihood of benefiting from the interest tax shelter."
What types of industries tend to use less financial leverage?
"Industries with less predictable future earnings, such as computers or drugs, tend to use less financial leverage. Also, Industries with a higher concentration of growth and startup firms tend to use less financial leverage."
"Why is the use of debt financing referred to as financial ""leverage""?"
It is called leverage because it magnifies gains or losses.
What is the basic goal of financial management with regard to capital structure?
The basic goal is to minimize the value of non-marketed claims.
What does capital restructuring involve?
Capital restructuring involves changing the amount of leverage a firm has without changing the firm's assets.
How does a firm increase leverage?
The firm can increase leverage by issuing debt and repurchasing outstanding shares.
How does a firm decrease leverage?
The firm can decrease leverage by issuing new shares and retiring outstanding debt.
What is financial flexibility?
Financial flexibility tells how much a company is willing to devote to capital structure versus dividend policy.
What is the primary goal of financial managers?
The primary goal of financial managers is to maximize stockholder wealth or the value of the firm.
What will the optimal capital structure of the firm result in?
Maximize shareholder wealth or minimize the WACC (same thing)
How does leverage affect the EPS and ROE of a firm?
"Leverage amplifies the variation in both the EPS and the ROE. If we increase the amount of debt in a restructuring, we are decreasing the amount of outstanding shares."
Why is equity financing always more expensive than debt financing?
Due to the risk premium - equity is riskier than debt.
What are examples of direct costs of bankruptcy?
legal and administrative costs
What are examples of indirect costs of bankruptcy?
"inefficiencies created in the workplace, bad company culture, decreased sales due to poor company outlook, mgt spending time worrying about avoiding bankruptcy rather than running the business, interruptions in operations, loss of valuable employees"
What is the difference between chapter 11 and chapter 7 bankruptcy?
chapter 11 is reorganization and chapter 7 is liquidation
What is financial distress?
significant problems in meeting debt obligations
What is the effect of intangible assets on capital structure?
"A key driver in capital structure is the intangible assets. The more intangible assets a firm has, the higher the debt financing should be."
How does the value of the tangible and intangible assets change during financial distress?
"For PP&E, value is maintained. For intangible, value is not maintained."