Corporate financeLesson 1 of 2 in the course How Firms Raise Capital

Capital Structure: Debt, Equity, and Market-Value Weights

5 flashcards · 5 quiz questions · 5 match pairs · 5 fill-in sentences · English

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Summary

A company needs assets to operate, and it needs financing to acquire those assets. This lesson introduces the balance sheet’s two sides, the major sources of capital, and why raising money creates a cost for a firm.

A firm’s assets are the resources it uses to produce and sell its products or services. For a shirt manufacturer, assets might include sewing machines, a building, fabric, buttons, and thread. Assets appear on the left-hand side of a basic balance sheet.

All flashcards

How do debt and equity differ?
Debt is borrowed financing that generally must be repaid; equity is ownership financing, often raised by selling shares.
What is a firm's capital structure?
The relative proportions of debt and equity a firm uses to finance its assets.
What does financial leverage refer to?
The debt a firm uses as part of its financing.
Why does supplying capital have an opportunity cost?
Investors give up the chance to use their money in another investment. The expected return demanded for supplying capital compensates for that opportunity cost.
Why use market values to calculate capital structure weights?
The weights represent fractions of the firm's current value, so they are calculated from current market values rather than accounting book values.

Quiz questions

  1. Why are market values used to calculate a firm's debt and equity weights?Answer: They represent the current value of the firm's financing claims.
  2. A firm has debt with a face value of $5 million trading at 97% of face value. What is its market value of debt?Answer: $4.85 million
  3. A company has 1 million shares trading at $15 per share. What is its market value of equity?Answer: $15 million
  4. If DD is market-value debt and EE is market-value equity, which expression gives the debt weight?Answer: D/(D+E)D/(D+E)
  5. How does WACC combine a firm's debt and equity costs of capital?Answer: It averages them using their respective shares of the firm's value as weights.

Based on Principles of Finance by Julie Dahlquist, Rainford Knight (OpenStax), licensed CC BY 4.0. Adapted into a summary, flashcards and quizzes.

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