Corporate Finance: Capital Structure Principles
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Questions and Answers

What is the Target Capital Structure?

The mix of debt, preferred stock and common equity the firm plans to raise to fund its future projects.

What does the term Capital Component refer to?

The investor-supplied items like debt, preferred stock, and common equity used to raise funds.

What does WACC stand for?

Weighted Average Cost of Capital.

What is the Before-Tax Cost of Debt?

<p>The interest rate the firm must pay on new debt.</p> Signup and view all the answers

What is the After-Tax Cost of Debt formula?

<p>rd(1-T).</p> Signup and view all the answers

Define the Cost of Preferred Stock.

<p>The required rate of return that investors demand on the firm's preferred stock.</p> Signup and view all the answers

What is the Cost of Retained Earnings?

<p>The component cost of common equity or internal equity.</p> Signup and view all the answers

What is the Cost of New Common Stock?

<p>The cost of external equity raised by issuing new stock.</p> Signup and view all the answers

What are Flotation Costs?

<p>The percentage cost of issuing new stock.</p> Signup and view all the answers

What is the Retained Earnings Breakpoint?

<p>The amount of capital raised beyond which new common stock must be issued.</p> Signup and view all the answers

Who provides the capital considered in the WACC calculation?

<p>Investors.</p> Signup and view all the answers

How is the Market Value of Equity calculated?

<p>Number of shares of stock outstanding multiplied by the current stock price.</p> Signup and view all the answers

What does Component Cost refer to?

<p>The cost of each component of the capital components.</p> Signup and view all the answers

What do wd, wp, and wc represent?

<p>Target weights of debt, preferred stock, and common equity.</p> Signup and view all the answers

Does debt have a tax adjustment factor for the WACC calculation?

<p>True</p> Signup and view all the answers

Are there two different component costs for common equity?

<p>True</p> Signup and view all the answers

Which component cost for common equity tends to be more relevant?

<p>False</p> Signup and view all the answers

True or False: The stock price depends on after-tax cash flows.

<p>True</p> Signup and view all the answers

True or False: The cost of debt is the interest rate on new debt.

<p>True</p> Signup and view all the answers

Which is more reflective of the current market cost of debt, the coupon rate or YTM?

<p>YTM.</p> Signup and view all the answers

Is a tax adjustment made to the cost of preferred stock?

<p>False</p> Signup and view all the answers

What are the two ways common equity is raised?

<ol> <li>By retaining some of the current year's earnings; 2. Issuing new common stock.</li> </ol> Signup and view all the answers

Why does equity raised from issuing new common stock have a higher cost than retaining earnings?

<p>Flotation costs incurred to sell the new stock.</p> Signup and view all the answers

What kind of cost does retained earnings incur?

<p>Opportunity cost.</p> Signup and view all the answers

True or False: The firm needs to earn at least as much on any earnings retained as the stockholders could earn on alternative investments of comparable risk.

<p>True</p> Signup and view all the answers

What are the four problems with the CAPM approach?

<ol> <li>Stand-Alone Risk; 2. Rrf estimation; 3. Estimating future beta; 4. Estimating Market risk Premium.</li> </ol> Signup and view all the answers

What is the weakness of the Bond-Yield-plus-Risk-Premium approach?

<p>It only provides a ballpark estimate due to the indeterminate risk premium.</p> Signup and view all the answers

Name three factors a firm cannot control.

<ol> <li>Interest rates; 2. General level of stock prices; 3. Tax rates.</li> </ol> Signup and view all the answers

What are three ways a firm can affect its cost of capital?

<ol> <li>By changing its capital structure; 2. By changing its dividend payout ratio; 3. By altering its capital decision rules.</li> </ol> Signup and view all the answers

True or False: Each project's hurdle rate should reflect the risk of the project, not the risk associated with the firm's average project.

<p>True</p> Signup and view all the answers

Study Notes

Target Capital Structure

  • Mix of debt, preferred stock, and common equity for funding future projects.
  • Defines how a firm plans to raise capital.

Capital Component

  • Investor-supplied items: debt, preferred stock, and common equity.
  • Essential for financing projects.

Weighted Average Cost of Capital (WACC)

  • Averages the costs of debt, preferred stock, and common equity.
  • Represents the overall cost of capital for a firm.

Before-Tax Cost of Debt (rd)

  • Interest rate paid by a firm on new debt.
  • Can be determined by consulting bankers or finding the Yield to Maturity (YTM) on existing debt.

After-Tax Cost of Debt (rd(1-T))

  • Relevant for calculating WACC.
  • Considers tax deductibility of interest payments.

Cost of Preferred Stock (rp)

  • Rate of return required by investors on preferred stock.
  • Calculated as: preferred dividend (Dp) / current price (Pp).

Cost of Retained Earnings (rs)

  • Rate of return required by investors on a firm's common stock.
  • Represents internal equity.

Cost of New Common Stock (re)

  • Cost associated with raising external equity through new stock issuance.
  • Includes flotation costs; mainly affects rapidly growing firms.

Flotation Costs (F)

  • Percentage cost of issuing new stock.
  • Integral in determining the overall cost of new common equity.

Flotation Cost Adjustment

  • Additional cost added to rs to account for flotation when calculating re.

Retained Earnings Breakpoint

  • Capital threshold beyond which new common stock needs to be issued.

Providers of Capital for WACC Calculation

  • Investors are the primary providers considered in WACC.

Market Value of Equity

  • Calculated as the number of shares outstanding multiplied by the current stock price.

Component Cost

  • Individual cost of each capital component.
  • Example: cost of debt is reflected in the borrowing rate.

Target Weights (wd, wp, wc)

  • Target proportions of debt, preferred stock, and common equity.
  • Actual weights may differ from these targets.

Tax Adjustment for Debt in WACC

  • Interest on debt is tax-deductible, unlike preferred stock dividends and common stock returns.

Component Costs for Common Equity

  • Internal equity (rs) represents retained earnings.
  • External equity (re) represents new stock issuance.

Relevance of Component Costs for Common Equity

  • Internal equity (rs) is typically more relevant for established firms, while external equity (re) is relevant for growing, young firms.

Stock Price Dependency

  • Stock price relies on after-tax cash flows, reinforcing the use of after-tax cost of debt in WACC.

Cost of Debt

  • Defined as the interest rate on new debt only.
  • Focuses on new debt for accurate budgeting decisions.

Yield to Maturity (YTM)

  • More relevant than the coupon rate for determining the current market cost of debt.

Tax Adjustment for Preferred Stock

  • No adjustment is made since preferred dividends are not tax-deductible.

Common Equity Raising Methods

  • Retaining current earnings.
  • Issuing new common stock.

Higher Cost of New Equity vs. Retained Earnings

  • Issuing new stock incurs flotation costs, raising its cost compared to retained earnings.

Retained Earnings Cost

  • Opportunity cost for shareholders who could have invested retained earnings elsewhere.

Opportunity Cost of Retained Earnings

  • Firm must earn returns at least equal to what stockholders could achieve with alternative investments.

Weaknesses of the CAPM Approach

  • Stand-alone risk and lack of diversification can distort beta calculation.
  • Difficulty in estimating future beta and market risk premiums.

Limitations of Bond-Yield-plus-Risk-Premium Approach

  • Provides rough estimates; risk premium is hard to determine accurately.

Factors Firm Cannot Control

  • Interest rates, stock prices, and tax rates.

Ways Firms Can Affect Cost of Capital

  • Adjusting capital structure.
  • Changing dividend payout ratios.
  • Modifying capital decision rules.

Project Hurdle Rate

  • Each project's hurdle rate should correspond to its specific risk rather than the firm's average risk.

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Description

This quiz explores the key elements of corporate finance, including target capital structure and the various components used for funding projects. Test your knowledge of Weighted Average Cost of Capital (WACC) and the different costs associated with debt, preferred stock, and retained earnings.

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