Finance 306 Test #3 review

Finance 306 Test#3 - Finance 306 Test#3 Review Chapter 12 The cost of capital depends primarily on the use of the funds not the source Cost of debt

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Finance 306 Test #3 Review Chapter 12: The cost of capital depends primarily on the use of the funds, not the source Cost of debt – the return that lenders require on the firm’s debt Cost of preferred stock = the fixed dividend/ the current price per share of the preferred stock Weighted average cost of capital (WACC) – the weighted average of the cost of equity and the after tax cost of debt Pure play approach (to estimating the required return on an investment) use of a WACC that is unique to a particular project, based on companies in similar lines of business Know how to calculate WACC, cost of equity, and cost of debt Chapter 13: Homemade leverage – the use of personal borrowing to alter the degree of financial leverage M&M proposition I – the value of a firm is independent of its capital structure. It also states that it is completely irrelevant how a firm chooses to arrange its finances M&M proposition II – a firm’s cost of equity capital is a positive linear function of its capital structure, which tells us that the cost of equity depends on 3 things: the required rate of return on the firm’s assets, the firm’s cost of debt, and the firm’s debt-to-equity ratio Business risk – the equity risk that comes from the nature of the firm’s operating activities Financial risk – the equity risk that comes from the financial policy (i.e. capital structure) of the firm Interest tax shield – the tax saving attained by a firm from the tax deductibility of interest expense (to calculate simply multiply the interest payment made to bondholders times the corporate tax rate) Direct bankruptcy costs – the costs that are associated with bankruptcy, such as legal and administrative expenses
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Indirect bankruptcy costs – the costs of avoiding a bankruptcy filing incurred by a financially distressed firm Financial distress costs – the direct and indirect costs associated with going bankrupt or experiencing financial distress Static theory of capital structure – theory that a firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress (p. 408-09) Bankruptcy – a legal proceeding for liquidating or reorganizing a business Liquidation – (chapter 7 bankruptcy) means termination of the firm as a going concern, and involves selling off all assets of the firm. Reorganization – (chapter 11 bankruptcy) financial restructuring of a failing firm to attempt to continue operations as a going concern. Absolute priority rule (APR) – the rule establishing the priority of claims in liquidation; after payment of the bankruptcy administration costs, payments are made to creditors who have collateral, then to shareholders, common stockholders being the last on the list Chapter 14: Dividend – a payment made out of a firm’s earnings to its owners, in the form of either
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This note was uploaded on 04/07/2008 for the course FIN 306 taught by Professor Littleson during the Spring '08 term at Clemson.

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Finance 306 Test#3 - Finance 306 Test#3 Review Chapter 12 The cost of capital depends primarily on the use of the funds not the source Cost of debt

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