FIN 601 Exam 1

Because bankruptcy costs declined

Changes in bankruptcy code make bankruptcy less costly to firms, then firms typically increase their financial leverage because...

Coefficient of variance (CV) = St. dev / Expected value risk for a unit of value

Coefficient of variance formula

MM Irrelevance Theorem

Capital structure doesn't matter; firm value is determined by cash flows; capital structure is just a way to divide a firm's free cash flows between debt holders and shareholders

Clientele effect

impede changing dividend policy; different groups of investors, or clientele, prefer different dividend policies; firm's past dividend policy determines its current clientele of investors; groups of similar investors tend to flock to stocks that have dividend policies consistent with their needs

Tax advantage of debt

interest is tax-deductible but dividends are not

Financial options

investors have no influence on underlying cash flows

Real options

managers can influence the size and risk of a project's cash flows by taking actions during the project's life in response to changing market conditions

1 (most simple) - use discounted cash flow valuation and ignore any real options by assuming their values are 0 2 - use discounted cash flow valuation and include qualitative recognition of any real option's value 3 - use decision tree analysis 4- use the standard model for a financial option 5 - develop a unique, project-specific model by using financial engineering techniques

name the 5 possible methods for real option and valuing them (simple to most difficult)

Optimal cost structure

obtains where a balance is struck between tax benefits and bankruptcy costs; where firm value is maximized

Deposit

one cash flow

risk aversion --> risk premium

positive relationship between risk and required return

-explicitly identify the embedded options

pros of decision tree

Treasury stock

repurchases shares will be retired or become ___________ (for future re-issuance)

stocks more risky than bonds

stock are ___ risky than bonds

-high tax rate -low business risk

take advantage of tax benefits by issuing debt especially if the firm has...

Abandonment options

terminate the project for salvage value

Financial risk

the additional risk as a result of using debt

Free Cash Flow (FCF)

the amount of cash flow available to investors (creditors and owners) after the firm has met all operating needs and paid for investments in net fixed assets and net current assets

the distribution policy defines the level of distribution to shareholders and the form of distribution

the distribution policy defines...

Yield to maturity and Internal rate of return

the expected rate of return, estimated based on future cash flows

Capital structure

the mix of debt and equity; how a firm finances its assets

A real option

the right (but not the obligation) to undertake certain initiatives to alter the cash flows of an investment project; should be taken into consideration for capital budgeting or you may be underinvesting

Business risk

the risk a firm's stockholders would face if the firm had no debt; inherent risk in the operations; varies from industry to industry and firm to firm; a concern of the COO

Present Value

the sum of discounted future cash flows

1. have broker / trustee purchase on open market over a period of time 2. make a tender offer to shareholder 3. make a block (targeted) repurchase

the three ways to repurchase stock

Dividend payout rates have fallen, stock repurchases have increased; repurchases now total more dollars in distributions than dividends; a smaller percentage of companies now pay dividends; when young companies first begin making distributions, it is often in the form of repurchases

trend in dividend / repurchases

Abandonment option

type of real option that allows a firm to shut down a project if its cash flows are lower than expected

time value of money

underlies the discounted cash flows method

investment project

uneven cash flows during the lifetime of the project

corporation

uneven free cash flows til infinity

Financial leverage

use of debt creates _________

-there is a long time before you must make the decision -the underlying project is very risky

value of real option if likely high if...

Investment timing options

wait to make a better - informed decision or wait to take advantage of lower cost of capital

Replication method

what you would implement only if demand turns out high enough

-net income belongs to shareholders -retain only if reinvestment produces better return

why distributions

Dividends

Stock price down, # of shares doesn't change

Repurchases

Stock price no change, # of shares down

True

T/F: In general, investment timing options make it less likely for a project to be immediately accepted today

False

T/F: The presence of managerial, or real, options decreases the value of an investment or project

Higher equity ratio --> lower payout

Target capital structure: Higher equity ratio --> ____ payout

Tradeoff theory

Tax benefits vs bankruptcy costs should take advantage of tax benefits - use debt Avoid high bankruptcy costs - do not use too much debt

Decision tree analysis

a tree like graph or model of decisions and their possible consequences; decisions made at stages, not all at once

discount rates

all are required rates of return, the minimum acceptable rate of return determined by the riskiness of cash flows

Flexibility

alter the use of the production line

as weight of debt increases, cost of equity increases

as weight of debt increases, cost of equity....

Dividends

cash distributions to all shareholders

stock repurchases

cash distributions to some shareholders in exchange for their shares

-using the project's cost of capital is probably inappropriate -discrete scenarios

cons of decision tree

Amortized loan

constant cash flows for a finite time

Perpetuity

constant cash flows for ever

Annuity

constant cash flows for finite time

bond

constant coupons and an extra en-of-period payment

Stable dividend

constant dividends or dividends growing at the long-run growth rate

Regular dividends plus extras

constant dividends, or constant growth dividends plus nonrecurring extras in case of windfall earnings; another variation of residual dividend policy

stock

dividends, probably constant, til infinity

Expansion or contraction options

expand or contract capacity of production line; a type of growth option

-the option term to expiration is longer -the return volatility of underlying assets is greater

financial options more valuable if..

Debt to equity ratio

for ever dollar of equity from shareholders, how much is borrowed

A call (put) option

gives its holders the right, but not the obligation to buy (sell) an asset at a predetermined price within a specified period of time

tax rate cut = tax benefits declines

holding all else equal, the Trump Administration's tax reform would typically cause the firm to use less debt because...

Bankruptcy costs

if debt holders don't get paid; direct costs (assessment costs, attorney fees, fire sale...)

Default

if debt holders don't get paid; shareholders lose the firm

Exercise value

Call: Max (0, stock price - strike price)

Signaling

Investors perception of future Free Cash Flows change; Cut/termination - future free cash flows decline Initiation/increase - future free cash flows rise

Minimize cost of capital

Maximize firm value means minimizing ________

Recapitalization

Modifying capital structure without changing the firm size; issue debt, using proceeds to repurchase stock

Income Statement

A financial statement showing the revenue and expenses for a fiscal period.

Balance Sheet

A financial statement that reports assets, liabilities, and owner's equity on a specific date.

-high business risk -many potential investment opportunities (future growth potential) *small high tech companies*

Avoid bankruptcy costs by maintaining excess borrowing capacity, especially if the firm has...

unstable dividends conflicting signals doesn't appeal to any specific clientele

Cons of residual dividend policy

Irrelevance theory

Distribution doesn't influence the firm value. But could change the perception of expected FCF's; Dividends vs capital gains: different implications

Distribution = Net Income - (Target equity ratio) (total capital budget)

Distribution formula

Dividend cut / termination --> share price decline

Dividend cut / termination --> share price ___________

Dividend initiation / increase --> share price rise

Dividend initiation / increase --> share price ________

Bird in the hand theory

Dividends are less risky than capital gains; dividends reduce cash flow at manager's discretion; investors would value dividend payers more and value high-payout firms more

Tax effect theory

Dividends taxed immediately; capital gains taxes are deferred until shares sold - lower effective tax rate; also capital gains are taxed at a time of the investor's choice - more flexibility; taxes are avoided if stock held til death; investors value non-dividend-payers more

Usually no

Does distribution policy influence cost of capital?

No

Does it influence free cash flow?

Residual distribution model

First, determines the optimal capital budget; find the reinvested earnings needed for the capital budget; pay out after any leftover earnings (the residual) as either dividends or stock repurchases

Debt issue and stock repurchase do not affect price

How does debt issuance and stock repurchase affect stock price

Stock price rises after announcement of recapitalization but doesn't change in debt issuance or stock repurchase

How is stock prices affected by announcement of recapitalization

Then issue equity or pay back debt

If actual debt ratio is above the optimal level, .....

Then issue debt or repurchase stock

If actual debt ratio is below the optimal level, ....

neither influences firm value

In the absence of informational content or agency implication, how is firm value influenced

More good projects --> lower payout

Investment opportunities: More good projects --> ____ payout

Managers pros and cons

Repurchases are more flexible, avoiding sending out negative signals of dividend cut/termination Can use repurchases to achieve other goals But stable dividends attractive to some investors

Investors pros and cons

Repurchases have a tax advantage over dividends Dividends are more dependable

Higher net income --> higher payout

Profitability: Higher net income --> ______ payout

minimizes new stock issues and flotation costs (do not issue new stock as long as net income >= required equity

Pros of residual dividend policy

When managerial actions can alter a project's cash flow stream and hence its value

Real options exist when which of the following occurs?

Target Capital Structure

The optimal mix of debt, preferred stock, and common equity with which the firm plans to finance its investments. May change over time Trade-off between risk and return to achieve goal of maximizing the price of the stock

risk aversion

The tendency to prefer a sure gain of a moderate amount over a riskier outcome, even if the riskier outcome might have a higher expected payoff.

Those who need cash income prefer dividend payers

Those who need cash income prefer ________ payers

Those who want to reinvest prefer non-dividend payers

Those who want to reinvest prefer _________ payers

Time value = option price - exercise value

Time value formula

Raise capital with the same mix of debt and equity

To maintain the optimal capital structure, the firm should...

Certain real options allow companies to change capacity output in response to changing market conditions

What is most accurate about real options

It assumes capital investment is a one-time decision; in reality a a manager can take actions after the project is accepted to increase its value

Why is NPV not good enough for capital budgeting

Beta

a measure of risk

Long run distribution

a potential remedy to residual dividend policy; estimate average payout ratio 5-10 years based on average projected data