Midterm 4
Including preferred stock in the WACC formula adds which term if P is the market value of preferred stock and RP is the cost of preferred?
(P/V) × RP
Including preferred stock in the WACC formula adds which term if P is the market value of preferred stock and RP is the cost of preferred? Multiple choice question.
(P/V) × RP
A reverse stock split results in
- a higher share price - an investor owning fewer shares
A capital restructuring may include
- issuing more equity - issuing debt and repurchasing equity - issuing more debt
An optimal capital structure will
- minimize the cost of capital - maximize the value of the firm
Bankruptcy is very valuable because
- payments to creditors cease pending the outcome of the bankruptcy process - it can be used strategically to improve a firm's competitive position
The growth rate of dividends can be found using
- security analysts' forecasts - historical dividend growth rates
In 2010, 80% of the aggregate dividends from U.S. companies were paid by
100 large firms
Based on M&M Proposition I with corporate taxes, the optimal capital structure is
100% debt
The following are advantages of the SML approach:
Adjusts for risk Does not require the company to pay a dividend
Which of the following is true about stock dividends and stock splits?
Both will increase the total number of shares. Both will reduce the share price.
Which of the following are positives of paying dividends?
Cash dividends can underscore good results. Stock price usually increases with the announcement of a new or increased dividend.
A corporation gains no value from an interest tax shield if which of the following are true?
Corporate tax rates are zero. The corporation is an all-equity firm. The corporation has no debt.
Flotation costs will
Decrease in value of stock
Which costs of financial distress are easier to measure?
Direct costs are easy to measure.
What can we say about the dividends paid to common and preferred stockholders?
Dividends to preferred stockholders are fixed. Dividends to common stockholders are not fixed.
Which of the following are examples of firms which filed for bankruptcy for strategic reasons?
Dow Corning Texaco Johns Manville Continental Airlines
True or false: Stockholders care most about the dividend maximization of the firm.
False
True or false: In the WACC calculation, V = E − D.
False V = E + D
______ is the term that describes the capital structure when debt is used to finance assets.
Financial leverage
Which of the two types of costs of bankruptcy are more difficult to quantify?
Indirect costs are difficult to quantify.
Which of the following assumptions is necessary for M&M Proposition I to hold?
Individuals can borrow on their own at an interest rate equal to that of the firm.
Which of the following is(are) true relative to dividends?
Investors will view a dividend cut as bad news. Dividend increases tend to lag earnings increases. Dividend stability is important.
Which of the following is true of the impact of financial leverage?
It magnifies gains and losses.
What is the required return on a stock (RE), according to the constant dividend growth model, if the growth rate (g) is zero? Multiple choice question.
RE = D1/P0
The formula for calculating the cost of equity capital that is based on the dividend discount model is
RE = D1/P0 + g
The formula of the SML is
RE = Rf + β × (RM − Rf)
What is the equation for finding the cost of preferred stock?
RP = D/P0
The present value of the interest tax shield equals what?
TC × D
How does the level of debt affect the weighted average cost of capital (WACC)?
The WACC initially falls and then rises as debt increases.
According to M&M Proposition I, the value of a firm is the same for debt financing as it is for equity financing because of which of the following?
The asset to be financed is the same. M&M demonstrated that debt financing is neither better nor worse than equity financing.
Which of the following will apply when a firm's debt levels are extremely high?
The benefits of debt financing may be more than offset by the costs of financial distress. The possibility of financial distress will become a chronic problem.
Which of the following are generally true about the cost of equity and the cost of debt?
The cost of debt increases with leverage. The cost of equity may increase with leverage. The cost of debt is generally lower than the cost of equity.
Which of the following describe a firm that takes advantage of a reorganization?
The firm continues to operate. The business must have its reorganization approved by its creditors. It is allowed to issue new securities.
What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level?
The firm overall will become riskier. It will reject projects that it should have accepted. It will accept projects that it should have rejected.
Accounting for the time value of money, which of the following is true of an increase in dividend payout at a point in time?
The net effect is zero. It is exactly offset by a decrease somewhere else.
What is the likely impact on a stock's price when dividends are paid?
The price will fall.
Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings (EBIT)?
The rate of return on assets is unaffected by leverage.
Which of the following are reasons why investors might favor a high dividend payout?
Transaction costs for selling low dividend stocks can be avoided. There is a preference for current income. There is a preference for tax and legal benefits from high dividends.
True or false: Dividend policy is irrelevant.
True
True or false: Firm value is maximized when the WACC is minimized.
True
Given V = E + D, if we divide both E and D by , we can calculate the capital structure weights.
V
What is the expression for the value of a levered firm in the presence of corporate taxes?
Value of levered firm = Value of unlevered firm + Tax benefit of debt
What is the appropriate discount rate to use only if the proposed investment is a replica of the firm's existing operating activities?
WACC
According to the clientele effect, can a firm boost its share price by raising dividends?
Yes, but only if an unsatisfied clientele exists.
Which of the following is true about a firm's cost of debt?
Yields can be calculated from observable data. It is easier to estimate than the cost of equity.
If D is the market value of a firm's debt, E the market value of that same firm's equity, V the total value of the firm (E + D), RD the yield on the firm's debt, TC is the corporate tax rate, and RE the cost of equity, the weighted average cost of capital is Blank______. Multiple choice question.
[E/V] × RE + [D/V] × RD ×(1 − TC)
A stock dividend will result in which of the following?
a decrease in the value per share an increase in shares outstanding
In the United States, dividends have historically been taxed at Blank______ rate compared with capital gains.
a higher
An investor who invests in the stock of a levered firm rather than in an all-equity firm will require
a higher expected return
The dividend policy question addresses whether the firm should payout:
a larger or smaller percentage of its earnings now.
Which of the following involves a firm distributing stock instead of cash to its owners?
a stock dividend a stock split
Using an analyst's forecast for a firm's earnings growth and a stock's dividend yield, you can find the cost of equity by
adding these two components
Which of the following are direct costs of financial distress?
administrative expenses legal fees
The discount rate for the firm's projects equals the cost of capital for the firm as a whole when
all projects have the same risk as that of the firm overall
The costs of financial distress depend mostly on how easily the ownership of the firm's Blank______ can be transferred.
assets
The fact that failure to meet debt obligations can result in bankruptcy is
bad for the firm
Rank each of the following in order of priority of payment.
bankruptcy administrative expenses wages salaries and commissions consumer claims payment to common shareholders
If there are no taxes or flotation costs, then investors will
be indifferent between dividends and a repurchase
Some risk adjustment to a firm's WACC for projects of differing risk, even if it is subjective, is probably
better than no risk adjustment
Financial distress can arise in the form of possible
business failure legal bankruptcy
The equity risk that comes from the nature of a firm's operating activities is known as
business risk
Dividends paid to common stockholders Blank______ be deducted from the payer's taxable income for tax purposes.
cannot
Which of the following industries tend to have a low leverage?
computers drugs
Which of the following are components used in the construction of the WACC?
cost of preferred stock cost of debt cost of common stock
Which of the following is tax deductible to the firm?
coupon interest paid on bonds
A firm's ability to pay dividends may be restricted by:
covenants in a bond indenture.
Bankruptcy costs may exceed the tax shield benefits of
debt
The value of a levered firm is higher than the value of an unlevered firm in the presence of corporate taxes owing to the tax shield benefit of
debt
The date on which the company's Board of Directors passes a resolution to pay a dividend is called the Blank______ date.
declaration
The cost of debt will begin to increase as the
degree of leverage increases
The rate used to discount project cash flows is known as the
discount rate required return cost of capital
A(n) Blank______ occurs whenever a firm makes a payment to its owners from a source other than current or accumulated retained earnings.
distribution
When a payment is made from a firm's earnings to its owners in the form of cash, it is called a
dividend
A strong argument can be made that:
dividend policy does not matter
The dividend growth model is applicable to companies that pay
dividends
A firm can pay out its cash earnings to its shareholders in which of the following ways?
dividends share repurchase
Dividends received by shareholders can be expressed in which of the following ways?
dividends per share dividend payout dividend yield
According to M&M Proposition I, a firm's capital structure choices
do not affect the value of the firm
To calculate cash flow from assets, we need to first calculate what the firm's tax bill would have been if it had not used debt financing. What is the expression for the "would-have-been" tax bill?
earnings before interest and taxes (EBIT) times the firm's tax rate (TC)
The return an investor in a security receives is Blank______ the cost of the security to the company that issued it. Multiple choice question.
equal to
The optimal level of debt in the presence of corporate taxes and bankruptcy costs occurs at the point at which the present value of distress costs Blank______ the present value of the tax shield benefits.
equals
If the firm is all-equity, the discount rate is equal to the firm's cost of Blank______ capital.
equity
In order to receive a dividend, a stockholder must purchase stock before a certain date. That date is called the
ex-dividend date
The date that establishes those individuals entitled to a declared dividend is called the
ex-dividend date
True or false: Based on M&M Proposition I, even including taxes, capital structure does not matter to the firm.
false
True or false: Conglomerates are companies that specialize only in projects similar to the project your firm is considering.
false
True or false: Direct costs are very difficult to measure and, thus, are often estimated.
false
True or false: Dividend payments are concentrated in a large set of small firms.
false
True or false: Dividends are irrelevant.
false
True or false: Finding the cost of equity is fairly straightforward.
false
True or false: For publicly traded companies, the component of the dividend yield that must be estimated is the dividend.
false
True or false: Holding equity in an unlevered firm has no risk.
false
True or false: Projects should always be discounted at the firm's overall cost of capital.
false
True or false: The SML approach is advantageous because all it requires is estimation of beta.
false
True or false: The legal process of bankruptcy is typically quick and inexpensive.
false
True or false: There is a precise mathematical equation for determining the optimal level of debt for any firm.
false
True or false: Under current law, a repurchase has no advantage over a cash dividend.
false
True or false: When total book liabilities exceed the book value of the total assets, a firm is said to have reached fallen angel insolvency.
false
According to the survey discussed in the text, which of the following is of very little importance to managers in setting dividend policy?
flotation costs to issue new equity
To estimate the dividend yield of a particular stock, we need
forecasts of the dividend growth rate, g the last dividend paid, D0 the current stock price
The tax deductibility of interest payments is
good for the firm
To a tax-paying stockholder, a stock repurchase
has significant tax advantages compared to a cash dividend
Equity carries risk; thus, an investor should expect a return than that on less risky debt.
higher
The value of a levered firm will be than the value of an identical unlevered firm because the levered firm's taxes will be . (Enter only one word per blank.)
higher lower
An individual can duplicate a levered firm through a strategy called Blank______ leverage where the investor uses his own funds plus borrowed funds to buy stocks.
homemade
With Blank______, an investor is able to replicate a corporation's capital structure by borrowing funds and using those funds along with their own money to buy the company's stock.
homemade leverage
How is the optimal debt level determined?
in a subjective manner
A stock split is a(n) in a firm's shares outstanding without any change in owners' equity.
increase
If the degree of leverage increases, the cost of debt will
increase
Capital structure decisions are made Blank______ investment decisions.
independent of
Customers refusing to buy GM cars when the company filed for Chapter 11 for fear of not being able to get service for the cars in the future is an example of Blank______ costs of financial distress.
indirect
Which two of the following are broad types of costs of financial distress?
indirect costs direct costs
The crux of dividend policy is whether the firm should pay out money to its shareholders or take that money and:
invest it for shareholders.
Components of the WACC include funds that come from
investors
Finding a firm's overall cost of equity is difficult because
it cannot be observed directly
A firm that pays cash dividends is signaling Blank______ and Blank______.
it is not hoarding too much cash it expects to continue to be profitable
A stock dividend is not a true dividend because
it is not paid in cash
The effect arises because older, large firms are unwilling to cut dividends.
legacy
What is generally the most important component of direct bankruptcy costs?
legal costs
The risk of too much Blank______ is bankruptcy.
leverage
Liquidation differs from reorganization in that
liquidation terminates business activity while reorganization allows the firm to continue operating
The tax shield afforded by debt will be of the least use to firms with
losses carried forward negative EBT
What are some examples of indirect financial distress costs?
lost reputation lost sales
Flotation costs may the payout for firms. (Enter only one word per blank.)
lower
The cost of debt is generally than the cost of equity. (Enter only one word per blank.)
lower
The value of a levered firm will be greater than the value of an identical unlevered firm because the levered firm's taxes will be
lower
According to the survey discussed in the text, the highest priority for financial managers is to
maintain a consistent dividend policy
In the WACC calculation, D represents the value of the firm's debt.
market
The most appropriate weights to use in the WACC are the Blank______ weights.
market value
We should use values in the WACC. Because values are often similar to market values for debt, we often use book value for debt and market value for equity.
market, book
The possibility of bankruptcy costs has a(n) Blank______ effect on the value of the firm.
negative
With a share repurchase, earnings per share will increase, and total earnings will
not change
When a firm authorizes a trustee to repurchase shares as they become available, they are using a(n) Blank______ purchase technique.
open market
In the United States, dividends received have historically been taxed as
ordinary income
Preferred stock
pays a constant dividend pays dividends in perpetuity
Which of the following might be tax-exempt investors?
pension funds trust funds university endowment funds
The value of a levered firm in M&M Proposition I with corporate taxes equals the value of an all equity firm
plus the tax rate times the value of debt
The expected return on equity is Blank______ to leverage.
positively related
Other companies that specialize only in projects similar to the project your firm is considering are called
pure plays
Which of the following are forms of cash dividends?
regular cash dividends extra dividends liquidating dividends special dividends
If an all-equity firm discounts a project's cash flows with the firm's overall weighted average cost of capital even though the project's beta is less than the firm's overall beta, it is possible that the project might be Blank______. Multiple choice question.
rejected, when it should be accepted
The following are disadvantages of the SML approach:
requires estimation of beta requires estimation of the market risk premium
Which of the following industries tend to have a high leverage?
restaurants airlines
Relatively young firms should consider a dividend policy aimed at
retaining earnings to reinvest in the firm
Earnings per share will and total earnings will remain unchanged under a share repurchase. (Enter only one word per blank.)
rise
The WACC of a firm reflects the and the target capital structure of the firm's existing assets as a whole.
risk
Volatility or Blank______ increases for equity holders when leverage increases.
risk
To estimate a firm's equity cost of capital using the SML approach, we need to know the
risk-free rate stock's beta market risk premium
A dividend can be in the form of cash or
shares of common stock
Dividends are heavily concentrated among a relatively number of , mature firms.
small large
The idea that a firm borrows to the point that the tax benefit of debt is exactly equal to the increased probability of financial distress is called the Blank______ theory of capital structure.
static
An alternative way to pay out a firm's earnings to shareholders instead of cash dividends is a
stock repurchase
It is difficult to establish discount rate for individual projects, so firms often adopt an approach that involves making adjustments to the overall WACC.
subjective
A(n) Blank______ repurchase occurs when a firm repurchases shares from specific individual stockholders.
targeted
A university endowment fund might prefer high-dividend-paying stocks since it is usually
tax-exempt
Which of the following investors might prefer a high dividend payout?
tax-exempt investors
When a firm announces to all of its stockholders that it is willing to buy a fixed number of shares at a specific price, it is referred to as a Blank______.
tender offer
It is often in everyone's best interest to devise a "workout" strategy that avoids bankruptcy because
the bankruptcy process can be long and expensive
SmartKids, a textbook publisher, is considering investing in a software company that collects and stores data. What beta should SmartKids use to assess the risk of the project?
the beta for software companies that collect and store data
The concept that stocks attract certain investors due to a firm's dividend policy and the resulting tax impact is called
the clientele effect
Which of the following is considered to be the main factor influencing a firm's dividend decision?
the consistency of its dividend policy
M&M Proposition II shows that
the cost of equity rises with leverage
A firm's capital structure refers to
the firm's mix of debt and equity
A beneficial rule to follow is to set the firm's capital structure so that
the firm's value is maximized
Under M&M Proposition II, a firm's WACC remains unchanged regardless of changes in its capital structure because as the % of debt increases
the increase in the cost of both debt and equity is exactly offset by the increase in the % of lower cost debt
The static theory of capital structure suggests employing debt to the point that its cost equals the cost of
the increased probability of bankruptcy
The tax savings attained by a firm from the tax deductibility of interest expense is called
the interest tax shield
The unwillingness of many older, giant firms to cut dividends is referred to as
the legacy effect
The WACC is the minimum required return for
the overall firm
Under M&M Proposition II with no taxes, the weighted average cost of capital is invariant to the debt level because
the return on assets (RA) is unchanged
Dividend policy can best be described as the:
the time pattern of dividend payout
The basic question of dividend policy is the choice of
the time pattern of dividend payout
A stock split increases the number of outstanding shares, while
the total owners' equity remains constant
M&M Proposition I states if the assets and operations (left-hand side of the balance sheet) for two firms are the same, then
the value of the two firms is equal how the firms are financed is irrelevant
A company may consider a reverse stock split for which of the following reasons?
to reduce transaction costs to investors to increase the share price to a "respectable" level to meet exchange listing requirements to increase liquidity
If a firm uses its overall cost of capital to discount cash flows from projects in higher risk divisions, it will accept Blank______ projects.
too many
Free cash flow is better described as
total distributable cash flow
The difference between the lowest and highest prices at which a stock has traded is called its
trading range
True or false: A firm will often split the stock to keep the stock price within a proper trading range.
true
True or false: According to the absolute priority rule, administrative expenses associated with the bankruptcy are paid first in the distribution of the proceeds of liquidation.
true
True or false: An important thing that we know about dividends is that stock prices typically react to unexpected changes in dividends.
true
True or false: Flotation costs may reduce the payout for some firms.
true
True or false: Free cash flow is very similar to cash flow from assets.
true
True or false: If there are no imperfections, then a cash dividend and a share repurchase are essentially the same thing.
true
True or false: It is possible for the present value of distress costs to exceed the present value of tax savings.
true
True or false: One disadvantage of dividends is that they are taxed to recipients.
true
The cost of capital depends primarily on the Blank______ of funds, not the Blank______. Multiple choice question.
use; source
The WACC is the overall rate of return the firm must earn on its existing assets to maintain the of its stock.
value
What does WACC stand for?
weighted average cost of capital
A dividend Blank______ is calculated as a percentage of the stock's market price.
yield
For a firm with outstanding debt, the cost of debt will be the Blank______ on that debt.
yield to maturity
If a firm issues no debt, its average cost of capital will equal
its cost of equity
True or false: Interest paid is a tax-deductible expense, so a company's tax bill is lower than it would have been had the company not used debt financing.
true
True or false: M&M demonstrated that debt financing is neither better nor worse than equity financing.
true
True or false: The SML approach is advantageous because all it requires is the estimation of beta.
false
True or false: The cost of capital depends on the source of the funds.
false
True or false: The cost of equity is D1/P0 minus the analysts' estimates of growth.
false
True or false: The discount rate is also known as the expected return.
false
M&M Proposition I does not work with corporate taxes because
levered firms pay lower taxes than unlevered firms
True or false: RP = D/P0
true
True or false: The return an investor in a security receives is equal to the cost of the security to the company that issued it.
true
Which of the following are true?
The market value of debt and equity are not reliable in case of privately owned company. Ideally, we should use market values in the WACC.
True or false: The expected percentage is the overall rate of return the firm must earn on its existing assets to maintain the value of its stock.
false
True or false: The growth rate of dividends can be found using the CAPM.
false
True or false: The primary disadvantage of the dividend growth model approach is its simplicity.
false
The weighted average cost of capital rises at higher levels of debt owing to
financial distress costs
An investor who buys the common stock of a levered firm is subject to more risk due to the addition of
financial risk
The equity risk that comes from the financial policy or capital structure decisions of the firm is known as
financial risk
