Corporate Finance Structure Flashcards

A leveraged buyout (LBO) typically changes a target's capital structure by doing what?

Answer: Sharply increasing the proportion of debt

An LBO acquires a company using a high proportion of borrowed funds, greatly increasing leverage.

Under the original Modigliani-Miller proposition (no taxes), capital structure is said to be what?

Answer: Irrelevant to total firm value

Without taxes or frictions, MM showed that capital structure does not affect total firm value.

A firm with high, stable cash flows and many tangible assets is generally able to support what?

Answer: More debt because assets provide collateral and cash covers payments

Stable cash flows and tangible collateral increase debt capacity and lower distress risk.

The use of debt to increase the potential return on equity is best described by which term?

Answer: Financial leverage

Financial leverage uses debt to magnify the returns available to equity holders.

Which of the following would most likely raise a firm's cost of debt?

Answer: A downgrade in its credit rating

A credit downgrade signals higher default risk, so lenders demand a higher interest rate.

Agency costs of debt can arise when shareholders have an incentive to do what?

Answer: Take on excessively risky projects at the expense of bondholders

Shareholders may favor risky projects because they capture the upside while creditors bear the downside.

Times interest earned (interest coverage) ratio measures a firm's ability to do what?

Answer: Cover its interest obligations from operating earnings

The times-interest-earned ratio compares EBIT to interest expense, gauging ability to service debt.