BEC 2 - Capital Structure

• When several mortgages (secured against an asset) are pooled
• A trustee acts on behalf of the bondholders to foreclose on the mortgage assets in the event of default.

Non-investment grade, high risk, used to raise capital for acquisitions or leveraged buyouts

Pay interest only when certain income thresholds are achieved; used in re-orgs

• Unsecured, ST general credit
• Subordinated Debenture = ranks behind senior creditors, higher risk = higher interest

• Unsecured, ST (<270 days) bond sold in a special money market forum to finance ST obligations such as A/P or inventory purchases.
• Benefits: (1) if <270 days these do not have to be registered with the SEC, (2) take less time than applying for a loan, (3) buyers have no claim on a company's assets

• Benefits: variable cost with no maturity risk; thus, increased credit worthiness. Dividends are not mandatory.
• More equity lowers key comparative measurements such as Return on Equity, Earnings per Share.
• Since shareholders are the last in line to receive payout should the company liquidate, the shareholders expected a higher rate of return for the risk they take.

The ratio of debt to equity that produces the lowest WACC.

• Capital Lease
• O-W-N-S
• * Ownership transfers at end of lease
• * Written BPO
• * Ninety (90%) of the FV ≤ PV of min. lease pmts
• * Seventy-five (75%) of economic life
• The org must put the leased item asset and the lease obligation liability on the books
• Operational Lease
• Any lease not meeting the above criteria is operational. This is considered
• "off book" as no asset or liability is posted, just monthly lease pmts

• When the lessee wants to manage cash flow from operations.
• For an operating lease, the cash expended for the entire lease payment comes from operations.
• For a capital lease, only the interest portion of the lease payment comes from operations, the remainder pays the principal and is assigned to cash for financing.
• A higher operating cash flow leads to better interest rates for future debt financing.

• False
• The IRS views these as a distribution of profits, not an actual expense, and thus are not tax deductible.

• DEBT vs EQUITY
• (1) No, Yes
• (2) Yes, No
• (3) No, Yes
• (4) Yes, No
• (5) Low, High
• (6) Fixed, Variable

• Company: To determine if a new project should be performed. The new project must cover the cost of the funds employed for that project.
• Say a company has a WACC of 10% and wants to start a new project. The cost of raising the capital would be about 10%. If the expected return on the project is 7% it would lose 3%; but, if the return is 15% it could expect about a 5% profit.
• Investor: The higher the WACC, the less the company is creating value b/c it must overcome more expensive borrowing costs. Ex=if the company produces 10% returns, and the WACC is 8%, the company is only producing 2% of value (10%-8%=2%) thus for each dollar earned, only 2 cents is profit.

• Weighted Avg Cost of Capital (or Credit)
• WACC = (D/V)(R1)(1-t) + (E/V)(R2) + (P/V)(R3) where
• D=market value of the company's debt
• E=market value of the company's equity
• P=market value of the company's preferred stock
• V=total market value of the company (D+E+P)
• R1=wt avg cost of debt [use the effective interest rate]
• t=tax rate
• R2=shareholder expected rate of return
• R3=effective return on preferred stock

• FALSE
• APIC isn't used anywhere in the calculation

• Makes it easier to accept new projects because the expected return can be lower.
• It increases the firm's value as measured by (1) the residual income, (2) the Free Cash Flow to the Firm (FCFF)/WACC.

The cash available to pay investors after a company pays its costs of doing business, invests in ST assets (like inventory) and invests in LT assets (like PP&E).

Bonds are preferrable when the tax rate is higher as the interest on bonds receive a tax deduction, but dividends paid do not.

• Capital Asset Pricing Model
• Discounted Cash Flow
• Bond Yield Plus Risk Premium
• Synonomouse with common equity

Dividends are paid from retained earnings. The opportunity cost to the shareholder is to determine if the return that the company will receive by using those retained earnings is greater than the amount the investor would have gained if he/she would have received that money as a dividend to invest elsewhere.

• Risk-free rate + Beta(Market Rate - Risk-Free Rate) where
• Risk Premium: Beta(Market Rate - Risk-Free Rate)
• Market Risk Premium: (Market Rate - Risk-free Rate)
• So CAPM could be: risk-free rate + risk premium OR
• risk-free rate + (Beta x Market Risk Premium)

• Cost of Retained Earnings or Cost of Common Equity
• Rate of return needed to make an investment at a certain risk level over time to be equally attractive to investors compared to less risky investments to entice them to your offering.
• It doesn't mean the investor will earn this amount of return.

• Another method of determining the rate of return (aka Cost of Retained Earnings or Cost of Common Equity) needed to make an investment at a certain risk level over time to be equally attractive to investors compared to less risky investments.
• If the dividend is expected to grow each year, compute the dividend return per share at the end of the year.

• (future dividend amt / current stock price) + growth rate OR
• NOTE: If the dividend amt provided in the problem is "just" paid, it must be adjusted to become "next year's" dividend amt, as follows.
• [(current dividend x [1+g])/Current stock price] +g, where g=growth rate
• If growth rate isn't provided: (Retention Rate x ROE) = (1-payout rate) x ROE [if we're paying out 40% we must be retaining 60%]

• Another method of calculating the cost of retained earnings or Cost of Common Equity
• Stocks are more risky than bonds (with the set interest rate). To make a stock equally attractive to investors compared to the less risky bond, a premium must be added.
• BYRP=Pretax cost of bonds (firm's typical bond yield rate) + market risk premium
• Market Risk Premium: Market Rate - Risk-Free Rate

• Effective annual interest payments / debt outstanding (aka proceeds).
• To determine the relevant pretax cost of long-term debt that will help determine the best debt-to-equity mix for the company (WACC).

• After-tax cost of debt = pretax cost of debt x (1-tax rate)
• aka Yield to Market (YTM) or Market Rate

A term used with loans equal to one-hundredth of 1 percent, or 0.01 percent.

• Preferred stock dividends / net proceeds of preferred stock, where
• dividends = par value * rate; net proceeds = amount received - issuance costs
• Preferred stock is more risky for the company. It is obligated to pay dividends, but cannot deduct dividends for tax purposes. Plus, because preferred stockholders receive payout during liquidation after credits, they expect a higher rate of return.
• Benefits: dividends aren't legally required and can delay payment.

The costs associated with issuing new stock.

Current stock price x no. of shares outstanding

The underpricing is subtracted as if it were float cost.