Capital structure
Debt + Equity
Commercial paper (debt financing)
Unsecured, ST debt instrument issued by corporation
Matures in 270 days or less & typically matures in 30 days
Proceeds MUST be used to finance CA
Debentures (debt financing)
Unsecured obligation of issuing company
Subordinated Debentures (debt financing)
Bond issue that's unsecured & ranks behind senior creditors in event of issuer liquidation
Command higher interest rates
Income Bonds (debt financing)
Securities that pay interest only upon achievement of target income levels
VERY RISKY
Junk Bonds (debt financing)
Characterized by high default risk & high return
Noninvestment grade bonds
Mortgage bonds (debt financing)
Loan secured by residential/commercial real property
Trustees act on behalf of bondholders to foreclose on mortgage assets in event of default
Leasing (debt financing)
contractual agreement in which owner of asset (lessor) allows lessee to use property in exchange for periodic lease payments
Operating lease
1. Lessee records ROU asset & lease liability
2. Amortize ROU & decrease lease liability w/ payment
3. Lease expense = interest expense + amortization
Finance lease
1. Lessee records ROU asset & lease liability
2. Amortize ROU & decrease lease liability w/ payment
3. Interest expense & Amortization expense recorded separately
Finance lease requirements
1. O wnership transfer at end of lease
2. W ritten purchase option lessee reasonably certain to exercise
3. N et present value of all lease payments + guaranteed residual value => asset's FV
4. E conomic life primarily in terms of lease
5. S pecialized as
Preferred stock (equity financing)
hybrid security
1. Fixed dividend payment
2. Timing of dividend payment at discretion of BOD
Common stock (equity financing)
basic equity ownership security of corporation
1. Voting rights
2. Lowest claim to assets
Weighted average cost of capital
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 = mix of financing that produces LOWEST WACC
Value of a firm
PV of cash flow produced by firm - costs of capital used to finance
Computing Weighted average cost of capital
average cost of debt & equity financing associated w/ firm's existing assets & operations
WACC Formula
(Common equity/sum) + (Preferred equity/sum) + [(debt/sum)x[Required rate of return x(1-tax)]
Cost of debt computed on after-tax basis
b/c interest expense is tax deductible
Weighted average cost of debt
Debt costs generally stated as interest rate of various debt instruments
Basis points = 1/100 percent
Weighted average interest rate
Effective annual interest payments/Debt outstanding
Cost of preferred debt
Dividends paid to preferred stockholders
Preferred stock dividends/Net proceeds of preferred stock (net of flotation costs or issuance costs)
Cost of retained earnings
Rate of return required by firm's common stockholders
Capital Asset Pricing Model (CAPM) (Cost of retained earnings computation) Assumption
1. Cost of RE = risk-free rate + risk premium
2. Market risk premium = systematic risk associated w/ overall stock market
3. Beta coefficient = representation of volatility/risk of stock relative to volatility of overall market
4. Risk premium = stock's b
CAPM Cost of Retained Earnings
Risk-free rate + [Beta x (Market return - Risk free rate)]
DCF Cost of Retained Earnings
(Dividend per share expected at end of year 1/current market value or price) + constant rate of growth
Discounted Cash Flow (DCF) (Cost of retained earnings computation) Assumption
1. Stocks in equilibrium w/ risk & return
2. Estimated expected rate of return will yield estimated required rate of return
Bond Yield Plus Risk Premium (BYRP) (Cost of retained earnings computation) Assumption
1. Equity & debt security values comparable before taxes
2. Risks associated w/ both individual firm & state of economy
BYRP Cost of Retained Earnings
Pretax cost of LT debt = Market risk premium