Finance 338 Exam #3 Study Guide
positive negative
Purchasing short-term investments is a _____ use of FCF, and selling short-term investments is a ____ use.
minimizes weighted average cost of capital
The optimal capital structure ______ the firm's _____ ____ ____ ___ _____.
dividend irrelevance theory
holds that dividend policy has no effect on either the price of a firm's stock or its cost of capital
holder of record date
if a company lists the stockholder as an owner on this date, then the stockholder receives the dividend
residual distribution model
in this model, firms should pay dividends only when more earnings are available than needed to support the optimal capital budget
stock repurchases
occurs when a firm repurchases its own stock- these shares of stock are then referred to as treasury stock
target distribution ratio
percentage of net income distributed to shareholders through cash dividends or stock repurchases
distribution policy
the policy that sets the level of distributions and the form of distributions (dividends and stock repurchases) and the stability of distributions
financial risk
the risk added by the use of debt financing- debt financing increases the variability of earnings before taxes (but after interest); thus, along with business risk, it contributes to the uncertainty of net income and earnings per share
business risk
the risk inherent in the operations of the firm, prior to the financing decision- this, it is the uncertainty inherent in future operating income of earnings before interest and taxes- caused by many factors: two of the most important are sales variability and operating leverage
optimal capital structure
As with all financial decisions, the firm should try to set a capital structure that maximizes the stock price, or shareholder value. This is called the _____ _____ _____.
debt financing
Between debt and equity financing, this form of financing is less expensive when compared on an after-tax basis.
low-regular-dividend-plus-extras
Business Logistics Corp. uses a policy that allows it to pay a small, consistent dividend in year when earnings are low or large capital investments are required. In some years, the firm pays an extra dividend when excess funds are available.
False
TRUE/FALSE: In general, the more business risk that a firm experiences, the more financial leverage the firm will want to employ in its capital structure.
true
TRUE/FALSE: Modigliani and Miller argues that each shareholder can construct his or her own dividend policy.
True
TRUE/FALSE: To address the concerns of many shareholders, some managers prefer to issue new debt securities or preferred stock when raising new long-term funds.
True
TRUE/FALSE: Under the pecking order hypothesis, a firm will raise capital by using its net income, selling its marketable securities, issuing debt, and then issuing stock as the last resort.
True
TRUE/FALSE: When its earnings are decreasing, the use of greater levels of debt capital in a firm's capital structure magnifies the negative return earned by the firm's shareholders beyond that earned by the shareholders of an otherwise identical unlevered firm.
modern capital structure theory high low
_____ _____ ______ ____, constructed by Modigliani and Miller, began in 1958 and provided justifications for increasing leverage under certain assumptions. CEOs and CFOs were encouraged to adopt this theory into practice, especially when spending is ___ and the risk of servicing debt is ___.
information content
a theory that holds that investors regard dividend change as "signals"of management forecasts- thus, when dividends are raised, this is viewed by investors as recognition by management of future earnings increases, therefore, if a firm's stock price increases with a dividend increase, the reason may not be investor preference for dividends but rather expectations of higher future earnings; conversely, a dividend reduction may signal that management is forecasting poor earnings in the future
leveraged buyout
a way to bond a cash flow in which a large amount of debt and a small amount of cash are used to finance the purchase of a company's shares, after which the firm "goes private"
holder-of-record date
all shareholders as of this date will be mailed a dividend check
recapitalization
when a firm issues enough additional debt to optimize its capital structure and then uses the debt proceeds to repurchase stock
signaling theory
This capital structure theory suggests that a firm with favorable investment prospects is more likely to issue debt, rather than equity, securities.
symmetric information
This is the situation in which managers and investors have the same information regarding the past and present condition, performance, and future prospects of a company.
beyond
According to signaling theory, a firm with a very positive outlook might tend to use debt financing ____ the normal target capital structure.
direct
Other things held constant, this is the nature of the relationship between a firm's earnings volatility and bankruptcy risk.
capital structure
The company's ____ ____ policy determines the amount of debt and interest payments.
target payout ratio
percentage of net income paid as a cash dividend
pay interest expenses pay down the principal on debt pay dividends repurchase stock buy short term investments non operating assets
5 ways to use FCF: 1) ___ _____ ____ (after tax) 2) ___ ____ ___ _____ __ ____ 3) ___ _____ 4) ______ ____ 5) ___ ___-___ _____ or other _____ _____
total corporate risk
= business risk + financial risk
new
A ___ stock dividend reinvestment program invests the dividends in newly issued stock. This type of plan raises capital for the firm.
dilution
A fundamental concern of shareholders is the potential ____ of their ownership interest in, and control over, the firm.
large small high low
A high distribution ratio and a high payout ratio mean that a company pays ____ dividends and has ___ (or zero) stock repurchases- the dividend yield is relatively ___ and the expected capital gain is ___.
reduce
A leveraged buyout (LBO) helps the firm ____ both its excess cash flows and managers' temptation to incur wasteful expenses.
increase
An increase in debt financing beyond a certain point is likely to ____ the cost of equity.
reduce
An increase in the risk of bankruptcy is likely to ____ the firm's free cash flows in the future.
increase
As a firm uses more debt in its capital structure, lenders will usually _____ the interest rate charged.
financial leverage
Companies that use debt in their capital structure are said to be using _____ ______.
high
Dividends received far into the future are significantly more uncertain than dividends received in the near future.- favor a ___ payout ratio
pecking order hypothesis
Firms prefer internal funds, but if forced to raise external capital, they prefer debt rather than equity issuance.- what theory is described?
lower
Firms that have relatively ____ business risk compared to other firms in their industry are likely to use more leverage according to the trade-off theory.
true avoid
If a firm pays a dividend of $0.59 per share, the firm's stock price will also fall by $0.59.- This statement is ___ because if a firm pays a dividend of $0.59 per share, the price per share of the firm's stock will also fall by $0.59 to _____ any arbitrage opportunities.
standard deviation EBIT
In MM's initial model the assumption that business risk can be measured by the _____ _____ of ____ was made.
increase decrease no change
Indicate the effect each factor has on a firm's operating break-even point: - only the fixed cost increases- _____ - only the variable cost per unit decreases- _____ - only the firm's tax rate increases- _______
residual dividend
InputOutzone Inc. pays dividends only if more earnings are available than are needed to support the optimal capital budget.
more more fewer
Investors will likely prefer: risk-averse investors prefer to minimize uncertainty with their expectations of income from their investment- ____ dividends investors expect a reliable annual cash flow from their stock portfolios- ____ dividends with capital gains, shareholders in high tax brackets have the ability to defer taxes into the future- ____ dividends
less
Modigliani and Miller also pointed out that many institutional investors do not pay taxes and can buy and sell stocks with very low transaction costs. For these investors, dividend policy is ___ relevant than it is for an individual investor.
B
Most firms have earnings that vary considerably from year to year and do not grow at a reliably constant pace. Furthermore, their required investment may change often. Which statement is most accurate? A) a residual dividend policy can't be of any help to most firms B) most firms can still use the concepts behind a residual dividend policy to make long-run decisions about dividends
constant payout ratio
Praxis Corp. always pays the same percentage of its annual net income as dividends.
equity
Suppose the signaling theory is correct. Harris Inc. is planning a large expansion and needs to raise new capital. If management thinks the firm's stock is overvalued and its prospects are poor while investors are unaware of these opinions, will management want to raise capital using debt or equity?
True
TRUE/FALSE: Firms with higher levels of fixed-cost sources of financial capital, such as debt or preferred stock, in their capital structures will exhibit higher levels of financial risk, all other things being equal.
total risk
The ___ ___ in a firm is determined by evaluating the firm's business risk and financial risk.
working capital
The company's _____ ____ policy determines the investment in marketable securities.
minimizes maximizes increase increase
The optimal capital structure is the one that _____ the WACC and _____ the firm's stock price. Higher debt levels _____ the firm's risk. Consequently, higher levels of debt cause the firm's cost of equity to _____.
less
The payout ratio must be ___ than the distribution ratio because the distribution ratio includes stock repurchases as well as cash dividends.
increases
The pretax cost of debt _____ as the firm's risk of bankruptcy increases.
increases increases increases lower aggressive
The use of financial leverage _____ the expected ROE, _____ the probability of a large loss, and consequently _____ the risk borne by stockholders. The greater the firm's change of bankruptcy, the ____ its optimal debt ratio will be. An ______ manager is more likely to use debt in an effort to boost profits.
dividends
Under the US tax code, corporations are not allowed to deduct these payments made to suppliers of financial capital.
stable predictable dividend
Universal Drugmakers Inc.'s annual dividends increase by the same amount, or percentage, every year.
increase increases
Using leverage can _____ shareholder returns, but leverage also ______ the risk that shareholders bear.
takeover attempt
Washington and Jefferson Inc.'s management is worried that a private equity firm is interested in purchasing the company. The management has decided the company should repurchase shares on the open market in an attempt to increase the value of the firm's stock.- the company's motivation for the stock repurchase is to protect against a _____ ____.
A
What type of company is most likely to follow a strict residual dividend policy? A) a firm with stable, predictable earnings and investment B) all companies C) a firm whose earnings are cyclical and follow the economy D) a firm whose investment needs change often
large
When fixed costs are high, a small decline in sales can lead to a ____ decline in return on equity.
C D E
Which of the following are ways a firm can reduce cash flows to prevent mangers from wastefully spending excess cash flows? A) distribute excess funds to the firm's bondholders by paying more interest expense than it is legally obligated to pay B) Minimize the amount of debt in the firm's capital structure so the firm will be able to borrow money at a reasonable rate when good investment opportunities arise C) pay its excess cash flows to the shareholders in the form of higher dividends D) funnel excess cash flows back to the shareholders through stock repurchases E) increase the amount of debt in the firm's target capital structure in the hope that higher debt-service requirements will force managers to be more disciplined
B
Which of the following is not supported by theoretical and empirical research to date? A) tax rates fall at high debt levels B) Many large, successful firms use much more debt than the trade-off theory suggests C) a firm's cost of debt increases as its debt-to-assets ratio increases D) the optimal debt level occurs when the tax savings of additional debt are just offset by the increase in bankruptcy costs
A B
Which of the following would be considered advantages of a stock repurchase? A) stock repurchases allow a firm to distribute earnings to investors without chaining the amount of the regular cash dividend B) the market generally perceives a stock repurchase as a sign that management believes that the firm's stock is undervalued C) at times, the company will repurchase stock at a higher prices than the true value of the stock
yes
YES/NO: A firm's capital structure does not affect the firm's value. - Is this consistent with the conclusions of Modigliani and Miller's capital structure theory?
Low
___ levels of participation in a dividend reinvestment program suggest that stockholders are constant with the amount of cash dividends that the firm is paying out.
dividend reinvestment plans
_____ _____ ___ allow shareholders to reinvest their dividends in the company by purchasing additional shares instead of receiving cash dividend payments.
capital structure
_____ _____ decisions involve the ways a firm's assets are financed and are often presented as a percentage of the type of financing used, such as debt, preferred stock, and common equity.
dividend irrelevance
_____ _____ suggests that in a world with no market frictions or taxes, firms and investors are indifferent to the paying or receiving of dividends.
Arbitrage
_____ is the underlying assumption necessary for MM to prove their propositions.
dividend policy
______ ____ refers to the manner in which a firm distributes its earnings to shareholders.
recapitalization
_______ is the process through which firms make desired changes in their capital structure by using debt to repurchase equity.
dividend reinvestment plans
allows stockholders to automatically purchase shares of common stock of the paying corporation in lieu of receiving cash dividends; there are two types of plans- one involves only stock that is already outstanding; the other involves newly issued stock- in the first type, the dividends of all participants are pooled and the stock is purchased on the open market- participants benefit from lower transaction costs; in the second type, the company issues new shares to the participants- thus, the company issues stock in lieu of the cash dividend
asymmetric information
assumes managers have more complete information than investors and leads to a preferred "pecking order" of financing: (1) retained earnings, followed by (2) debt, and then (3) new common stock- also known as signaling theory
bird in the hand
assumes that investors value a dollar of dividends more highly than a dollar of expected capital gains, because a certain dividend is less risky than a possible capital gain- implies that a high-dividend stock has a higher price and lower required return, all else held equal
stock split
current shareholders are given some number (or fraction) of shares for each stock share owned- thus, in a 3-for-1 split, each shareholder would receive 3 new shares for each old share, thereby tripling the number of shares outstanding- usually occur when the stock price is outside of the optimal trading range
payment date
dividend checks are sent to shareholders
low-regular-dividend-plus-extras policy
dividend policy in which a company announces a low regular dividend that it is sure can be maintained; if extra funds are available, the company pays a specially designated extra dividend or repurchases shares of stock
reserve borrowing capacity
exists when a firm uses less debt under "normal" conditions than called for by the trade-off theory- allows the firm some flexibility to use debt in the future when additional capital is needed
stock dividends
increases the number of shares outstanding but at a slower rate than splits- current shareholders receive additional share on some proportional basis- thus, a holder of 100 shares would receive 5 shares at no cost if a 5% dividend were declared
trade-off theory
says that the value of a levered firm is equal to the value of an unlevered firm plus the value of any side effects, which include the tax shield and the expected costs due to financial distress
ex-dividend date
shares bought on or after this date do not entitle investors to the stock's dividend
Hamada equation
shows the effect of debt on the beta coefficient- increases in debt increase beta, and decreases in debt reduce beta
reverse split
situation in which shareholders exchange a particular number of shares of stock for a smaller number of new shares
clientele effect
the attraction of companies with specific dividend policies to those investors whose needs are best served by those policies- thus, companies with high dividends will have a clientele of investors with low marginal tax rates and strong desires for current income; conversely, companies with low dividends will have a clientele of investors with high marginal tax rates and little need for current income
unlevered beta
the beta it would have it it had no debt
payment date
the date on which a firm actually mails dividend checks
declaration date
the date on which a firm's directors issue a statement declaring a dividend
ex-dividend date
the date when the right to the dividend leaves the stock- established by stockbrokers to avoid confusion and its 2 business days prior to the holder-of-record date- if the stock sale is made prior to this date, then the dividend is paid to the buyer, if the stock is bought on or after this date, the divided is paid to the seller
optimal distribution policy
the distribution policy that maximizes the value of the firm by choosing the optimal level and form of distributions (dividends and stock repurchases)
operating leverage
the extent to which fixed costs are used in a firm's operations- if a high percentage of a firm's total costs are fixed costs, then the firm is said to have a high degree of operating leverage- it is a measure of one element of business risk but does not include the second major element, sales variability
declaration date
the firm announces its intention to pay a dividend
