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99 Cards in this Set
- Front
- Back
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Why is T-bill's return independent of the state of economy? Do T-Bills promise a completely risk-free return?
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T-bills' return are independent of the state of the economy because the Treasure will surely pay it.
T-bills are exposed to both inflation risk and reinvestment rate risk |
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Define each of the following terms:
Bond, Corporate Bond, Foreign Bond |
A bond is a promissory note.
It can be a treasury bond, which does not bear default risk or a corporate bond, which bears default risk. One should always keep in mind that governments' bond outside America may bear default risk and are exposed to exchange-rate risk. |
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What are the key features of a bond?
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Par value
Coupon rate Maturity (number of years until the bond matures) Issue date Default risk (rated form AAA to D) |
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What are call provisions and sinking fund provisions?
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Call provisions give the firm the right to call the bond before its maturity date, at an additional premium
Sinking fund provisions requires the issuer to retire the bond in an orderly fashion, through the means of a trustee, reducing risk. Sinking funds can work in a detrimental way to the investor, since they pose reinvestment rate risk. |
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How does one determine the value of any asset whose value is based on expected future cash flows?
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The summing the present value of such cash flows
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Define the nominal risk-free rate. what security can be used as an estimate of rf?
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Risk-free rate is the real-risk free rate plus the inflation premium, a rate that would exist in riskless asset. Since there's no truly riskless asset, the parameter from which the rf is estimated is the T-bill
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What is a bond spread, and how is it related to the default risk premium?How are bond ratings related to the default risk? What factors affect a company's bond rating?
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A “bond spread” is often calculated as the difference between a corporate bond’s yield and a Treasury security’s yield of the same maturity. Therefore:
Spread = DRP + LP. Bond’s of large, strong companies often have very small LPs. Bond’s of small companies often have LPs as high as 2%. Bond ratings are based upon a company’s default risk. They are based on both qualitative and quantitative factors, some of which are listed below. 1. Financial performance--determined by ratios such as the debt, TIE, FCC, and current ratios. 2. Provisions in the bond contract: A. Secured vs. Unsecured debt B. Senior vs. Subordinated debt C. Guarantee provisions D. Sinking fund provisions E. Debt maturity 3. Other factors: A. Earnings stability B. Regulatory environment C. Potential product liability D. Accounting policy |
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Describe a way to estimate the inflation premium (IP) for a T-Year bond.
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Treasury Inflation-Protected Securities (TIPS) are indexed to inflation. The IP for a particular length maturity can be approximated as the difference between the yield on a non-indexed Treasury security of that maturity minus the yield on a TIPS of that maturity.
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What is interest rate (or price) risk? Which bond has more interest rate risk, an annual payment 1-year bond or a 10-year bond? Why?
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Interest rate risk, which is often just called price risk, is the risk that a bond will lose value as the result of an increase in interest rates.The longer the maturity, the greater the change in value for a given change in interest rates, rd.
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What is reinvestment rate risk? Which has more reinvestment rate risk, a 1-year bond or a 10-year bond?
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Investment rate risk is defined as the risk that cash flows (interest plus principal repayments) will have to be reinvested in the future at rates lower than today's rate.The reinvestment rate risk on a long-term bond is significantly less than on a short-term bond.
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How are interest rate risk and reinvestment rate risk related to the maturity risk premium?
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Long-term bonds have high interest rate risk but low reinvestment rate risk. Short-term bonds have low interest rate risk but high reinvestment rate risk. Nothing is riskless! Yields on longer term bonds usually are greater than on shorter term bonds, so the MRP is more affected by interest rate risk than by reinvestment rate risk.
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Briefly describe bankruptcy law. If this firm were to default on the bonds, would the company be immediately liquidated? Would the bondholders be assured of receiving all of their promised payments?
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When a business becomes insolvent, it does not have enough cash to meet scheduled interest and principal payments. A decision must then be made whether to dissolve the firm through liquidation or to permit it to reorganize and thus stay alive.
The decision to force a firm to liquidate or to permit it to reorganize depends on whether the value of the reorganized firm is likely to be greater than the value of the firm’s assets if they were sold off piecemeal. In a reorganization, a committee of unsecured creditors is appointed by the court to negotiate with management on the terms of a potential reorganization. The reorganization plan may call for a restructuring of the firm’s debt, in which case the interest rate may be reduced, the term to maturity lengthened, or some of the debt may be exchanged for equity. The point of the restructuring is to reduce the financial charges to a level that the firm’s cash flows can support. If the firm is deemed to be too far gone to be saved, it will be liquidated an |
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Describe briefly the legal rights and privileges of common stockholders.
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The common stockholders are the owners of a corporation, and as such, they have certain rights and privileges as described below.
1. Ownership implies control. Thus, a firm’s common stockholders have the right to elect its firm’s directors, who in turn elect the officers who manage the business. 2. Common stockholders often have the right, called the preemptive right, to purchase any additional shares sold by the firm. In some states, the preemptive right is automatically included in every corporate charter; in others, it is necessary to insert it specifically into the charter |
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What happens if a company has a constant g that exceeds its rs? Will many stocks
have expected g > rs in the short run (i.e., for the next few years)? In the long run (i.e., forever)? |
The model is derived mathematically, and the derivation requires that rs > g. If g is greater than rs, the model gives a negative stock price, which is nonsensical. The model simply cannot be used unless (1) rs > g, (2) g is expected to be constant, and (3) g can reasonably be expected to continue indefinitely.
Stocks may have periods of supernormal growth, where gs > rs; however, this growth rate cannot be sustained indefinitely. In the long-run, g < rs. |
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What is market mutliple analysis?
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Analysts often use the P/E multiple (the price per share divided by the earnings per share) or the P/CF multiple (price per share divided by cash flow per share, which is the earnings per share plus the dividends per share) to value stocks. For example, estimate the average P/E ratio of comparable firms. This is the P/E multiple. Multiply this average P/E ratio by the expected earnings of the company to estimate its stock price. The entity value (V) is the market value of equity (# shares of stock multiplied by the price per share) plus the value of debt. Pick a measure, such as EBITDA, sales, customers, eyeballs, etc. Calculate the average entity ratio for a sample of comparable firms.
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What does market equilibrium mean?
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Equilibrium means stable, no tendency to change. Market equilibrium means that prices are stable--at its current price, there is no general tendency for people to want to buy or to sell a security that is in equilibrium. Also, when equilibrium exists, the expected rate of return will be equal to the required rate of return:
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If equilibrium does not exist, how will it be established?
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Securities will be bought and sold until the equilibrium price is established
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What is the Efficient Markets Yypothesis, what are its three forms, and what are its implications?
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The EMH in general is the hypothesis that securities are normally in equilibrium, and are “priced fairly,” making it impossible to “beat the market.” Weak-form efficiency says that investors cannot profit from looking at past movements in stock prices--the fact that stocks went down for the last few days is no reason to think that they will go up (or down) in the future. This form has been proven pretty well by empirical tests, even though people still employ “technical analysis.”
Semistrong-form efficiency says that all publicly available information is reflected in stock prices, hence that it won’t do much good to pore over annual reports trying to find undervalued stocks. This one is (I think) largely true, but superior analysts can still obtain and process new information fast enough to gain a small advantage. Strong-form efficiency says that all information, even inside information, is embedded in stock prices. This form does not hold--insiders know more, and could take advantage of that |
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What is capital budgeting?
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Capital budgeting is the process of analyzing additions to fixed assets. Capital budgeting is important because, more than anything else, fixed asset investment decisions chart a company’s course for the future. Conceptually, the capital budgeting process is identical to the decision process used by individuals making investment decisions. These steps are involved:
1. Estimate the cash flows—interest and maturity value or dividends in the case of bonds and stocks, operating cash flows in the case of capital projects. 2. Assess the riskiness of the cash flows. 3. Determine the appropriate discount rate, based on the riskiness of the cash flows and the general level of interest rates. This is called the project cost of capital in capital budgeting. 4. Evaluate the cash flows. |
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What is the difference between independent and mutually exclusive projects?
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Projects are independent if the cash flows of one are not affected by the acceptance of the other. Conversely, two projects are mutually exclusive if acceptance of one impacts adversely the cash flows of the other; that is, at most one of two or more such projects may be accepted. Put another way, when projects are mutually exclusive it means that they do the same job.
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Define the term net present value (NPV). What is each franchise’s NPV?
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The net present value (NPV) is simply the sum of the present values of a project’s cash flows:
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How is the IRR on a project related to the YTM on a bond?
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The IRR is to a capital project what the YTM is to a bond. It is the expected rate of return on the project, just as the YTM is the promised rate of return on a bond
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Define the term modified IRR (MIRR).
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MIRR is the discount rate that equates the present value of the terminal value of the inflows, compounded at the cost of capital, to the present value of the costs.
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What are the MIRR’s advantages and disadvantages vis-a-vis the regular IRR? What are the MIRR’s advantages and disadvantages vis-a-vis the NPV?
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MIRR is a better rate of return measure than IRR for two reasons: (1) It correctly assumes reinvestment at the project’s cost of capital rather than at its IRR. (2) MIRR avoids the problem of multiple IRRs—there can be only one MIRR for a given project.
MIRR does not always lead to the same decision as NPV when mutually exclusive projects are being considered. In particular, small projects often have a higher MIRR, but a lower NPV, than larger projects. Thus, MIRR is not a perfect substitute for NPV, and NPV remains the single best decision rule. However, MIRR is superior to the regular IRR, and if a rate of return measure is needed, MIRR should be used. Business executives agree. As noted in the text, business executives prefer to compare projects’ rates of return to comparing their NPVs. This is an empirical fact. As a result, financial managers are substituting MIRR for IRR in their discussions with other corporate executives. This fact was brought out in the October 1989 FMA meetings, where execu |
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What does the profitability index (PI) measure?
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The PI is equal to the present value of all future cash flows divided by the initial cost.
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What is the payback period?
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The payback period is the expected number of years required to recover a project’s cost.
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What is the rationale for the payback method?
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Payback represents a type of “breakeven” analysis: The payback period tells us when the project will break even in a cash flow sense.
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What is the difference between the regular and discounted payback periods?
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Discounted payback is similar to payback except that discounted cash flows are used
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What is the main disadvantage of discounted payback? Is the payback method of any real usefulness in capital budgeting decisions?
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Regular payback has 3 critical deficiencies: (1) It ignores the time value of money, (2) it ignores the cash flows that occur after the payback period, and (3) it does not provide a specific acceptance rule. Discounted payback does consider the time value of money, but it still fails to consider cash flows after the payback period and it does not provide a specific acceptance rule; so it still has basic flaws. In spite of these deficiencies, many firms today still calculate the discounted payback and give some weight to it when making capital budgeting decisions. However, payback is not generally used as the primary decision tool. Rather, it is used as a rough measure of a project’s liquidity and riskiness.
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What are normal and nonnormal cash flows?
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Normal cash flows begin with a negative cash flow (or a series of negative cash flows), switch to positive cash flows, and then remain positive. They have only one change in sign. (Note: normal cash flows can also start with positive cash flows, switch to negative cash flows, and then remain negative.) Nonnormal cash flows have more than one sign change. For example, they may start with negative cash flows, switch to positive, and then switch back to negative.
Projects with normal cash flows have outflows, or costs, in the first year (or years) followed by a series of inflows. Projects with nonnormal cash flows have one or more outflows after the inflow stream has begun. |
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What are the two primary ways companies raise common equity?
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A firm can raise common equity in two ways: (1) by retaining earnings and (2) by issuing new common stock.
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Why is there a cost associated with reinvested earnings?
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Management may either pay out earnings in the form of dividends or else retain earnings for reinvestment in the business. If part of the earnings is retained, an opportunity cost is incurred: Stockholders could have received those earnings as dividends and then invested that money in stocks, bonds, real estate, and so on.
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What factors influence a company’s WACC?
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There are factors that the firm cannot control and those that they can control that influence WACC.
Factors The Firm Cannot Control (Market Environment): Stock and Bond Markets The Market Risk Premium Tax Rates Factors The Firm Can Control: Capital Structure Policy Dividend Policy Investment Policy |
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What procedures can be used to estimate the risk-adjusted cost of capital for a particular division? What approaches are used to measure a division’s beta?
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The following procedures can be used to determine a division’s risk-adjusted cost of capital:
(1) Subjective adjustments to the firm’s composite WACC. (2) Attempt to estimate what the cost of capital would be if the division were a stand-alone firm. This requires estimating the division’s beta. The following approaches can be used to measure a division’s beta: (1) Pure play approach. Find several publicly traded companies exclusively in the project’s business. Then, use the average of their betas as a proxy for the project’s beta. (It’s hard to find such companies.) (2) Accounting beta approach. Run a regression between the project’s ROA and the S&P index ROA. Accounting betas are correlated (0.5 - 0.6) with market betas. However, you normally can’t get data on new project ROAs before the capital budgeting decision has been made. |
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What are three types of project risk? How can each type of risk be considered when thinking about the new division’s cost of capital?
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The three types of project risk are:
Stand-Alone Risk Corporate Risk Market Risk Market risk is theoretically best in most situations. However, creditors, customers, suppliers, and employees are more affected by corporate risk. Therefore, corporate risk is also relevant. Stand-alone risk is the easiest type of risk to measure. Taking on a project with a high degree of either stand-alone or corporate risk will not necessarily affect the firm’s market risk. However, if the project has highly uncertain returns, and if those returns are highly correlated with returns on the firm’s other assets and with most other assets in the economy, the project will have a high degree of all types of risk. |
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Explain in words why new common stock that is raised externally has a higher percentage cost than equity that is raised internally as retained earnings.
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Flotation costs
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What are four common mistakes in estimating the WACC?
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Don’t use the coupon rate on a firm’s existing debt as the pre-tax cost of debt. Use the current cost of debt.
2. When estimating the risk premium for the CAPM approach, don’t subtract the current long-term T-bond rate from the historical average return on stocks. For example, the historical average return on stocks has been about 12.7%. If inflation has driven the current risk-free rate up to 10%, it would be wrong to conclude that the current market risk premium is 12.7% – 10% = 2.7%. In all likelihood, inflation would also have driven up the expected return on the market. Therefore, the historical return on the market would not be a good estimate of the current expected return on the market. 3. Don’t use book weights to estimate the weights for the capital structure. Use the target capital structure to determine the weights for the WACC. If you don’t have the target weights, then use market value rather than book value to obtain the weights. Use the book value of debt only as a last resort. |
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Define “incremental cash flow.”
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This is the firm’s cash flow with the project minus the firm’s cash flow without the project.
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Should you subtract interest expense or dividends when calculating project cash flow?
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The cash flow statement should not include interest expense or dividends. The return required by the investors furnishing the capital is already accounted for when we apply the 10% cost of capital discount rate; hence, including financing flows would be “double counting.” Put another way, if we deducted capital costs in the table, and thus reduced the bottom-line cash flows, and then discounted those CFs by the cost of capital, we would, in effect, be subtracting capital costs twice.
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Why is it important to include inflation when estimating cash flows?
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The cost of capital is a nominal cost; i.e., it includes a premium for inflation. In other words, it is larger than the real cost of capital. Similarly, nominal cash flows (those that are inflated) are larger than real cash flows. If you discount the low, real cash flows with the high, nominal rate, then the resulting NPV is too low. Therefore, you should always discount nominal cash flows with a nominal rate, and real cash flows with a real rate. In theory, you could do the analysis either way and obtain the correct answer. However, there is no accurate way to convert a nominal cost of capital to a real cost. Therefore, you should inflate cash flows and then discount at the nominal cost of capital
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What does the term “risk” mean in the context of capital budgeting; to what extent can risk be quantified; and when risk is quantified, is the quantification based primarily on statistical analysis of historical data or on subjective, judgmental estimates?
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Risk throughout finance relates to uncertainty about future events, and in capital budgeting, this means the future profitability of a project. For certain types of projects, it is possible to look back at historical data and to statistically analyze the riskiness of the investment. This is often true when the investment involves an expansion decision; for example, if Sears were opening a new store, if Citibank were opening a new branch, or if GM were expanding its Chevrolet plant, then past experience could be a useful guide to future risk. Similarly, a company that is considering going into a new business might be able to look at historical data on existing firms in that industry to get an idea about the riskiness of its proposed investment. However, there are times when it is impossible to obtain historical data regarding proposed investments; for example, if GM were considering the development of an electric auto, not much relevant historical data for assessing the riskiness of the project would be avail
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What are the three types of risk that are relevant in capital budgeting?
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Stand-alone risk is the project’s total risk if it were operated independently. Stand-alone risk ignores both the firm’s diversification among projects and investors’ diversification among firms. Stand-alone risk is measured either by the project’s standard deviation of NPV (σNPV) or its coefficient of variation of NPV (CVNPV). Note that other profitability measures, such as IRR and MIRR, can also be used to obtain stand-alone risk estimates.
• Within-firm risk is the total riskiness of the project giving consideration to the firm’s other projects, that is, to diversification within the firm. It is the contribution of the project to the firm’s total risk, and it is a function of (a) the project’s standard deviation of NPV and (b) the correlation of the projects’ returns with those of the rest of the firm. Within-firm risk is often called corporate risk, and it is measured by the project’s corporate beta, which is the slope of the regression line formed by plotting returns on the project |
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How is each type of risk used in the capital budgeting process?
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Because management’s primary goal is shareholder wealth maximization, the most relevant risk for capital projects is market risk. However, creditors, customers, suppliers, and employees are all affected by a firm’s total risk. Since these parties influence the firm’s profitability, a project’s within-firm risk should not be completely ignored.
Unfortunately, by far the easiest type of risk to measure is a project’s stand-alone risk. Thus, firms often focus on this type of risk when making capital budgeting decisions. However, this focus does not necessarily lead to poor decisions, because most projects that a firm undertakes are in its core business. In this situation, a project’s stand-alone risk is likely to be highly correlated with its within-firm risk, which in turn is likely to be highly correlated with its market risk. |
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What is sensitivity analysis?
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Sensitivity analysis measures the effect of changes in a particular variable, say revenues, on a project’s NPV. To perform a sensitivity analysis, all variables are fixed at their expected values except one. This one variable is then changed, often by specified percentages, and the resulting effect on NPV is noted. (One could allow more than one variable to change, but this then merges sensitivity analysis into scenario analysis.)
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What is the primary weakness of sensitivity analysis? What is its primary usefulness?
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The two primary disadvantages of sensitivity analysis are (1) that it does not reflect the effects of diversification and (2) that it does not incorporate any information about the possible magnitudes of the forecast errors. Thus, a sensitivity analysis might indicate that a project’s NPV is highly sensitive to the sales forecast; hence, that the project is quite risky, but if the project’s sales, hence its revenues, are fixed by a long-term contract, then sales variations may actually contribute little to the project’s risk. It also ignores any relationships between variables, such as unit sales and sales price.
Therefore, in many situations, sensitivity analysis is not a particularly good risk indicator. However, sensitivity analysis does identify those variables that potentially have the greatest impact on profitability, and this helps management focus its attention on those variables that are probably most important. |
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What is scenario analysis?
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Scenario analysis examines several possible situations, usually worst case, most likely case, and best case. It provides a range of possible outcomes.
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Are there problems with scenario analysis? Define simulation analysis, and discuss its principal advantages and disadvantages.
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Scenario analysis examines several possible scenarios, usually worst case, most likely case, and best case. Thus, it usually considers only 3 possible outcomes. Obviously the world is much more complex, and most projects have an almost infinite number of possible outcomes.
Simulation analysis is a type of scenario analysis that uses randomly generated inputs rather than specific values. Here the uncertain cash flow variables (such as unit sales) are entered as continuous probability distribution parameters rather than as point values. Then, the computer uses a random number generator to select values for the uncertain variables on the basis of their designated distributions. Once all of the variable values have been selected, they are combined and an NPV is calculated. The process is repeated many times, say 1,000 times, with new values selected from the distributions for each run. The end result is a probability distribution of NPV based on a sample of 1,000 values. Simulation can provide the distribution |
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What is a real option? What are some types of real options?
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Real options exist when managers can influence the size and risk of a project’s cash flows by taking different actions during the project’s life in response to changing market conditions. Some types of real options are listed below:
1. Investment timing options 2. Growth options a. Expansion of existing product line b. New products c. New geographic markets 3. Abandonment options a. Contraction b. Temporary suspension c. Complete abandonment 4. Flexibility options a. Inputs b. Outputs c. Both |
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Should the company use the composite WACC as the hurdle rate for each of its divisions?
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The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk. Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk.
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What procedures can be used to estimate the risk-adjusted cost of capital for a particular division? What approaches are used to measure a division’s beta?
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The following procedures can be used to determine a division’s risk-adjusted cost of capital:
(1) Subjective adjustments to the firm’s composite WACC. (2) Attempt to estimate what the cost of capital would be if the division were a stand-alone firm. This requires estimating the division’s beta. The following approaches can be used to measure a division’s beta: (1) Pure play approach. Find several publicly traded companies exclusively in the project’s business. Then, use the average of their betas as a proxy for the project’s beta. (It’s hard to find such companies.) (2) Accounting beta approach. Run a regression between the project’s ROA and the S&P index ROA. Accounting betas are correlated (0.5 - 0.6) with market betas. However, you normally can’t get data on new project ROAs before the capital budgeting decision has been made. |
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Four common errors when estimating the WACC
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1. Don’t use the coupon rate on a firm’s existing debt as the pre-tax cost of debt. Use the current cost of debt.
2. When estimating the risk premium for the CAPM approach, don’t subtract the current long-term T-bond rate from the historical average return on stocks. 3. Don’t use book weights to estimate the weights for the capital structure. Use the target capital structure to determine the weights for the WACC. If you don’t have the target weights, then use market value rather than book value to obtain the weights. Use the book value of debt only as a last resort. 4. Always remember that capital components are sources of funding that come from investors. If it’s not a source of funding from an investor, then it’s not a capital component. |
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How one should interpret price-earnings ratios?
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As the market's assessments pof the firm's growth opportunities
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Book value, liquidation value and market value
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Book value = firm's value for accounting purposes
Liquidation value = the value of all firm's assets if they were to be sold at liquidation price Market value = based in the stock value, given by the market |
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Explicit and implicit cost of debt
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Explicit = the one demanded by bondholders
Implicit = additional cost of debt when borrowing bonds: the increase in the required return to equity |
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Two-types of assets companies own
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Operating and non-operating assets
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What are assets-in-place and how their value can be estimated?
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Assets-in-place are tangible and non-tangible assets. The PV of their expected cash flows, discounted at the WACC, is the value of the operations
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What is the total value of a corporation? Who has claims on this value?
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Total value = value of operations; value of nonoperating assets and value of growth options
Debtholders have first claim, then preferred stockholders, then common stockholders |
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Explain what value-based management is.
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VBM is the systematic application of the corporate valuation model to all corporate decisions and strategic initiatives. The objective of VBM is to increase market value added (MVA).
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What are the four value drivers? How does each of them affect value?
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MVA is determined by four drivers: sales growth, operating profitability (OP=NOPAT/sales), capital requirements (CR=operating capital / sales, and the weighted average cost of capital. MVA will improve if WACC is reduced, operating profitability (OP) increases, or the capital requirement (CR) decreases. Sales growth will increase value depending on the increase in the WACC
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What is expected return on invested capital (EROIC)? Why is the spread between EROIC and WACC so important?
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If the spread between the expected return, ROICt, and the required return, WACC, is positive, then MVA is positive and growth makes MVA larger. The opposite is true if the spread is negative.
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List six potential managerial behaviors that can harm a firm’s value.
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1. Expend too little time and effort.
2. Consume too many nonpecuniary benefits. 3. Avoid difficult decisions (e.g., close plant) out of loyalty to friends in company. 4. Reject risky positive NPV projects to avoid looking bad if project fails; take on risky negative NPV projects to try and hit a home run. 5. Avoid returning capital to investors by making excess investments in marketable securities or by paying too much for acquisitions. 6. Massage information releases or manage earnings to avoid revealing bad news. |
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What is corporate governance? List five corporate governance provisions that are internal to a firm and are under its control.
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Corporate governance is the set of laws, rules, and procedures that influence a company’s operations and the decisions made by its managers.
The provisions under a firm’s control are: (1) monitoring and discipline by the board of directors; (2) charter provisions and bylaws that affect the likelihood of hostile takeovers; (3) compensation plans; (4) capital structure choices; and (5) accounting control systems. |
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What characteristics of the board of directors usually lead to effective corporate governance?
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1) The CEO is not also the chairman of the board and does not have undue influence over the nominating committee; (2) the board has a majority of true outsiders who bring some type of business expertise to the board (and he board is not an interlocked board); (3) the board is not too large (abnormally large boards have little individual participation); and (4) board members are compensated appropriately (not too high, and some compensation is linked to company’s performance).
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List three provisions in the corporate charter that affect takeovers.
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These include the ban of targeted share repurchases (i.e., greenmail), shareholder rights provisions (i.e., poison pills), and restricted voting rights plans.
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Briefly describe the use of stock options in a compensation plan. What are some potential problems with stock options as a form of compensation?
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Gives owner of option the right to buy a share of the company’s stock at a specified price (called the strike price) even if the actual stock price is higher. Usually can’t exercise the option for several years (called the vesting period). Can’t exercise the option after a certain number of years (called the expiration, or maturity, date).
Manager can underperform market or peer group, yet still reap rewards from options as long as the stock price increases to above the exercise cost. Options sometimes encourage managers to falsify financial statements or take excessive risks. |
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What is block ownership? How does it affect corporate governance?
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Block ownership occurs when an outside investor owns large amount (i.e., block) of company’s shares. Large institutional investors, such as CalPERS or TIAA-CREF, often own large blocks. Blockholders often monitor managers and take active role, leading to better corporate governance.
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Briefly explain how regulatory agencies and legal systems affect corporate governance.
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Companies in countries with strong protection for investors tend to have better access to financial markets, a lower cost of equity, increased in market liquidity, and less noise in stock prices.
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What is meant by the term “distribution policy”? How have dividend payouts versus stock repurchases changed over time?
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Distribution policy is defined as the firm’s policy with regard to (1) the level of distributions, (2) the form of distributions (dividends or stock repurchases), and (3) the stability of distributions.
In terms of payouts, here are some facts. (1) The percent of total payouts to net income has been stable at around 26%-28%, but dividend payout rates have fallen while stock repurchases have increased. Repurchases are now greater than dividends. (2) A much smaller percentage of companies now pay dividends. When young companies first begin making distributions, it is usually in the form of repurchases. (3) Dividend payouts have become more concentrated in a smaller number of large, mature firms. |
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The terms “irrelevance,” “bird-in-the-hand,” and “tax effect” have been used to describe three major theories regarding the way dividend payouts affect a firm’s value. Explain what these terms mean, and briefly describe each theory.
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Dividend irrelevance refers to the theory that investors are indifferent between dividends and capital gains, making dividend policy irrelevant with regard to its effect on the value of the firm. “Bird-in-the-hand” refers to the theory that a dollar of dividends in the hand is preferred by investors to a dollar retained in the business, in which case dividend policy would affect a firm’s value.
The dividend irrelevance theory was proposed by MM, but they had to make some very restrictive assumptions to “prove” it (zero taxes, no flotation or transactions costs). MM argued that paying out a dollar per share of dividends reduces the growth rate in earnings and dividends, because new stock will have to be sold to replace the capital paid out as dividends. Under their assumptions, a dollar of dividends will reduce the stock price by exactly $1. Therefore, according to MM, stockholders should be indifferent between dividends and capital gains. The dividend preference, or “bird-in-the-hand” theory |
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What do the three theories indicate regarding the actions management should take with respect to dividend payout?
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If the dividend irrelevance theory is correct, then dividend payout is of no consequence, and the firm may pursue any dividend payout. If the bird-in-the-hand theory is correct, the firm should set a high payout if it is to maximize its stock price. If the tax effect theory is correct, the firm should set a low payout if it is to maximize its stock price. Therefore, the theories are in total conflict with one another.
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What results have empirical studies of the dividend theories produced? How does all this affect what we can tell managers about dividend payouts?
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Unfortunately, empirical tests of the theories have been mixed (because firms don’t differ just with respect to payout).. Some evidence shows that high payout firms have higher required stock return, which supports the dividend preference theory. But other research shows that high payout firms in countries with poor investor protection (where agency costs are most severe) are valued less than low payout firms, which supports the dividend preference theory.
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Discuss (1) the information content, or signaling, hypothesis, (2) the clientele effect, and (3) their effects on distribution policy.
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1. Different groups, or clienteles, of stockholders prefer different dividend payout policies. For example, many retirees, pension funds, and university endowment funds are in a low (or zero) tax bracket, and they have a need for current cash income. Therefore, this group of stockholders might prefer high payout stocks. These investors could, of course, sell some of their stock, but this would be inconvenient, transactions costs would be incurred, and the sale might have to be made in a down market. Conversely, investors in their peak earnings years who are in high tax brackets and who have no need for current cash income should prefer low payout stocks.
2. Clienteles do exist, but the real question is whether there are more members of one clientele than another, which would affect what a change in its dividend policy would do to the demand for the firm’s stock. There are also costs (taxes and brokerage) to stockholders who would be forced to switch from one stock to another if a firm changes its policy. |
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In general terms, how would a change in investment opportunities affect the payout ratio under the residual payment policy?
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A change in investment opportunities would lead to an increase (if investment opportunities were good) or a decrease (if investment opportunities were not good) in the amount of equity needed, hence in the residual dividend payout.
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What are the advantages and disadvantages of the residual policy?
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The primary advantage of the residual policy is that under it the firm makes maximum use of lower cost retained earnings, thus minimizing flotation costs and hence the cost of capital. Also, whatever negative signals are associated with stock issues would be avoided.
However, if it were applied exactly, the residual model would result in dividend payments which fluctuated significantly from year to year as capital requirements and internal cash flows fluctuated. This would (1) send investors conflicting signals over time regarding the firm’s future prospects, and (2) since no specific clientele would be attracted to the firm, it would be an “orphan.” These signaling and clientele effects would lead to a higher required return on equity which would more than offset the effects of lower flotation costs. Because of these factors, few if any publicly owned firms follow the residual model on a year-to-year basis. Even though the residual approach is not used to set the annual dividend, it is used when fir |
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Describe the procedures a company follows when it make a distribution through dividend payments.
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-Declaration date
-Holder-of-record date: date from which the company closes its stock transfer books and lists its shareholders.Transfer notifications past from this date are not considered -Ex-dividend date: date until which one can buy a stock and still receive its next dividends. By convention, its two days prior to the Holder-of-record date -Payment date |
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What is a stock repurchase? Describe the procedures a company follows when it make a distribution through a stock repurchase.
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A firm may distribute cash to stockholders by repurchasing its own stock rather than paying out cash dividends. Stock repurchases can be used (1) somewhat routinely as an alternative to regular dividends, (2) to dispose of excess (nonrecurring) cash that came from asset sales or from temporarily high earnings, and (3) in connection with a capital structure change in which debt is sold and the proceeds are used to buy back and retire shares.
A company announces intent to purchase a dollar amount of its own stock during a specific period. The announcement is not binding; in fact, companies often don’t actually complete the repurchase. Three methods are used for a repurchase: (1) Open market (usually through trustee) with stock purchases spread over a period of time; (2) Tender offer, where company buys directly from shareholders who wish to tender their stock to the company; or (3) Targeted stock repurchase in which the company buys from a large blockholder. |
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Discuss the advantages and disadvantages of a firm’s repurchasing its own shares.
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Advantages of repurchases:
1. A repurchase announcement may be viewed as a positive signal that management believes the shares are undervalued. 2. Stockholders have a choice--if they want cash, they can tender their shares, receive the cash, and pay the taxes, or they can keep their shares and avoid taxes. On the other hand, one must accept a cash dividend and pay taxes on it. 3. If the company raises the dividend to dispose of excess cash, this higher dividend must be maintained to avoid adverse stock price reactions. A stock repurchase, on the other hand, does not obligate management to future repurchases. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Mini Case: 14 - 19 4. Repurchased stock, called treasury stock, can be used later in mergers, when employees exercise stock options, when convertible bonds are converted, and when warrants are exercised. Treasury stock can also be resold in the o |
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Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the weighted average cost of capital and free cash flows.
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The impact of capital structure on value depends upon the effect of debt on: WACC and/or FCF.
Debt holders have a prior claim on cash flows relative to stockholders. Debt holders’ “fixed” claim increases risk of stockholders’ “residual” claim, so the cost of stock, rs, goes up. Firm’s can deduct interest expenses. This reduces the taxes paid, frees up more cash for payments to investors, and reduces after-tax cost of debt Debt increases the risk of bankruptcy, causing pre-tax cost of debt, rd, to increase. Adding debt increase the percent of firm financed with low-cost debt (wd) and decreases the percent financed with high-cost equity (wce). The net effect on WACC is uncertain, since some of these effects tend to increase WACC and some tend to decrease WACC. Additional debt can affect FCF. The additional debt increases the probability of bankruptcy. The direct costs of financial distress are legal fees, “fire” sales, etc. The indirect costs are lost customers, reductions in productivi |
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What is business risk? What factors influence a firm's business risk?
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Businsess risk is uncertainty about EBIT. Factors that influence business risk include: uncertainty about demand (unit sales); uncertainty about output prices; uncertainty about input costs; product and other types of liability; degree of operating leverage (DOL).
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What is operating leverage, and how does it affect a firm's business risk?
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Operating leverage is the change in EBIT caused by a change in quantity sold. The higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage. Higher operating leverage leads to more business risk, because a small sales decline causes a larger EBIT decline.
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Impact of financial leverage in ROE
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The firm’s basic earning power, BEP = EBIT/total assets, is unaffected by financial leverage.
Therefore, the use of financial leverage has increased the expected profitability to shareholders. The higher roe results in part from the tax savings and also because the stock is riskier if the firm uses debt. The use of debt will increase roe only if ROA exceeds the after-tax cost |
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What does capital structure theory attempt to do? What lessons can be learned from capital structure theory?
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MM theory begins with the assumption of zero taxes. MM prove, under a very restrictive set of assumptions, that a firm’s value is unaffected by its financing mix:
VL = VU. Therefore, capital structure is irrelevant. Any increase in roe resulting from financial leverage is exactly offset by the increase in risk (i.e., rs), so WACC is constant. MM theory later includes corporate taxes. Corporate tax laws favor debt financing over equity financing. With corporate taxes, the benefits of financial leverage exceed the risks because more EBIT goes to investors and less to taxes when leverage is used. MM show that: VL = VU + TD. If T=40%, then every dollar of debt adds 40 cents of extra value to firm. |
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What does the empirical evidence say about capital structure theory? What are the implications for managers?
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Tax benefits are important– $1 debt adds about $0.10 to value. This supports the Miller model with personal taxes. Bankruptcies are costly– costs can be up to 10% to 20% of firm value. Firms don’t make quick corrections when stock price changes cause their debt ratios to change– this doesn’t support trade-off model. After big stock price run ups, the debt ratio falls, but firms tend to issue equity instead of debt. This is inconsistent with the trade-off model, inconsistent with the pecking order theory, but is consistent with the windows of opportunity hypothesis. Many firms, especially those with growth options and asymmetric information problems, tend to maintain excess borrowing capacity.
Managers should take advantage of tax benefits by issuing debt, especially if the firm has a high tax rate, stable sales, and less operating leverage than the typical firm in its industry. Managers should avoid financial distress costs by maintaining excess borrowing capacity, especially if the firm has volat |
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Several reasons have been proposed to justify mergers. Among the more prominent are (1) tax considerations, (2) risk reduction, (3) control, (4) purchase of assets at below-replacement cost, (5) synergy, and (6) globalization. In general, which of the reasons are economically justifiable? Which are not? Which fit the situation at hand? Explain.
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Synergy (economies of scale, economies of vertical integration, elimination of inefficiencies)
Tax considerations Disposal of excess cash |
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What are the steps in valuing a merger?
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When the capital structure is changing rapidly, as in many mergers, the WACC changes from year-to-year and it is difficult to apply the corporate valuation model in these cases. The APV model works better when the capital structure is changing. The steps are:
1. Project FCFt ,TSt until the target is at its target capital structure for one year and and is expected to grow thereafter at a constant growth rate. 2. Project the horizon growth rate. 3. Calculate the unlevered cost of equity, rsu. 4. Calculate horizon value of tax shields using the constant growth formula and TSN. 5. Calculate the horizon value of the unlevered firm using the constant growth formula and FCFN. 6. Calculate the unlevered firm value as the present value of the unlevered horizon value and the FCFs at the unlevered cost of equity. 7. Calculate the value of the tax shields as the present value of the tax shield horizon value and the individual tax shields. 8. Calculate Vops as the sum of the unlevered value and the tax shield val |
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Why are we identifying interest expense separately since it is not normally included in calculating free cash flow or in a capital budgeting cash flow analysis? Why is investment in net operating capital included when calculating free cash flow?
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Note that these free cash flows are identical to what you would construct to use the corporate valuation model or to use standard capital budgeting procedures, except that we have also included separate lines for the interest expense and interest tax savings (which are calculated as interest x tax rate and are also called interest tax shields). In many merger analyses the debt levels change so dramatically that using the corporate value model would require re-estimating the WACC every year. Instead, the APV model breaks up the value of operations into two components:
Voperations = Vunlevered + Vtax shield . The free cash flows and interest tax savings are discounted separately at the unlevered cost of equity. This is more convenient to use than the corporate value model because the unlevered cost of equity can be used even when the capital structure is changing. Also, in straight capital budgeting and the simplest application of the corporate value model all debt involved is new debt, which is issued to f |
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There has been considerable research undertaken to determine whether mergers really create value and, if so, how this value is shared between the parties involved. What are the results of this research?
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Most researchers agree that takeovers increase the wealth of the shareholders of target firms, for otherwise they would not agree to the offer. However, there is a debate as to whether mergers benefit the acquiring firm’s shareholders. The results of these studies have shown, on average, the stock prices of target firms increase by about 30 percent in hostile tender offers, while in friendly mergers the average increase is about 20 percent. However, for both hostile and friendly deals, the stock prices of acquiring firms, on average, remain constant. Thus, one can conclude that (1) acquisitions do create value, but (2) that shareholders of target firms reap virtually all the benefits.
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What merger-related activities are undertaken by investment bankers?
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The investment banking community is involved with mergers in a number of ways. Several of these activities are: (1) helping to arrange mergers, (2) aiding target companies in developing and implementing defensive tactics, (3) helping to value target companies, (4) helping to finance mergers, and (5) risk arbitrage--speculating in the stocks of companies that are likely takeover targets.
Hopefully, investment bankers are not giving kickbacks to company executives who give them business, or providing fraudulent analyst reports to pump up the stocks of companies they would like to do business with. |
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What are the major types of divestitures? What motivates firms to divest assets?
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The three primary types of divestitures are (1) the sale of an operating unit to another firm, (2) setting up the business to be divested as a separate corporation and then “spinning it off” to the divesting firm’s stockholders, and (3) outright liquidation of assets. The reasons for divestitures vary widely. Sometimes companies need cash either to finance expansion in their primary business lines or to reduce a large debt burden. Sometimes firms divest to unload losing assets that would otherwise drag the company down, or divesting may be the result of an antitrust settlement, where the government requires a breakup.
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What is a leveraged buyout (LBO)? What are some of the advantages and disadvantages of going private?
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A leveraged buyout is a situation in which a small group of investors (which usually include the firm’s managers) borrows heavily to buy all the shares of a company. Advantages to going private include administrative cost savings, increased managerial incentives, increased managerial flexibility, increased shareholder participation, and increased financial leverage. The main disadvantage of going private is not having access to the large amounts of capital available in the equity market, making it difficult to fund a firm’s projects.
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What are holding companies? What are their advantages and disadvantages?
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Holding companies are corporations formed for the sole purpose of owning the stocks of other companies. The advantages include the ability to control a company without owning all its stocks and the ability to isolate risks. Disadvantages include the possible taxation of earnings at both the subsidiary and parent levels. Holding companies can also be easily dissolved by regulators.
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Explain the difference between financial risk and business risk.
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Business risk increases the uncertainty in future EBIT. It depends on business factors such as competition, operating leverage, etc. Financial risk is the additional business risk concentrated on common stockholders when financial leverage is used. It depends on the amount of debt and preferred stock financing.
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Briefly explain the difference between the CAPM and the arbitrage pricing theory (APT).
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The CAPM is a single-factor model, while the Arbitrage Pricing Theory (APT) can include any number of risk factors. It is likely that the required return is dependent on many fundamental factors such as the GNP growth, expected inflation, and changes in tax laws, and that different groups of stocks are affected differently by these factors. Thus, the apt seems to have a stronger theoretical footing than does the CAPM. However, the apt faces several major hurdles in implementation, the most severe being that the apt does not identify the relevant factors--a complex mathematical procedure called factor analysis must be used to identify the factors. To date, it appears that only three or four factors are required in the apt, but much more research is required before the apt is fully understood and presents a true challenge to the CAPM.
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What are two potential tests that can be conducted to verify the CAPM? What are the results of such tests? What is roll’s critique of CAPM tests?
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Since the CAPM was developed on the basis of a set of unrealistic assumptions, empirical tests should be used to verify the CAPM. The first test looks for stability in historical betas. If betas have been stable in the past for a particular stock, then its historical beta would probably be a good proxy for its ex-ante, or expected beta. Empirical work concludes that the betas of individual securities are not good estimators of their future risk, but that betas of portfolios of ten or more randomly selected stocks are reasonably stable, hence that past portfolio betas are good estimators of future portfolio volatility.
The second type of test is based on the slope of the SML. As we have seen, the CAPM states that a linear relationship exists between a security's required rate of return and its beta. Further, when the SML is graphed, the vertical axis intercept should be rRF, and the required rate of return for a stock (or portfolio) with beta = 1.0 should be rm, the required rate of return on the market. Var |
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Hostile vs Friendly Mergers
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In a friendly merger, the management of one firm (the acquirer) agrees to buy another firm (the target). In most cases, the action is initiated by the acquiring firm, but in some situations the target may initiate the merger. The managements of both firms get together and work out terms which they believe to be beneficial to both sets of shareholders. Then they issue statements to their stockholders recommending that they agree to the merger. Of course, the shareholders of the target firm normally must vote on the merger, but management's support generally assures that the votes will be favorable.
If a target firm's management resists the merger, then the acquiring firm's advances are said to be hostile rather than friendly. In this case, the acquirer, if it chooses to, must make a direct appeal to the target firm's shareholders. This takes the form of a tender offer, whereby the target firm's shareholders are asked to "tender" their shares to the acquiring firm in exchange for cash, stock, bonds, or some c |
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What method is used to account for mergers?
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Mergers must be accounted for using purchase accounting, in which the acquired company is treated as any other capital asset purchase. The old method called “pooling accounting” has been eliminated.
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Sources of synergy
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Economies of scale
Economies of vertical integration Complementary resources (one firm has resources the other could use) Surplus funds (excess cash) Eliminating inefficiencies (bad management) Industry Consolidation (inefficiencies in the industry due to the large amount of firms) |
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Shark-repellent changes to the corporate charter
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Changes to the corporate charter to protect the firm from a takeover
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Golden parachutes
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Large payoffs to managers who lose their jobs due to a merger
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