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Finance 402 Test 2

QuestionAnswer
Capital Structure is the mix of debt and equity that a firm uses to finance its activities
Leverage The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment. The amount of debt used to finance a firm's assets. higher debt higher leverage.
MM Proposition I No capital structure is any better or worse than any other capital structure for the firm's stockholders.
MM Proposition II The expected return on equity is positively related to leverage because the risk to equity-holders increases wih leverage.
Bankruptcy where ownership of the firm's assets are all transferred from the stockholders to the bondholders.
Financial Distress situation where a firm's operating cash flows are not sufficient to satisfy current obligations (such as trade credit or interest expenses) and the firm is forced to take corrective action.
Insolvency Inability to pay one's debts; lack of means to paying one's debts. Such a condition of a man's assets and liabilities that the former made immediately available would be insufficient to discharge the latter.
Liquidation means termination of the firm as a going concern; it involves selling the assets of the firm for salvage value. The proceeds, net of transaction costs, are distributed to creditors in order of established priority.
Reorganization is the option of keeping the firm a going concern; it sometimes involves issuing new securities to replace old securities.
Absolute Priority Rule (APR) Stipulates order of payment creditors before shareholders, in the event of liquidation. The APR is used in bankruptcies to decide what portion of payment will be received by which participants. Debts to creditors paid first & shareholders divide the rest.
Pecking-Order Theory Senior creditors always get first grabs at the proceeds from liquidation, and shareholders are the last to get paid. Prefer internal to external financing.
Free Cash Flow Hypothesis Expect to see more wasteful activity in a firm with a capacity to generate large cash flows than in one with a capacity to generate only small cash flows.
Leveraged Buyouts (LBOs) a purchaser (usually a team of existing mgmt) buys out the stockholders at a price above the current market. Company goes private.
Exchange Offers 1. offer allows stockholders to exchange some of their stock for debt, thereby increasing leverage. 2. allows bondholders to exchange some of their debt for stock, decreasing leverage.
Trade-off Theory choose the capital structure which maximizes the value of the firm
Signaling Theory managers often have better information (asymmetric information).
Marketable Claims/Non-marketable Claims marketable claims can be bought and sold in financial markets
Financial Slack Having readily available financing sources, especially important to firms with lots of NPV projects.
Economic Failure exists when a firm's revenues are insufficient to cover its total costs.
Business Failure any business which as terminated operations with a resultant loss to its creditors.
Technical Insolvency when a firm cannot meet its current obligations as they fall due. Could be temporary, or the first step towards economic failure.
Insolvency in Bankruptcy book value of a firm's total liabilities exceeds the true market value of its assets. Does not necessarily imply that the firm is in legal bankruptcy proceedings.
Legal Bankruptcy occurs when a firm files for bankruptcy under federal law.
Assignment an informal procedure for liquidating a firm. Title to the debtor's assets is transferred to a third party.
Assignee (trustee) The third party to whom title has been transferred and who is required to liquidate the firm's assets either through a private or public sale and then to distribute the proceeds among the firm's creditors on a pro rata basis.
Chapter 11 Bankruptcy Business reorganization guidelines.
Chapter 7 Bankruptcy Liquidation procedures
Trustee appointed to control the company when current management is incompetent or fraud is suspected. Used only in unusual circumstances.
Voluntary Bankruptcy A bankruptcy petition filed in federal court by the distressed firm's management.
Involuntary Bankruptcy A bankruptcy petition filed in federal court by the distressed firm's creditors.
Common Pool Problem individual creditors would have an incentive to foreclose on the firm even though it is worth more as a going concern.
Automatic Stay under Chapter 11, it limits the ability of creditors to foreclose unilaterally....can foreclose collectively.
Feasibility there is a reasonable chance that the reorganized company will be viable.
Bankruptcy Act of 2005 intended to prevent individuals and firms from shirking their obligations too easily by filing for bankruptcy.
Altman's Z score quantitative model that uses a blend of traditional financial ratios and multiple discriminant analysis.
Recapitalization Restructuring a company's debt & equity mixture, often with the aim of making a company's capital structure more stable. The process involves the exchange of one form of financing for another.
Tin Parachute An employment agreement that guarantees a severance payment to employees who are dismissed after a company has had a change in ownership.
Negative Covenant limits or prohibits actions that the company may take.
Protective Covenants agreements made between stockholders and bondholders, in an effort to lower interest rates.
Positive Covenant specifies an action that the company agrees to take or a condition the company must abide by.
agency costs An internal cost that arises from/be paid to an agent acting on behalf of a principal. It arises b/c of core problems such as conflicts of interest between shareholders and management.
Created by: hfoster