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Definition
| 1. The use of fixed cost funds (debt) to increase returns to shareholders |
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| 2. Degree of financial leverage |
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| 2. The percentage change in earnings per share divided by the percentage change in EBIT |
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| 3. The rate of return needed to compensate the suppliers of capital. |
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| 4. The rate of return required to compensate a company's common shareholders for the use of their capital |
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| 5. The rate of return required to compensate a company's debt holders for the use of their capital |
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| 6. Weighted average cost of capital (WACC) |
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Definition
| 6. The average of the cost of equity and the cost of debt calculated according to the proportion that each represents of the whole invested capital. |
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| 7. The amount of income taxes saved because of the deductibility of interest expense |
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| 8. The costs associated with managing the agency (principal agent) relationship between shareholders and corporate decision makers |
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| 9. Asymmetric information theory |
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Definition
| 9. A theory based on empirical research that indicates company managers have preferred order for obtaining capital for financing investment and do not constantly seek to identify and move towards an optimal structure |
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| 1. Explain how a company's funds flow in a cycle |
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Definition
1. Company's funds flow in the following cycle:
1. company securities are sold to suppliers of capital in the capital markets
2. Proceeds from the security's sale are used to purchase assets
3. cash returns from the assets can be retained in the company to finance operations or to finance the purchase of more assets
4. ulitimately, cash returns can be distributed to the suppliers of capital.
5. debt holders receive income in the form of interest pmts, and equity holders can receive income as cash dividends. |
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| 2. Describe the debt and equity features of preferred stock. |
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Definition
| 2. Preferred stock has features of both debt and equity. It can resemble debt if its dividend is a fixed obligation (either a stated percentage of the par value of the preferred share or a stated dollar amt per share) and can resemble euqity in that omission of a dividend does not result in the entire issue becoming payable immediately, as would a bond. |
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| 3. Explain why preferred stock might be converted to common. |
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Definition
| 3. Some preferred stock, like some debt securities, is convertible into common stock under terms and conditions specified at the time of issue. This feature is used when the co wants to sell common stock to increase capital, but when selling is not economical because the co's stock price is depressed. |
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| 4. Explain how debt capital is ususally raised |
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Definition
| 4. Debt capital is ususally raised through the sale of bonds in the capital market |
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| 5. Explain how debt is used to increase returns to shareholders |
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Definition
| 5. Using fixed cost funds (debt) to increase returns to shareholders is called financial leverage. This increase is accomplished by using the capital raised by the issue of debt to earn a rate of return higher than the fixed costs of that debt. |
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| 6. Describe financial leverage analysis |
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Definition
| 6. Financial leverage analysis is a technique used to compare earnings per share (EPS) under alternate capitalization plans with varying levels of debt and equity |
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| 7. Contrast the degree of fianncial leverage with the debt-to-equity ratio |
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Definition
| 7. The degree of fianncial leverage identifies the effect of a company's financial leverage on its earnings per share, whreas the debt-to-equity ratio indicates the amount of a company's financial leverage. |
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| 8. Explain why insurers require capital in addition to the capital required to invest in real assets |
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Definition
| 8. In addition to the capital required to invest in real assets, insurers require capital, or policyholders' surplus, to moderate the volatility in the insurance portfolio. If claim payments exceed projections, the insurer's equity capital must finance the shortfall in the short term. Over a longer term, premiums will be brought into balance with claims, and the company's policyholders' surplus will be restored. |
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| 9. Describe the other functions of insurer capital in addition to investing in real assets and moderating the volatility of the insurance portfolio. |
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Definition
| 9. In addition to serving the functions of investing in real assets and moderating the volatility of the insurance portfolio, insurer capital has several other functions. Insurer capital provides the financing for the creation and growth of the unearned premium, loss, and loss adjustment reserves required by statutory accounting rules as an insuer's premium volume increases. It also absorbs fluctuations in the value of the co's investment portfolio and in the gains and losses realized upon the sale of securities. |
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| 10. ID three approaches for estimating the cost of equity capital |
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Definition
10. The three approaches for estimating the cost of equity capital are:
1. Dividend growth model
2. Capital asset pricing model (CAPM)
3. Security Market Line (SML) |
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| 11. Explain how the cost of debt is similar to the cost of equity |
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Definition
| 11. Like the cost of equity, the cost of debt is essentially an opportunity cost concept that compares the return on insurer debt with the return on other debt of equivilant credit risk. |
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| 12. ID the two steps for determining the cost of debt for new issues |
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| 12. Determining the cost of debt for new issues is a two-step process. The first step determines the before-tax cost of debt. The second step is to adjust for taxes because bond interest is deductible for income tax purposes. |
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| 13. Describe one way insurers can approximate the cost of debt created by writing insurance policies |
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Definition
| 13. One way to approximate the cost of debt created by writing insurance policies is to use the cost of bonds with maturities similar to the duration of the reserves that are currently being issued by the insurer or by another co. with equivilant credit risk. |
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| 14. Explain why investment projects that have an expected rate of return greater than a company's WACC will create positive net present value for the company |
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Definition
| 14.Investment projects that have an expected rate of return greater than a company's WACC will create positive net present value for the company because |
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Term
| 15. Describe the optimal capital structure of a company |
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Definition
| 15. The opt5imal capital structure of a company is the combination of debt and equity capital at which the company continues to increase in value |
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Term
| 16. Explain what the Modigliani and Miller (M&M) proposition suggests about financial leverage. |
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Definition
| 16. The M&M propisition suggests that financial leverage has no effect on a company's cost of capital because the cost of capital depends not on how the company is financed but on the risk profile of the company itself compared with other companies. If the company issues more debt and its risk profile increases, the cost of equity capital will rise to offset the use of low cost debt and thereby leave the overall cost of capital constant. |
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| 17. Id the factors that affect the ability of models, such as the M&M proposition, to accurately predict the effect of financial leverage decisions. |
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Definition
| 17. The factors that affect the ability of models, such as the M&M proposition, to accurately predict the effect of financial leverage decisions are taxes, cost of financial distress, agency costs, and asymmetric information. |
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| 18. Describe the effect of a rising ratio of debt to equity |
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Definition
| 18. As the debt-to-equity ratio rises, a company will experience an increased risk of defaulting on its debt and an increased potential of bankruptcy. The owners of the securities issued by the company, who will bear the costs associated with these events, will also be assuming more risk as the company's use of debt equity continues to increase |
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| 19. Id the positive and negative effect of increasing financial leverage |
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Definition
| 19. Increasing financial leverage has both a positive and a negative effect. The positive effect is that the tax shield increases the company's value. However, as leverage rises, so does the probability of bankruptcy. Therefore, the negative effect of increasing financial leverage equates to the present value of bankruptcy costs. |
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| 20. Id the three categories of agency costs. |
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Definition
| 20. The three categories of agency costs are monitoring costs, bonding costs. and incentive alignment costs. |
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| 21. Explain how the asymmetric info theory affects the determination of an optimal capital structure. |
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Definition
| 21. Asymmetric info theory holds that co mgrs perfer to finance projects first with internally generated funds. If internal funds are inadequate, external funds will be raised first from the issuance of honds, and then only if necessary, from the issuance of new stock. The basis of this theory is that a company's financial mgrs have better info about the co's prospects than others and that they can better anticipate changes in the co's operating income. |
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| 22. Id the essential issue for insurers about their optimal capital structure |
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Definition
| 22. The essential issue for insurers about their optimal capital structure for insuers is how much insurance should be written for a given amount of policyholders' surplus. The optimal capital structure for an insurer is to have enough capital to support writing policies that are expected to be profitable, up to the point at which the next policy written would begin causing the value of the company to decline. |
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| 23. Id three significant factors capital markets use to value securities. |
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Definition
| 23. Three significant factors capital markets use to value securities are earnings, risk and growth. |
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Term
| 24. Explain how an insuer's form of ownership affects its capital strucuture decisions |
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Definition
| 24. Form of ownership affects insurers capital strucuture decisions because it is commonly accepted that stock co's are under greater pressure to perform because of shareholder overview of their activities. Empirical analysis shows that stock co's are generally more highly leveraged than mutual insurers. Because mutual insurers are owned by their policyholders, they do not issue stock and therefore do not have access to the external capital that is available to stock insurers. Therefore, the optimal capital structure of a mutual differs from that of a stock insurer because a mutual insurer's equity capital comes from the sale of insurance policies and the compensation to the policyholder owners is paid in the form of lower premiums. |
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Term
| 25. Explain the effect that capital structure can have on the company's valuation. |
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Definition
25. The capital structure of an insurer can affect the co's valuation. Selling more insurance on a fixed dollar amt of equity or policyholders' surplus increases the expected return to the owners of the insurer, provided the spread is favorable. A favorable spread occurs when the cost of policyholder-supplied funds is less than the available rates of return on investments.
As more policies are sold, the risk of default starts to rise but is still outweighed by the benefits of the spread. Eventually, the market perceives that the co's exposure, as measured by the written premium-to-surplus ratio, is so high that the cost of policyholder funds exceeds the rates of return available from investments and the company's value will decline if additional insurance is sold |
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Term
| 26. Explain why policyholders, agents and brokers, and regulatory agencies have an incentive to monitor insurer financial healther. |
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Definition
| 26. Policyholders have an incentive to monitor their insurers solvency when they bear the costs of financial distress. For example, lg corporate clients who do not receive protection from guarantee associations have an interest in monitoring their insurers' financial health. Agents and brokers also have an incentive to monitor company financial health. Excessive leverage can harm a co's rating and cause agents and brokers to send clients to safer companies. Reulatory agencies, as required by law, monitor insurer financial conditions for those companies within their jurisdiction. If leverage becomes too high, the regulator can instruct management to alter its policies, and mgmt could lose control of the co to the regulator. |
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