Finance 319 Test 1

Front 1

_____ is from an investor’s point of view

Back 1

Required return

Front 2

_____ is the same return from the firm’s point of view

Back 2

Cost of capital

Front 3

_____ is the same return as used in a PV calculation

Back 3

Appropriate discount rate

Front 4

_____ decisions – neither the NPV rule nor the IRR rule can be implemented without knowledge of the appropriate discount rate

Back 4

good capital budgeting

Front 5

_____ decisions – the optimal/target capital structure minimizes the cost of capital

Back 5

financing

Front 6

_____ is the firm’s combination of debt and equity. A firm’s cost of capital reflects the average riskiness of all of the securities it has issued, which may be less risky (bonds) or more risky (common stock).

Back 6

Capital structure

Front 7

Advantages and Disadvantages of the Dividend Growth Model Approach

Back 7

-easy to understand and use
-Approach only works for dividend paying firms
-RE is very sensitive to the estimate of g
-Historical growth rates may not reliably predict future growth rates
-Risk is only indirectly accounted for by the use of the price

Front 8

Advantages and Disadvantages of the SML Approach

Back 8

This approach explicitly adjusts for risk in a fashion that is consistent with capital market history
-It is applicable to virtually all publicly traded stocks
-The main disadvantage is that the past is not a perfect predictor of the future, and both beta and the market risk premium vary through time

Front 9

The _____ is equal to the yield-to-maturity not the coupon rate of existing debt because it is the market rate of interest that would be required on new debt issues – interest rate on new debt can easily be estimated using the yield-to-maturity on outstanding debt or by knowing the bond rating and looking up rates on new issues with the same rating.

Back 9

cost of debt

Front 10

_____ is the overall return the firm must earn on its assets to maintain the value of its stock. It is a market rate that is based on the market’s perception of the risk of the firm’s assets.

Back 10

WACC

Front 11

The WACC is the appropriate discount rate only if the proposed investment is of similar risk as the firm’s existing assets.

Back 11

Capital Budgeting Decisions

Front 12

Divisional Cost of Capital

Back 12

When a firm has different operating divisions with different risks, its WACC is an average of the divisional required returns. In such cases, the cost of capital for projects of average risk in each division needs to be established.

Front 13

Cost of equity

Back 13

The return that equity investors require on their investment in the firm.

Front 14

Cost of debt

Back 14

The return that lenders require on the firm's debt.

Front 15

Weighted average cost of capital (WACC)

Back 15

The weighted average of the cost of equity and the aftertax cost of debt.

Front 16

Pure play approach

Back 16

The use of a WACC that is unique to a particular project, based on companies in similar lines of business.

Front 17

Pecking order of available financing

Back 17

-Well-established, financially stable firms have option of debt financing through bonds or equity financing through selling stock
-Younger, not-so-well-established firms may seek bank loans
-Just-beginning or financially distressed firms may resort to Venture Capital for financing

Front 18

Venture Capital

Back 18

financing for new, high risk ventures

Front 19

Venture Capitalists

Back 19

individuals who invest their own money

Front 20

Venture Capital Firms

Back 20

firms that specialize in managing money pooled from various sources and investing it

Front 21

First-stage financing

Back 21

“seed money” used to get venture off the ground (planning, research)

Front 22

Second-stage financing

Back 22

investment to begin operations and manufacturing

Front 23

Tombstones

Back 23

large advertisements for the new issue that are prepared by underwriter

Front 24

General Cash offer

Back 24

sale offered to public on cash basis

Front 25

Rights offer

Back 25

sale first offered to existing shareholders on a pro rata basis

Front 26

IPO

Back 26

first public issue of equity by a firm

Front 27

SEO

Back 27

equity issue by firm that has already issued equity to the public

Front 28

Underwriters

Back 28

intermediaries between securities issuer and public

Front 29

Syndicate

Back 29

a group of underwriters working on the same issue

Front 30

Spread

Back 30

difference in the underwriters’ buying price and offer price

Front 31

Aftermarket

Back 31

trading period after the new issue is initially sold to the public

Front 32

Over allotment

Back 32

more shares sold than actually exist in issue

Front 33

Lockup Agreement

Back 33

prevents insiders from selling their shares for a period of time

Front 34

Quiet period

Back 34

40 calendar days after IPO when firm and underwriters must limit communication with public to ordinary announcements and facts

Front 35

Underpricing

Back 35

-occurs when the offer price is set lower than the market value
-leaves “money on the table” for issuer
-advantage to new shareholder
-cost to old shareholder

Front 36

Why do Stock prices tend to decline when a company announces a seasoned equity offering?

Back 36

A lot of the decline may be due to the private information known by management (called asymmetric information) and the signals that the choice to issue equity sends to the market.
Managerial information concerning value of the stock
expectation that managers will issue equity only when they believe the current price is too high

Front 37

Managerial information concerning value of the stock

Back 37

expectation that managers will issue equity only when they believe the current price is too high

Front 38

Debt usage

Back 38

expectation that a firm will issue debt as long as it can afford to (allows stockholders to benefit more from good projects)

Front 39

Issue costs

Back 39

equity is more expensive to issue than debt from a straight flotation cost perspective

Front 40

Privileged subscription

Back 40

Issue of common stock offered to existing stockholders.
Offer terms are evidenced by warrants or rights.
Rights are often traded on exchanges or over the counter.

Front 41

The Mechanics of a Rights Offering

Back 41

Early stages are the same as for a general cash offer, i.e., obtain approval from directors, file a registration statement, etc.
The difference is in the sale of the securities.
Current shareholders get rights to buy new shares.
They can subscribe (buy) the entitled shares, sell the rights or do nothing.

Front 42

The Value of a Right

Back 42

A right has value if the subscription price is below the share price.
How much a right is worth depends on how many rights it takes to buy a share and the difference between the stock price and the subscription price.
If it takes N rights to buy one share, the value of one right is equal to

Front 43

Ex Rights

Back 43

When a privileged subscription is used, the firm sets a holder-of-record date.
The stock sells rights-on, or cum rights, until two business days before the holder-of-record date.
After that, the stock sells without the rights or ex rights.

Front 44

Effects on Shareholders

Back 44

Absent taxes and transaction costs, shareholder wealth is not differentially affected whether they exercise or sell their rights. Nor does it matter what subscription price the firm sets as long as it is below the market price.

Front 45

Issuing Long-term Debt

Back 45

The process for issuing long-term debt is similar to issuing stock except that the registration statement must include the bond indenture.

Front 46

Differences between private placements and public issues

Back 46

-No SEC registration is required for a private placement
-Direct placements may have more restrictive covenants
-Private placements are easier to renegotiate, if necessary
-Issuance costs are generally lower on private placements, although the coupon rate is generally higher

Front 47

Shelf registration

Back 47

SEC Rule 415 allows a company to register all securities that it expects to issue within the next two years in one registration statement. The firm can then issue the securities in smaller increments, as funds are needed during the two-year period. Both debt and equity can be registered using Rule 415.

Front 48

venture capital (VC)

Back 48

Financing for new, often high-risk ventures.

Front 49

registration statement

Back 49

A statement filed with the SEC that discloses all material information concerning the corporation making a public offering.

Front 50

Regulation A

Back 50

An SEC regulation that exempts public issues of less than $5 million from most registration requirements.

Front 51

Prospectus

Back 51

A legal document describing details of the issuing corporation and the proposed offering to potential investors.

Front 52

red herring

Back 52

A preliminary prospectus distributed to prospective investors in a new issue of securities.

Front 53

Tombstone

Back 53

An advertisement announcing a public offering.

Front 54

general cash offer

Back 54

An issue of securities offered for sale to the general public on a cash basis.

Front 55

rights offering

Back 55

A public issue of securities in which securities are first offered to existing shareholders.

Front 56

initial public offering

Back 56

A company's first equity issue made available to the public. Also called an unseasoned new issue or an IPO.

Front 57

seasoned equity offering (SEO)

Back 57

A new equity issue of securities by a company that has previously issued securities to the public.

Front 58

Underwriters

Back 58

Investment firms that act as intermediaries between a company selling securities and the investing public.

Front 59

Syndicate

Back 59

A group of underwriters formed to share the risk and to help sell an issue.

Front 60

gross spread

Back 60

Compensation to the underwriter, determined by the difference between the underwriter's buying price and offering price.

Front 61

firm commitment underwriting

Back 61

The type of underwriting in which the underwriter buys the entire issue, assuming full financial responsibility for any unsold shares.

Front 62

best efforts underwriting

Back 62

The type of underwriting in which the underwriter sells as much of the issue as possible, but can return any unsold shares to the issuer without financial responsibility.

Front 63

Dutch auction underwriting

Back 63

The type of underwriting in which the offer price is set based on competitive bidding by investors. Also known as a uniform price auction.

Front 64

Green Shoe provision

Back 64

A contract provision giving the underwriter the option to purchase additional shares from the issuer at the offering price. Also called the overallotment option.

Front 65

lockup agreement

Back 65

The part of the underwriting contract that specifies how long insiders must wait after an IPO before they can sell stock.

Front 66

ex-rights date

Back 66

The beginning of the period when stock is sold without a recently declared right, normally two trading days before the holder-of-record date.

Front 67

holder-of-record date

Back 67

The date on which existing shareholders on company records are designated as the recipients of stock rights. Also, the date of record.

Front 68

standby underwriting

Back 68

The type of underwriting in which the underwriter agrees to purchase the unsubscribed portion of the issue.

Front 69

standby fee

Back 69

An amount paid to an underwriter participating in a standby underwriting agreement.

Front 70

oversubscription privilege

Back 70

A privilege that allows shareholders to purchase unsubscribed shares in a rights offering at the subscription price.

Front 71

Dilution

Back 71

Loss in existing shareholders' value, in terms of either ownership, market value, book value, or EPS.

Front 72

term loans

Back 72

Direct business loans of, typically, one to five years.

Front 73

private placements

Back 73

Loans, usually long-term in nature, provided directly by a limited number of investors.

Front 74

shelf registration

Back 74

Registration permitted by SEC Rule 415, which allows a company to register all issues it expects to sell within two years at one time, with subsequent sales at any time within those two years.

Front 75

The “optimal” or “target” capital structure is that debt/equity mix that simultaneously

Back 75

(a) maximizes the value of the firm
(b) minimizes the weighted average cost of capital
(c) maximizes the market value of the common stock.

Front 76

Homemade leverage

Back 76

if all market participants have equal access to the capital markets, there’s nothing special about corporate borrowing.

Front 77

M&M Proposition I

Back 77

without corporate taxes and bankruptcy costs, the firm cannot affect its value by altering its capital structure.

Front 78

M&M Proposition II

Back 78

a firm’s cost of equity capital is a positive linear function of its capital structure (still assuming no taxes):

Front 79

Business risk

Back 79

the risk inherent in a firm’s operations

Front 80

Financial risk

Back 80

the extra risk to stockholders that results from debt financing

Front 81

Financial distress

Back 81

the direct and indirect costs of avoiding bankruptcy.

Front 82

The Static Theory of Capital Structure

Back 82

-Firms borrow because tax shields are valuable
-Borrowing is constrained by the costs of financial distress
-The optimal capital structure balances the incremental benefits and costs of borrowing

Front 83

Case I

Back 83

No taxes or bankruptcy costs

Front 84

Case II

Back 84

Corporate taxes, no bankruptcy costs

Front 85

Case III

Back 85

Corporate taxes and bankruptcy costs

Front 86

Taxes

Back 86

tax shields are more important for firms with high marginal tax rates

Front 87

Financial distress

Back 87

the lower the risk (or cost) of distress, the more likely a firm is to borrow funds

Front 88

homemade leverage

Back 88

The use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed.

Front 89

M&M Proposition I

Back 89

The proposition that the value of the firm is independent of the firm's capital structure.

Front 90

M&M Proposition II

Back 90

The proposition that a firm's cost of equity capital is a positive linear function of the firm's capital structure.

Front 91

business risk

Back 91

The equity risk that comes from the nature of the firm's operating activities.

Front 92

financial risk

Back 92

The equity risk that comes from the financial policy (i.e., capital structure) of the firm.

Front 93

interest tax shield

Back 93

The tax saving attained by a firm from interest expense.

Front 94

unlevered cost of capital

Back 94

The cost of capital of a firm that has no debt.

Front 95

direct bankruptcy costs

Back 95

The costs that are directly associated with bankruptcy, such as legal and administrative expenses.

Front 96

indirect bankruptcy costs

Back 96

The costs of avoiding a bankruptcy filing incurred by a financially distressed firm.

Front 97

financial distress costs

Back 97

The direct and indirect costs associated with going bankrupt or experiencing financial distress.

Front 98

static theory of capital structure

Back 98

The theory that a firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress.

Front 99

Bankruptcy

Back 99

A legal proceeding for liquidating or reorganizing a business.

Front 100

Liquidation

Back 100

Termination of the firm as a going concern.

Front 101

Reorganization

Back 101

Financial restructuring of a failing firm to attempt to continue operations as a going concern.

Front 102

absolute priority rule (APR)

Back 102

The rule establishing priority of claims in liquidation.

Front 103

Normal dividends, usually paid on a quarterly basis (if paid)

Back 103

Regular cash dividend

Front 104

Paid over and above the regular dividend, may or may not be repeated

Back 104

Extra cash dividend

Front 105

One-time dividend paid over and above the regular dividend, won’t be repeated

Back 105

Special dividend

Front 106

The dividend is declared by the Board of Directors and becomes a liability of the firm

Back 106

Declaration date

Front 107

Occurs 2 days prior to the date of record, if you purchase the stock on or after the ex-dividend date, you will not receive the dividend

Back 107

Ex-dividend date

Front 108

Firm prepares the list of stockholders who will receive dividends

Back 108

Date of record

Front 109

What is the date of payment?

Back 109

Day checks are mailed

Front 110

The _____ drops by the amount of the dividend (all else equal) on the ex-dividend date.

Back 110

Stock Price

Front 111

The _____ of the stock is the PV of expected future dividends, if the present dividend will no longer be received, then the price will drop by that amount.

Back 111

Value

Front 112

Selling shares in the appropriate proportion to create an equivalent cash flow to receiving the dividend stream you want. If you receive dividends that you don’t want, you can purchase additional shares

Back 112

Homemade dividends

Front 113

The _____ says that dividend policy is irrelevant because investors that prefer high payouts will invest in firms that have high payouts, and investors that prefer low payouts will invest in firms with low payouts.

Back 113

Clientele Effect

Front 114

True or False: Dividends are irrelevant

Back 114

False

Front 115

True or False: Dividend policy is irrelevant

Back 115

True – absent market imperfections

Front 116

Dividend policy is _____ if there is some market imperfection that affects investors’ desire for dividends now versus later.

Back 116

Relevant

Front 117

Investors that are in high marginal tax brackets might prefer _____ dividend payouts.

Back 117

Lower

Front 118

If a firm has a high dividend payout, then it will be using its cash to pay dividends instead of investing in positive NPV projects.

Back 118

Flotation Costs

Front 119

Bond indentures often contain a provision that limits the level of dividend payments.

Back 119

Dividend Restriction

Front 120

Paying dividends now rather than later resolves uncertainty.

Back 120

Uncertainty Resolution

Front 121

Changes in dividends may be important signals if the market anticipates that the change will be maintained through time. If the market believes that the change is just a rearrangement of dividends through time, then the impact will be small. The reaction to the information contained in dividend changes is called the _____.

Back 121

Information content effect

Front 122

A Compromise Dividend Policy

Back 122

In practice, managers tend to have the following goals, in order of importance:
-avoid cutting back on positive NPV projects to pay a dividend (excess cash has value)
-avoid dividend cuts
-avoid the need to sell equity
-maintain a target debt-to-equity ratio
-maintain a target dividend payout ratio

Front 123

Survey Evidence on Dividends

Back 123

-Almost 94% of the managers that responded to the survey indicated that they try to avoid reducing the dividends per share
-About 84% of the managers indicate that they try to maintain consistency with historic dividends
-Less than 10% of managers worry about flotation costs

Front 124

Cash Dividends versus Repurchase

Back 124

A firm may choose to buy back outstanding shares instead of paying a cash dividend (or instead of increasing a regular dividend). If we assume no market imperfections, then stockholder wealth is unaffected by the choice between share repurchases and cash dividends.

Front 125

Dividend

Back 125

A payment made out of a firm's earnings to its owners, in the form of either cash or stock.

Front 126

Distribution

Back 126

A payment made by a firm to its owners from sources other than current or accumulated retained earnings.

Front 127

regular cash dividend

Back 127

A cash payment made by a firm to its owners in the normal course of business, usually made four times a year.

Front 128

declaration date

Back 128

The date on which the board of directors passes a resolution to pay a dividend.

Front 129

ex-dividend date

Back 129

The date two business days before the date of record, establishing those individuals entitled to a dividend.

Front 130

date of record

Back 130

The date by which a holder must be on record in order to be designated to receive a dividend.

Front 131

date of payment

Back 131

The date the dividend checks are mailed.

Front 132

homemade dividend policy

Back 132

The tailored dividend policy created by individual investors who undo corporate dividend policy by reinvesting dividends or selling shares of stock.

Front 133

information content effect

Back 133

The market's reaction to a change in corporate dividend payout.

Front 134

clientele effect

Back 134

The observable fact that stocks attract particular groups based on dividend yield and the resulting tax effects.

Front 135

residual dividend approach

Back 135

A policy under which a firm pays dividends only after meeting its investment needs while maintaining a desired debt-equity ratio.

Front 136

target payout ratio

Back 136

A firm's long-term desired dividend-to-earnings ratio.

Front 137

Repurchase

Back 137

Another method used to pay out a firm's earnings to its owners, which provides more preferable tax treatment than dividends.

Front 138

stock dividend

Back 138

A payment made by a firm to its owners in the form of stock, diluting the value of each share outstanding.

Front 139

stock split

Back 139

An increase in a firm's shares outstanding without any change in owners' equity.

Front 140

trading range

Back 140

The price range between the highest and lowest prices at which a stock is traded.

Front 141

reverse split

Back 141

A stock split in which a firm's number of shares outstanding is reduced.