Financial Management II Terms

Reviewer (Cost of Capital and Leverage)

1. The cost of capital is the rate of
return that a firm must earn on the
projects in which it invests to maintain
the market value of its stock. It can
also be thought of as the rate of return
required by the market suppliers of
capital to attract their funds to the
firm.
2. Business riskthe risk to the firm of
being unable to cover operating costs
is assumed to be unchanged. This
assumption means that the firms
acceptance of a given project does not
affect its ability to meet operating
costs.
3. Financial riskthe risk to the firm of
being unable to cover required
financial obligations (interest, lease
payments, preferred stock dividends)
is assumed to be unchanged. This
assumption means that projects are
financed in such a way that the firms
ability to meet required financing
costs is unchanged.
4. Target capital structure - The
desired optimal mix of debt and equity
financing that most firms attempt to
maintain.
5. The cost of long-term debt, ki, is
the after-tax cost today of raising longterm funds through borrowing. For
convenience, we typically assume that
the funds are raised through the sale
of bonds.
6. The net proceeds from the sale of a
bond, or any security, are the funds
that are actually received from the
sale.
7. Flotation coststhe total costs of
issuing and selling a securityreduce
the net proceeds from the sale. These
costs apply to all public offerings of
securitiesdebt, preferred stock, and
common stock.
8. The cost of preferred stock, kp, is
the ratio of the preferred stock

dividend to the firms net proceeds

from the sale of the preferred stock.
9. Cost of common stock equity, ks The rate at which investors discount
the expected dividends of the firm to
determine its share value.
10.Constant-growth
valuation
(Gordon) model - Assumes that the
value of a share of stock equals the
present value of all future dividends
(assumed to grow at a constant rate)
that it is expected to provide over an
infinite time horizon.
11.Capital
asset
pricing
model
(CAPM) - Describes the relationship
between the required return, ks, and
the non diversifiable risk of the firm as
measured by the beta coefficient, b.
12.Cost of retained earnings, kr - The
same as the cost of an equivalent fully
subscribed issue of additional common
stock, which is equal to the cost of
common stock equity, ks.
13.Cost of a new issue of common
stock, kn - The cost of common stock,
net of under pricing and associated
flotation costs.
14.Underpriced - Stock sold at a price
below its current market price, P0.
15.weighted average cost of capital
(WACC), ka - Reflects the expected
average future cost of funds over the
long run; found by weighting the cost
of each specific type of capital by its
proportion in the firms capital
structure.
16.Book value weights - Weights that
use accounting values to measure the
proportion of each type of capital in
the firms financial structure.
17.Market value weights - Weights that
use market values to measure the
proportion of each type of capital in
the firms financial structure
18.Historical weights - Either book or
market value weights based on actual
capital structure proportions.
19.Target weights - Either book or
market value weights based on
desired capital structure proportions.

20.Weighted marginal cost of capital

(WMCC) - The firms weighted
average cost of capital (WACC)
associated with its next dollar of total
new financing.
21.Break point - The level of total new
financing at which the cost of one of
the
financing
components
rises,
thereby causing an upward shift in the
weighted marginal cost of capital
(WMCC).
22.Weighted marginal cost of capital
(WMCC) - schedule Graph that relates
the firms weighted average cost of
capital to the level of total new
financing.
23.Investment
opportunities
schedule (IOS) - A ranking of
investment possibilities from best
(highest return) to worst (lowest
return).
Leverage and Capital Structure
1. Leverage results from the use of
fixed-cost assets or funds to magnify
returns to the firms owners.
2. Capital structure - The mix of longterm debt and equity maintained by
the firm.
3. Operating leverage is concerned
with the relationship between the
firms sales revenue and its earnings
before interest and taxes, or EBIT.
(EBIT is a descriptive label for
operating profits.)
The potential use of fixed
operating costs to magnify the
effects of changes in sales on
the firms earnings before
interest and taxes.
4. Financial leverage is concerned with
the relationship between the firms
EBIT and its common stock earnings
per share (EPS).
The potential use of fixed
financial costs to magnify the
effects of changes in earnings
before interest and taxes on the
firms earnings per share.

5. Total leverage is concerned with the

relationship between the firms sales
revenue and EPS.
The potential use of fixed costs,
both operating and financial, to
magnify the effect of changes in
sales on the firms earnings per
share.
6. Breakeven
analysis,
sometimes
called cost-volume-profit analysis, is
used by the firm (1) to determine the
level of operations necessary to cover
all operating costs and (2) to evaluate
the
profitability
associated
with
various levels of sales.
7. Operating breakeven point - The
level of sales necessary to cover all
operating costs; the point at which
EBIT $0.
8. Fixed costs are a function of time,
not sales volume, and are typically
contractual; rent, for example, is a
fixed cost.
9. Variable costs vary directly with
sales and are a function of volume, not
time; shipping costs, for example, are
a variable cost.
10.Degree of operating leverage
(DOL) -The numerical measure of the
firms operating leverage.
11.Degree of financial leverage (DFL)
- The numerical measure of the firms
financial leverage.
12.Degree of total leverage (DTL) The numerical measure of the firms
total leverage.
13.Pecking order - A hierarchy of
financing that begins with retained
earnings, which is followed by debt
financing and finally external equity
financing.
14.Asymmetric
informationThe
situation in which managers of a firm
have
more
information
about
operations and future prospects than
do investors.
15.Signal - A financing action by
management that is believed to reflect
its view of the firms stock value;
generally, debt financing is viewed as

a positive signal that management

believes the stock is undervalued,
and a stock issue is viewed as a
negative signal that management
believes the stock is overvalued.
16.Optimal capital structure - The
capital
structure
at
which
the
weighted average cost of capital is

minimized, thereby maximizing the

firms value.
17.EBITEPS approach - An approach
for selecting the capital structure that
maximizes earnings per share (EPS)
over the expected range of earnings
before interest and taxes (EBIT).