Capital Structure

the mix of debt (long-term and short-term) and equity used to finance operations and growth.

How should corp. raise money? stocks/bonds

interest expense risk increases but NI/Equity = ROI

Shot Term
notes payable, commercial paper, and line of credit

Long Term
notes payable, debentures, bonds, and finance leases

unsecured, short-term debt instrument issued by a corporation - matures in 270 days or less
Must be used to finance current assets

Unsecured obligation of the issuing company.
holder of a debenture has the status of a general creditor.

Unsecured and ranks behind senior creditors in the event of an issuer liquidation
Commands higher interest rates because of the higher risk.

Pay interest only upon achievement of target income levels
used in reorganizations

high default risk and high return
also called noninvestment grade
used to raise capital for acquisitions and leveraged buyouts

loan that is secured by residential or commercial real property
Distinguishing feature of mortgage bonds is that trustees act on behalf of bondholders to foreclose on mortgage assets in the event of default.

whether or not it makes more sense to buy an asset or rent the asset. Cost benefit analysis.

Lessor - owner of an asset

Lessee - party exchanging payments for use

Operating lease

Financing lease

Both types of leases will result in the lessee recording a right-of-use (ROU)asset and a lease liability on the balance sheet. The ROU asset will be amortized and the lease liability will be paid down over the life of the asset.
Operating lease - lease expense represents the interest expense and the amortization of ROU asset on the income statement
Financing lease - interest and amortization expenses are accounted for separately on the income statement

Yes - there is an exception for leases with terms of 12 months or less.

OWN-ES
O- Ownership - transfer at the end of the lease
W- Written purchase option that the lessee is reasonably certain to exercise
N - Net present value of all lease payments and guaranteed residual value is equal to or substantially exceeds the underlying asset's fair value.
E - Economic life of the underlying asset is primarily encompassed within the term of the lease
S - Specialized asset such that it will not have an expected alternative use to the lessor when the lease ends.
Note: if none of the above criteria are met, or if the lease is short term (12 months or less), the lease is an operating lease

A = L + E
variable cost with no maturity risk thus, credit worthiness increased but NI/E = ROE as the equity in the equation increases the return on investment decreases
different forms of ownership
rights of shareholders to a firms assets in bankruptcy (liquidation) are less than that of both secured and unsecured bondholders.

has features similar to both debt and equity
require a fixed dividend - similar to coupon payments made on debt instruments
like equity because the timing of the dividend payment is ant the discretion of the board of directors (not mandatory) and the divident payments are not tax deductible

Cumulative Dividends - dividends in arrears may need to be paid prior to distribution of common stock dividends
Participating Feature - may participate in declared dividends along with common shareholders
Voting Rights - Rare

basic equity ownership security of a corporation
includes voting rights
option dividend payments by the issuer
issued with a stated par value
when common stock is issued at a given market price the proceeds received by the issuer are separated between the common stock account and addition paid in capital account
Common sock shareholders have LOWERS claim to firms assets in a liquidation.

If the weighted average cost of capital is less that the ROIC then the net present value goes up
Weighted average cost of capital is the average cost of all forms of financing used by a company
Often used internally as a hurdle rate for capital investment decisions.
optimal capital structure is the mix of financing instruments that produces the lowest WACC
The lower the hurdle, the easier it is to expect "+" spread - ROIC > WACC decreases

The average cost of debt and equity financing associated with a firm's existing assets and operations
Covers cost of funds employed
Know the formula - determined by weighting the cost of each specific type of capital by its proportion to the firm's total capital Structure
The percentage equity and percentage debt in capital structure is calculated using the market values

Long-Term Elements:

long-term debt, preferred stock, common stock, and retained earnings
Shot-Term Elements:

short term "interest bearing" debt - notes payable
After - Tax Cash Flows: cost of debt is computed on an after - tax basis because interest expense is tax deductible

represents the cost of debt before considering the tax shielding effects of the debt.

Because interest on debt is tax deductible, the tax savings reduces the actual cost of debt. Know formula

The more incentive exists to use debt financing

Lowers - first in line if company liquidates

equal to the rate of return required by the firm's common stockholders.

A firm should earn at least as much on any earnings retained and reinvested in the business as stockholders could have earned on alternative investments.

Capital Asset Pricing Model (CAPM)
Discounted Cash Flow (DCF)
Bond yield plus risk premium (BYRP)

Key Assumptions:

equal to the risk-free rate plus a risk premium
market risk premium is equal to the systematic risks associated with the overall stock market
Beta - representation of the volatility (risk) of the stock relative to the volatility of the overall market.
risk premium is the stock's beta coefficient multiplied by the market risk premium
Calc = risk free rate + [Beta x (Market return-risk free rate)]

Key Assumptions:

Stocks normally in equilibrium relative to risk and return
estimated expected rate of return will yield an estimated required rate of return
expected growth may be based on projections
Calc. Know

Key Assumptions

equity and debt security values are comparable before taxes
risks are associated with both the ind. firm and the state of the economy. Risk premiums depend on nondiversiable risk
Risk estimation can be derived by using a market analysis survey approach.

Calculating the average of the three costs.