Module 1: Capital Structure 1

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