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5. Financial Leverage [LO1] Why is the use of debt financing referred to as financial "leverage"?

5. It's called leverage (or "gearing" in the UK) because it magnifies gains or losses

8. Dividend Policy [LO2] For initial public offerings of common stock, 2017 was a slow year, with about $24.53 billion raised by the process. Relatively few of the 108 firms involved paid cash dividends. Why do you think that most chose not to pay cash dividends? Use the following information to answer the next two questions: Historically, the U.S. tax code treated dividend payments made to shareholders as ordinary income. Thus, dividends were taxed at the investor's marginal tax rate, which was as high as 38.6 percent in 2002. Capital gains were taxed at a capital gains tax rate, which was the same for most investors and fluctuated through the years. In 2002, the capital gains tax rate stood at 20 percent. In an effort to stimulate the economy, President George W. Bush presided over a tax plan overhaul that included changes in dividend and capital gains tax rates. The new tax plan, which was implemented in 2003, called for a 15 percent tax rate on both dividends and capital gains for investors in higher tax brackets. For lower-tax bracket investors, the tax rate on dividends and capital gains was set at 5 percent through 2007, dropping to zero in 2008

. If these firms just went public, they probably did so because they were growing and needed the additional capital. Growth firms typically pay very small cash dividends, if they pay a dividend at all. This is because they have numerous projects available, and they reinvest the earnings in the firm instead of paying cash dividends.

. Would you use all the comparable firms in calculating the average? Why or why not? [medium]

. No. Eliminate the outliers, because they are likely to skew the average. The average P/E ratio without GET and King World is 25.16.

1. The optimal capital structure is achieved when the [Easy] A. debt-equity ratio is equal to 1. B. weight of equity is equal to the weight of debt. C. cost of equity is maximized given a pre-tax cost of debt. D. debt-equity ratio is such that the cost of debt exceeds the cost of equity. E. debt-equity ratio results in the lowest possible weighted average cost of capital.

. This is the definition of "optimal" capital structure.

. What assumptions are you making when you use the industry-average P/E ratio to value Paramount Communications? [easy]

1) Paramount is similar to the average firm in the industry in terms of growth and risk. (2) The marker is valuing communications firms correctly, on average.

4. Observed Capital Structures [LO1] Refer to the observed capital structures given in Table 16.7 of the text. What do you notice about the types of industries with respect to their average debt-equity ratios? Are certain types of industries more likely to be highly leveraged than others? What are some possible reasons for this observed segmentation? Do the operating results and tax history of the firms play a role? How about their future earnings prospects? Explain.

4. The more capital-intensive industries, such as airlines, cable television, and electric utilities, tend to use greater financial leverage. Also, industries with less predictable future earnings, such as computers or drugs, tend to use less financial leverage. Such industries also have a higher concentration of growth and startup firms. Overall, the general tendency is for firms with identifiable, tangible assets and relatively more predictable future earnings to use more debt financing. These are typically the firms with the greatest need for external financing and the greatest likelihood of benefiting from the interest tax shelter.

Which of the following statements are correct in relation to M & M Proposition II with no taxes? I. The required return on assets is equal to the weighted average cost of capital. II. Financial risk is determined by the debt‐equity ratio. III. Financial risk determines the return on assets. IV. The cost of equity declines when the amount of leverage used by a firm rises. a. I and III only b. II and IV only c. I and II only d. III and IV only e. I and IV only

: Indeed, in M&M with no taxes, wacc = RA=wE*RE + wD*RD (I is correct) and financial risk is (RU - RD)*(D/E), which is determined by D/E ratio (II is correct). However, financial risk determines the return on equity, not on asset (III incorrect), and the cost of equity increases with leverage (IV incorrect). (c)

2. Stock Repurchases [LO4] What is the impact of a stock repurchase on a company's debt ratio? Does this suggest another use for excess cash?

A stock repurchase reduces equity while leaving debt unchanged. The debt ratio rises. A firm could, if desired, use excess cash to reduce debt instead. This is a capital structure decision.

1. The tradeoff theory of capital structure with tax and bankruptcy costs advocates that the optimal capital structure for a firm: [Medium/Hard] a. Equates WACC and the after-tax cost of debt because debt is always cheaper. b. Remains fixed over time. c. Is independent of the firm's tax rate. d. Is independent of the firm's debt-equity ratio. e. Equates the tax savings from an additional dollar of debt to the increased bankruptcy costs.

ANSWER: E: The optimal amount of leverage is when the benefits of leverage = cost of financial distress. When the cost of financial distress > benefits of leverage, WACC increases from its optimal amount.

1. How many statements below are correct about the Modigliani-Miller theorem? [Medium/Hard] i. The theorem is not an exact description of reality. ii. The theorem provides a benchmark to understand how the capital structure could affect WACC. iii. The theorem implies that firms have benefited from financing with debt due to a higher required rate of return on debt compared with equity. iv. The value of the firm is not affected by its capital structure under any assumptions. a. zero statements b. one statement c. two statements d. three statements e. four statements.

ANSWER: c. two statements. Statements i. and ii. are correct. The theorem is not an exact description of reality, but it helps us understand in reality how the capital structure could affect WACC through different frictions. The theorem is under three assumptions: (1) No bankruptcy; (2) no taxation; (3) perfect capital markets (no transaction costs and the same borrowing cost for both investors and the firm).

Which of the following statements are true? i. Using debt, rather than equity, saves money on taxes ii. Using too much debt increases costs of financial distress iii. The optimal capital structure balances tax savings and financial distress a. i only b. ii only c. iii only d. i and ii only e. i, ii, and iii

All the statements are correct

8. Bankruptcy and Corporate Ethics [LO3] Firms sometimes use the threat of a bankruptcy filing to force creditors to renegotiate terms. Critics argue that in such cases, the firm is using bankruptcy laws "as a sword rather than a shield." Is this an ethical tactic?

As in the previous question, it could be argued that using bankruptcy laws as a sword may be the best use of the asset. Creditors are aware at the time a loan is made of the possibility of bankruptcy, and the interest charged incorporates this possibility

1. As a result of which one of the following a business firm ceases to exist as a going concern? [Easy] A. partial share repurchase B. liquidation C. reorganization D. capital restructuring

B. Bankruptcy is a legal process to deal with the problem that a firm cannot fulfill its debt obligations. However, it does not necessarily mean that the firm ceases to exist. There are two ways of resolving bankruptcy: liquidation and reorganization. Liquidation simply sells the assets of the firm and dissolves the firm. Reorganization continues the operation of the firm, but makes old creditors into new equity holders.

1. If the optimal amount of debt for a firm is positive, then [Medium] A. direct financial distress costs must equal the present value of the interest tax shield. B. the value of this levered firm must exceed the value of the unlevered firm with the same assets. C. value of the firm is minimized. D. value of the firm is equal to unlevered firm value plus interest tax shield benefits. E. debt-equity ratio is equal to 1.0.

B. If the optimal amount of debt is positive, then this levered firm must be "better off" (i.e., having higher firm value) compared to the unlevered firm with the same assets.

3. Optimal Capital Structure [LO1] Is there an easily identifiable debt-equity ratio that will maximize the value of a firm? Why or why not?

Because many relevant factors such as bankruptcy costs, tax asymmetries, and agency costs cannot easily be identified or quantified, it's practically impossible to determine the precise debt-equity ratio that maximizes the value of the firm. However, if the firm's cost of new debt suddenly becomes much more expensive, it's probably true that the firm is too highly leveraged.

1. Business Risk versus Financial Risk [LO1] Explain what is meant by business risk and financial risk. Suppose Firm A has greater business risk than Firm B. Is it true that Firm A also has a higher cost of equity capital? Explain.

Business risk is the equity risk arising from the nature of the firm's operating activity and is directly related to the systematic risk of the firm's assets. Financial risk is the equity risk that is due entirely to the firm's chosen capital structure. As financial leverage, or the use of debt financing, increases, so does financial risk and, hence, the overall risk of the equity. Thus, Firm B could have a higher cost of equity if it uses greater leverage.

1. Dividend Policy Irrelevance [LO2] How is it possible that dividends are so important, but at the same time, dividend policy is irrelevant?

Dividend policy deals with the timing of dividend payments, not the amounts ultimately paid. Dividend policy is irrelevant when the timing of dividend payments doesn't affect the present value of all future dividends.

: Which one of the following is the equity risk related to a firm's capital structure policy? a. market b. systematic c. idiosyncratic d. business e. financial

Financial risk (risk of leverage). In Proposition II: RE = RU + (RU - RD)*(D/E)*(1 - t), where (RU - RD)*(D/E)*(1 - t) - compensation for the financial risk (risk of leverage) (e)

3. Dividend Chronology [LO1] On Tuesday, December 5, Hometown Power Co.'s board of directors declares a dividend of 75 cents per share payable on Wednesday, January 17, to shareholders of record as of Wednesday, January 3. When is the ex-dividend date? If a shareholder buys stock before that date, who gets the dividends on those shares, the buyer or the seller?

Friday, December 29 is the ex-dividend day. Remember not to count January 1 because it is a holiday, and the exchanges are closed. Anyone who buys the stock before December 29 is entitled to the dividend, assuming they do not sell it again before December 29.

: Which one of the following refers to the ability of shareholders to undo a firm's dividend policy and create an alternative dividend policy by reinvesting dividends or selling shares of stock? a. Perfect foresight model b. Personalizationc. Recapitalizationd. Offsetting leverage e. Homemade dividend policy

Homemade dividend policy-The homemade dividends refer to the inflow of cash that an investor determines to fulfill his cash flow objectives. He fulfills his cash flow objectives by selling some percentage of shares from his portfolio or receiving the traditional dividends.

Which of the following tend to keep dividends low? I. shareholders desiring current income II. terms contained in bond indenture agreements III. investors with high dividend tax rates but low capital gains tax rates IV. flotation costs a. II and III only b. I and IV only c. II, III, and IV only d. I, II, and III only e. I, II, III, and IV

II - debt covenants can restrict the amount of dividends that companies can pay. III - such investors would prefer low dividend so that they would pay lower taxes on capital gains. IV - companies paying out large dividends 2ould need to raise capital more frequently. If flotation costs (costs of raising new capital) are high, the companies would prefer to keep the fund for investing and not to pay dividends. (c)

. Alternative Dividends [LO1] Some corporations, like one British company that offers its large shareholders free crematorium use, pay dividends in kind (that is, offer their services to shareholders at below-market cost). Should mutual funds invest in stocks that pay these dividends in kind? (The fundholders do not receive these services.)

No, because the money could be better invested in stocks that pay dividends in cash which benefit the fundholders directly.

How would you answer in the following debate? Q: Isn't it true that the riskiness of a firm's equity will rise if the firm increases its use of debt financing? A: Yes, that's the essence of M&M Proposition II. Q: And isn't it true that, as a firm increases its use of borrowing, the likelihood of default increases, thereby increasing the risk of the firm's debt? A: Yes. Q: In other words, increased borrowing increases the risk of the equity and the debt? A: That's right. Q: Well, given that the firm uses only debt and equity financing, and given that the risks of both are increased by increased borrowing, does it not follow that increasing debt increases the overall risk of the firm and therefore decreases the value of the firm?

No, you cannot make this conclusion. While it is true that the equity and debt costs are rising, the key thing to remember is that the cost of debt is still less than the cost of equity. Since we are using more and more debt, the WACC does not necessarily rise.

7. Bankruptcy and Corporate Ethics [LO3] As mentioned in the text, some firms have filed for bankruptcy because of actual or likely litigation-related losses. Is this a proper use of the bankruptcy process?

One answer is that the right to file for bankruptcy is a valuable asset, and the financial manager acts in shareholders' best interest by managing this asset in ways that maximize its value. To the extent that a bankruptcy filing prevents "a race to the courthouse steps," it would seem to be a reasonable use of the process.

9. Bankruptcy and Corporate Ethics [LO3] As mentioned in the text, Continental Airlines filed for bankruptcy, at least in part, as a means of reducing labor costs. Whether this move was ethical, or proper, was hotly debated. Give both sides of the argument.

One side is that Continental was going to go bankrupt because its costs made it uncompetitive. The bankruptcy filing enabled Continental to restructure and keep flying. The other side is that Continental abused the bankruptcy code. Rather than renegotiate labor agreements, Continental abrogated them to the detriment of its employees. In this question, as well as the last several, an important thing to keep in mind is that the bankruptcy code is a creation of law, not economics. A strong argument can always be made that making the best use of the bankruptcy code is no different from, for example, minimizing taxes by making the best use of the tax code. Indeed, a strong case can be made that it is the financial manager's duty to do so. As the case of Continental illustrates, the code can be changed if socially undesirable outcomes are a problem.

1. Lay out how you would get to the free cash flow to the firm (what would you add and/or subtract to the base number?) from the following measures of cash flow. [easy]

Possible answers: FCFF = EBIT (1- tax rate) + Depreciation - Capital Spending - DWorking Capital FCFF = (EBITDA - Depreciation) (1- tax rate) + Depreciation - Capital Spending - DWorking Capital FCFF = Net Income + Interest (1-t) + Depreciation - Capital Spending - DWorking Capital FCFF = (Earnings before taxes + Interest Expenses) (1 - tax rate) + Depreciation - Capital Spending - DWorking Capital

1. The typical approach to valuing a company using multiples/comparables does not suggest: a. Using ratios of companies from other industries in which the company does not operate. b. Using P/E ratios of the company's industry competitors. c. Adjusting the set of ratios for outlier values. d. Defining a set of comparable companies. e. Relying on the law of one price.

Solution: (a) The approach suggests using P/E ratios of comparable companies that usually operate in the same industry.

1. The stock price value obtained using the multiples/comparables approach does not rely on: I. The law of one price. II. Available set of comparable companies. III. Meaningful cash flow projections. a. Only I b. Only II c. Only III d. Only I and II e. Only II and III

Solution: (c) To conduct valuation using multiples, we do not need to make cash flow projections.

10. Capital Structure Goal [LO1] What is the basic goal of financial management with regard to capital structure?

The basic goal is to minimize the value of non-marketed claims.

5. Dividends and Stock Price [LO1] If increases in dividends tend to be followed by (immediate) increases in share prices, how can it be said that dividend policy is irrelevant?

The change in price is due to the change in dividends, not due to the change in dividend policy. Dividend policy can still be irrelevant without a contradiction.

. Dividend Reinvestment Plans [LO1] The DRK Corporation has recently developed a dividend reinvestment plan, or DRIP. The plan allows investors to reinvest cash dividends automatically in DRK in exchange for new shares of stock. Over time, investors in DRK will be able to build their holdings by reinvesting dividends to purchase additional shares of the company. A large number of companies offer dividend reinvestment plans. Most companies with DRIPs charge no brokerage or service fees. In fact, the shares of DRK will be purchased at a 10 percent discount from the market price. A consultant for DRK estimates that about 75 percent of DRK's shareholders will take part in this plan. This is somewhat higher than the average. Evaluate DRK's dividend reinvestment plan. Will it increase shareholder wealth? Discuss the advantages and disadvantages involved here.

The plan will probably have little effect on shareholder wealth. The shareholders can reinvest on their own, and the shareholders must pay the taxes on the dividends either way. However, the shareholders who take the option may benefit at the expense of the ones who don't (because of the discount). Also as a result of the plan, the firm will be able to raise equity by paying a 10 percent flotation cost (the discount), which may be a smaller discount than the market flotation costs of a new issue for some companies.

. Ex-Dividend Stock Prices [LO1] How do you think this tax law change affected ex-dividend stock prices?

The stock price drop on the ex-dividend date should be lower. With taxes, stock prices should drop by the amount of the dividend, less the taxes investors must pay on the dividends. A lower tax rate lowers the investors' tax liability.

6. Dividends and Stock Price [LO1] Last month, Central Virginia Power Company, which had been having trouble with cost overruns on a nuclear power plant that it had been building, announced that it was "temporarily suspending payments due to the cash flow crunch associated with its investment program." The company's stock price dropped from $28.50 to $25 when this announcement was made. How would you interpret this change in the stock price (that is, what would you say caused it)?

The stock price dropped because of an expected drop in future dividends. Since the stock price is the present value of all future dividend payments, if the expected future dividend payments decrease, then the stock price will decline.

: The value of a firm is maximized when the: a. cost of equity is maximized. b. levered firm value equations unlevered firm value. c. levered cost of capital is maximized. d. weighted average cost of capital is minimized. e. debt-equity ratio is minimized.

We know that PV is inversely related to the discount rate. Since we can consider the firm value as a collection of net present values of all its projects and wacc as a discount rate, then the firm value and the wacc are inversely related. Thus, when the wacc is minimized, the firm value is maximized. (d)

. Stock Repurchases [LO4] How do you think this tax law change affected the relative attractiveness of stock repurchases compared to dividend payments?

With a high tax on dividends and a low tax on capital gains, investors, in general, will prefer capital gains. If the dividend tax rate declines, the attractiveness of dividends increases.

] Suppose you are looking at a company with no change in capital spending, no change in net working capital, and no depreciation. Since the company is not increasing its assets, EBIT is constant. What is the value of the company?

With the assumptions given, the adjusted cash flows are a perpetuity, so we can discount the cash flows using the perpetuity equation.

: Fill in the blanks in the following sentence: "The costs of financial distress, such as , are usually larger than the costs of financial distress" a. Indirect, loss of valuable employees, direct a. Direct, loss of valuable employees, indirect b. Indirect, legal costs of bankruptcy, direct c. Direct, legal costs of bankruptcy, indirect d. Direct, credit limits, indirect

a) We know that indirect costs of financial distress are typically large and larger than direct costs of financial distress. And the example is loss of valuable employees. See Lecture 19 (Bankruptcy is costly)

: Based on M & M Proposition II with taxes, the weighted average cost of capital: a. is equal to the aftertax cost of debt. b. has an inverse relationship with the cost of equity capital. c. is unaffected by the tax rate. d. decreases as the debt-equity ratio increases. e. is equal to RU × (1 - TC).

a. decreases as the debt-equity ratio increases.

5. DCF Cost of Equity Estimation [LO1] What are the advantages of using the DCF model for determining the cost of equity capital? What are the disadvantages? What specific piece of information do you need to find the cost of equity using this model? What are some of the ways in which you could get this estimate?

advantage of the DCF: simplicity. disadvantages: only to firms that actually pay dividends; ( many don't pay) growth rate must be estimated since you cant find it in the market. sensitive to changes in the growth rate, which is a very uncertain

The common stock of Dayton Dry Goods has historically had a low dividend yield that is expected to continue. As a result, the majority of its shareholders are individuals who prefer capital gains over cash dividends for tax reasons. The fact that most of these shareholders have similar characteristics is referred to by which one of the following terms? a. Asymmetric information effect b. Clientele effect c. Investor effect d. Distribution effect Market reaction effect

b. Clientele effect The clientele effect states that for various reasons, some investors prefer low (high) dividend payouts, and they will buy stocks of companies with low (high) payout.

The business risk of a firm: a. depends on the firm's level of unsystematic risk. b. is inversely related to the required return on the firm's assets. c. is dependent upon the relative weights of the debt and equity used to finance the firm. d. has a positive relationship with the firm's cost of equity. e. has no relationship with the required return on a firm's assets according to M & M Proposition II.

d has a positive relationship with the firm's cost of equity. RE = RA + (RA - RD) *(D/E), where RA is the business risk of the firm. When RA increases, RE also increases (d).

1. Price-to-earnings ratio cannot be computed using only

d. Return on equity and number of shares.