Key Terms
Capital structure
The mix of debt and equity a firm uses to finance its assets. Assets sit on the left side of the balance sheet.
Financial leverage
The debt portion of that mix.
After-Tax Cost of Debt Formula
After-Tax Cost of Debt = YTM x (1 - Tax Rate)
Formula
R(e) = (D1 / P0) + g
Where
D1 = next year's expected dividend = D0 x (1 + g) P0 = current stock price g = constant dividend growth rate
EXAMPLE (using CAPM for equity)
D% = 24.43%, after-tax cost of debt = 4.99% E% = 75.57%, cost of equity (CAPM) = 13.4% WACC = (0.2443 x 4.99%) + (0.7557
Unlevered firm
Financed 100% by equity; no debt; unlevered equity.
Levered firm
Uses both debt and equity; levered equity.
KEY POINT (MM PROPOSITION I)
In perfect capital markets (no taxes, no transaction costs), the total value of the firm does not change based on how it
MM PROPOSITION II
When leverage increases, the cost of equity rises proportionally with the debt-to-equity ratio. The cheaper cost of debt
WHY EQUITY HOLDERS DEMAND MORE WITH LEVERAGE
Debt holders are paid first. Equity holders are residual claimants; they only get paid after everyone else.
Financial distress
When a firm has trouble meeting debt obligations.
Preferred stock
Equity with a fixed dividend that must be paid before common dividends.
Order of claimants (first to last)
1. Debt holders (bondholders) - paid interest first 2.
Cost of Preferred Stock Formula
R(pfd) = Annual Dividend / Price Per Share