FINA 4200 Fall 2019 Final Exam Review
At what rate does IRR assume reinvestment?
at IRR
IPO: Prospectus
Formal summary that provides information on an issue of securities.
Projects L and S each have an initial cost of $10,000, followed by a series of positive cash inflows. Project L has total, undiscounted cash inflows of $16,000, while S has total undiscounted inflows of $15,000. Further, at a discount rate of 10 percent, the two projects have identical NPVs. Which project's NPV will be more sensitive to changes in the discount rate? (Hint: Projects with steeper NPV profiles are more sensitive to discount rate changes.) A) Project S. b)Project L. c)Both projects are equally sensitive to changes in the discount rate since their NPVs are equal at all costs of capital. d)Neither project is sensitive to changes in the discount rate, since both have NPV profiles which are horizontal. e)The solution cannot be determined unless the timing of the cash flows is known
b)Project L.
What do stronger firms tend to do when requiring more funding?
"Stronger" firms tend to go public rather than get acquired by another firm. - Size (capital stock), productivity, sales growth, market share, capital expenditure ratio
IPO: Underpricing
(money left on the table) - Issuing securities at an offer price set below the true value of the security
What cash flows do we discount for CF projections? How do we treat incremental CFs? How do we treat accounting earnings?
- Actual cash inflows and outflows - Incremental Cash Flows - only CFs that change as a result of the project - Never discount accounting earnings, however, they can be used to back out CF
Define Primary and Secondary offerings
- An IPO is called a primary offering when new shares are sold to raise additional cash for the company. - It is a secondary offering when the company's founders and the venture capitalist cash in on some of their gains by selling shares.
What are some of the main causes of bankruptcy? What are systematic factors? What are firm specific factors such as: Operation factors, financial factors, agent factors?
- Anything that impacts a firm's expected future FCF Systematic factors - General economic trends - Industry trends - Firm specific factors - Related to firm's operations - Shift in consumer tastes - Obsolete technology - Demographic changes in firm's retail locations Related to firm's financials - Too much debt - Unexpected increase in interest rates Related to firm's agents Errors / Misjudgments / Fraud
True or False:
IPOs can be and commonly are both primary and secondary
What is the declaration date? What is decided here?
The Board of Directors declares a payment of dividends, decides on the Record date.
What is the main goal of formal reorganization? What is estimated? What is the process regarding capital structure? What happens to the firms securities?
- Appropriate capitalization rate determined - Estimate company's value - Appropriate capital structure for the company after it emerges from Chapter 11 determined - Reorganized firm's securities then allocated to the various claimants in a fair and equitable manner.
What is missing from the irrelevance dividend theory that assumes investor will have equal outcome whether company issues desired dividend or or homemade dividend strategy is used? What does the model assume?
- Brokerage costs to sell the shares - Taxes on capital gain from selling - Model assumes frictionless market
Regarding informal reorganization, What type of committee is formed? Who arranges and conducts the meeting between the managers and creditors?
- Creditors form a committee consisting of 4-5 of the largest creditors, and 1-2 of the smaller ones - Meetings arranged and conducted by an adjustment bureau - The adjustment bureau is run by the local chapter of the National Credit Manager's Association
What is the idea behind absolute/Relative priority and fairness regarding Bankruptcy proceedings? Who should compensation be based? How must claims be reconized?
- Creditors should be compensated for their claims in a rigid hierarchical order, and senior claims must be paid in full before junior claims receive anything - Balanced consideration should be given to all claimants -Claims must be recognized in the order of their legal and contractual priority
What is the procedure and timeline for issuing a cash dividend?
- Declaration Date - Record Date - Ex-Dividend Date
How is depreciation treated in CF projections? What it its main purpose?
- Depreciation is an accounting number, not a cash flow - While we do not ignore depreciation. we just need to assess the CF Effect as it is a tax shield
What is the managements line of action in an informal reorganization?
- Draw up a list of creditors, with amounts of debt owed - Classify creditors, ranging from first-mortgage holders to unsecured creditors - Develop information showing the value of the firm under different scenarios... Share with creditors - Explain to creditors
How are fairness and feasibility implemented in Formal Reorganization? What must be estimated? What else must be analyzed for predictions? What is the main goal?
- Future sales estimated - Operating conditions analyzed so that future earnings and cash flows can be predicted... How to improve earnings and reduce fixed charges?
IPO: Book Building - what is Investment banker hoping for?
- Investment banker asks investors to indicate how many shares they plan to buy, and records this in a "book". Investment banker hopes for oversubscribed issue.
What are the 5 main dividend theories?
- Irrelevance theory - Preference theory - Tax effect - Clientele Effect - Signaling effect
What are the central issues to address when evaluating bankruptcy? What if it is temporary? Regarding rehabilitation?
- Is the inability to meet debt payments a temporary cash flow problem OR is it permanent as the asset values have significantly declined below the liabilities of the firm? -If it is a temporary thing, then can an agreement be reached with creditors OR if it is permanent who gets the liquidation value? nShould there be rehabilitation / liquidation? -Should rehabilitation / liquidation be informal / formal? nWho controls the firm during rehabilitation / liquidation... Existing management / a trustee?
Upon getting NOPAT for capital budgeting incremental cash flow projections, what steps are next?
- Make adjustments (such as adding back in depreciation) - Incorporate CapX and changes in working capital
What is the "Static tradeoff" view regarding Bankruptcy Costs and Agency Costs?
- Managers "trade-off" the costs and benefits of debt •VL = VU + PV(Tax shield) - PV(distress costs) - PV(net agency costs)
When companies declare a stock dividend, Is cash leaving the firm? What is the company doing essentially?
- No cash leaves the firm - the firm is increasing the number fo shares outstanding
Share Repurchase: What are he main types?
- Open Market repurchase - Tender offer - targeted repurchase
What are 5 sources that synergies can come from?
- Operating economies: economies of scale, etc. - Financial economies: lower transaction costs etc. - Tax effects: combined enterprise pays less in taxes than the separate firms would pay - Differential management efficiency - Increased market power
What are some reasons for low dividends?
- Personal Taxes - Issuance Costs
IPO: Roadshow
- Presentations given by a company's management and underwriters to institutional investors; small investors historically have been shut out. Roadshows are used to build interest in an IPO. Company is in "Quiet Period"
What are the main uses of the payback period? What does a shorter payback imply? How does payback period relate to risk?
- Provide information on how long funds will be tied up in a project - So, shorter the payback, quicker the recovery of invested capital, greater the liquidity - Cash flows expected in the distant future are generally riskier than near-term cash flows, so, payback is often used as an indicator of a project's riskiness
IPO: Flipping
- Quickly taking profits by selling IPO shares after they have increased in after-market trading.
Dividend theory: Signaling Effect How do stock price trend with increases and cuts in dividends? How do firms address this and when do they increase dividends? What does a higher dividend increase than expected imply? What about if it is lower?
- Rise with increases and fall with cuts -Firms reluctant to cut dividends, and don't raise till they forecast good future earnings Higher - Indicator of positive form prospects Lower - Implies negative firm prospects
Explain the irrelevance theory of dividend policy: How does it affect firm value? Do investors need a dividend? Will they pay higher premiums for higher payout? How does it say that investors will create income streams?
- Says that dividend policy doesn't affect firm value - Investors don't need the firm to pay dividends - Says that investors will not pay higher premiums for higher payout - States that investors will create their own income streams through homemade dividends
What are the two main solutions for a startup company when they need more capital than can be provided by smaller investors?
- Sell the business to a larger firm (M&A). - Go public (IPO).
Hostile Merger What does the acquirer do? How do they usually end up?
- Target firm's management resists the merger. - Acquirer makes tender offer directly to the target firm's stockholders, and tries to get 51% to tender their shares. - Often, mergers that start out hostile end up as friendly, when offer price is raised.
IPO: Lock-up period - How ling usually?
- The period-typically 180 days-following an IPO during which directors, officers and other insiders are barred from selling their shares. If a stock is trading well above its offering price, underwriters may allow insiders to sell shares earlier
What is synergy regarding a merger?
- Value of the whole exceeds sum of the parts. - Merger is beneficial to both A's and B's stockholders.
What is Over-Allotment or the Green Shoe Option? What is the effect?
- happens when demand for the stock exceeds the allotment granted to the underwriter. - The effect of the over-allotment on the underwriters' incentives is that they have an incentive to maintain or help increase the stock price after the first day of trading.
What is extension regarding informal reorganization? What is it related to and what does it do?
- is related to maturity of debt - Postpone the dates of required interest or principal payments
When do you apply replacement chain analysis? Is it always appropriate? When is the best time to use it?
- only if mutually exclusive projects with significantly different lives are being compared - it is not always appropriate to extend the analysis to a common life. - should only be done if there is a high probability that the projects will actually be repeated at the end of their initial lives...
The regular cash dividend: How often do public companies pay these? What do they sometimes throw in? What is an extreme example of a dividend?
- quarterly - Sometimes firms will trow in a "Special Dividend" Extreme case would be a liquidating dividend, which is generally done with the intent of shutting down the business
What are indirect distress costs?
-Impaired ability to conduct business (likely the largest overall) •Lost sales, suppliers, employees •Lost investment opportunities -May have to sell assets as a discount •"Fire" sale
Residual Distribution Model: What goes into the optimal distribution ratio?
-Investors preferences for dividends versus capital gains -Firm's investment opportunities -Target capital structure -Availability and cost of external capital
What are direct distress costs? How do they relate to value lost?
-Legal and administrative costs •Enron more than $1 billion •WorldCom approximately $600 million •Lehman Brothers around $1.6 billion -Tend to be small relative to value lost •Estimates of around 3-10% of firm value
To find the optimal structure of a firm, what all must be calculated for each capital structure under consideration?
-Levered Beta -Cost of Equity -WACC -Corporate Value
If tax rate on dividends is the same as the rate on capital gains, what may still be the preferred payout by investors? Why?
-Payout in the form of repurchases may still be preferred as investors - Capital gain tax can be postponed whereas dividend income is taxable immediately, thus it costs less today
How does the Modified Internal Rate of Return Differ from traditional IRR? At what rate does it assume reinvestment?
1) Assumes reinvestment at WACC... 2) Does not lead to multiple rates of return
What is the model used to evaluate wealth of shareholders and share repurchases? Name the line items
1) Begin with weight of debt 2) Value of operations 3) Add in any short term investments 4) Find total intrinsic value 5) Subtract out debt (value of the St investments) 6) Arrive at Intrinsic value of equity 7) Divide by number of shares outstanding 8) Arrive at value of stock 9) Add back in cash distributed in repurchase (same as S-T investments/Debt) 10) Arrive at Wealth of Shareholders
What is the basic process of beginning a bankruptcy claim? Is this claim voluntary or involuntary? What happens after the filing? What happens after that under Ch 11? What is the final step is reorganization doesn't work?
1) Case is opened by filing a petition with one of the bankruptcy courts 2) Petition can be voluntary (management) or involuntary (Creditors) 3) After filing, a committee of unsecured creditors is appointed by Office of US Trustee to negotiate with management 4) Under Ch 11, trustee will be appointed to take over the company is the court deems current mgmt incompetent or if fraud is suspected 4) If a reorganization cannot be worked out, the firm be liquidated under Chapter 7
What are the 4 steps to the residual distribution model?
1) Determine optimal capital budget 2) Determine amount of equity needed to finance that budget, given the target capital structure 3) Use reinvested earnings to meet equity requirements to the extent possible 4) Pay dividends only if more earnings are available
What are the main disadvantages of going public?
1) Direct and indirect costs of going public 2) Loss of privacy 3) Costs of periodic reporting of company financials 4) MGMT loses freedom because there is now a board of directors 5) Higher risk of loss of total company control through takeovers
What are the main drawbacks fo the Payback Period?
1) Does not take into account the cost at which invested capital has been raised 2) Ignores cash flows received after the payback period
What are the basic steps for evaluating recapitalization?
1) Find $ value of debt 2) Find $ value fo equity (Repeat steps 1 and 2 for each capital structure) 3) Now evaluate the situation of the firm if they move to another capital structure via things like issuing debt
What are the steps for finding the MIRR?
1) Find FV of all cash inflows to terminal year at WACC 2) Sum the FVs to find the terminal value 3) PV all of the cash outflows to current year at WACC 4) Find the discount rate that causes the PV to equal Cost 5) This rate is the MIRR
How to calculate the profitability index?
1) Find PV of all future CFs 2) Sum the PVs 3) Divide Sum by initial cost
How is the crossover rate calculated? What if the projects do not cross?
1) Find the cash flow differences between the two projects 2) Enter these differences in the CF register 3) Press IRR button If project do not cross, then one project dominates the other
When engaging in a merger, what two questions must the acquirer ask? What are two approached to these questions?
1) How much would the target be worth after being incorporated into acquirer? 2) How much should the acquirer offer for the target? Can use DCF or Market Multiple Approach
List basic steps of an IPO
1) Select underwriter (investment banker) 2)File registration document (form S-1) with SEC 3) Choose price range for preliminary (or "red herring") prospectus 4)Go on road show and underwriters build books nSet final offer price in final prospectus
Why does the IRR mislead?
1) size and timing of CFs for mutually exclusive projects 2) Reversal of CF can lead to Multiple IRRs 3) Reinvestment rate assumption - IRR assumes reinvestment at IRR
What are the three most common ways to estimate the cost of common equity?
1. CAPM 2. Dividend Yield plus Growth Rate (DCF Method) 3. Own bond yield plus Judgmental Risk Premium
How do you calculate payback period?
Add next years cash flow to previous years deficit until CFs become positive, divide the positive CF of the year of payback by the previous years deficit to get the percentage of the year that it took. Add full years to the decimal to get total payback time
When were bankruptcy laws first enacted? Bankruptcy law consists of how many Odd numbered chapters and how many even numbered chapters?
1898 8 Odd numbered and 1 even
Agency costs: Given examples
1: Incentive to take large risks 2: Incentive toward underinvestment 3: Cashing out
What is the Ex-Dividend date regarding cash dividends? When is it relative to the other key dates? How are shareholders who purchase stock on or after this date treated? How are shareholders who purchase stock before this date treated? What does it reflect?
2 business days before record date. •Buy on/after this date you do not get the dividend. •Buy on the 3rd you do get the dividend. •Reflects time for settlement
What discounted CF techniques can be used to value a company during a merger?
Adjusted Present Value Model Free Cash Flow to Equity Model Corporate Valuation Model
Do most corporations employ a target debt-equity ratio?
yes, in a survey, about 80% of fortune 500 companies have a target ratio
Which of the following statements is most correct? a) All else equal, if a bond's yield to maturity increases, its price will fall. b) All else equal, if a bond's yield to maturity increases, its current yield will fall. c) If a bond's yield to maturity exceeds the coupon rate, the bond will sell at a premium over par. d) All of the answers above are correct. e) None of the answers above is correct.
A
Which of the following statements is most correct? a) The before-tax cost of preferred stock may be lower than the before-tax cost of debt, even though preferred stock is riskier than debt. b) If a company's stock price increases, this increases its cost of common stock. c) If the cost of equity capital increases, it must be due to an increase in the firm's beta. d) Statements a and b are correct. e) Statements a, b, and c are correct.
A
What is a call provision on a bond?
A call provision is a stipulation on the contract for a bond—or other fixed-income instruments—that allows the issuer to repurchase and retire the debt security.
What is the "a bird in the hand is worth more than two in the bush" argument regarding preference for payout? How does this affect the investors required return and the firms cost of capital?
A return as a dividend is a sure thing whereas capital gain is more risky So shareholders prefer dividends, which exposes them to less risk and therefore lowers their required return Lowers the firms cost of capital and increases form value
In reality, what does a secondary offering look like? Does the cash raised here flow to the company?
A secondary offering therefore is no more than a sale of shares from the early investors in the firm to new investors, and the cash raised in a secondary offering does not flow to the company.
Which of the following does not increase a company's market value? A) Increasing expected g rate of sales B) Increasing expected operating profitability (NOPAT/SALES) C) Decreasing the Capital requirements (CAPITAL/SALES) D) Decreasing the WACC E) Increasing the expected rate of return on invested capital
A) Increasing expected g rate of sales USE MVA formulas to explain
When the market's required rate of return for a particular bond is much less than its coupon rate, the bond is selling at: A) Premium B) Discount C) Cannot be determined without more info D) Face Value
A) Premium
A company estimates that its WACC is 10%. Which of the following independent projects should the company accepts? A) Project A describes an up-front expenditure of $1,000,000 and generates a NPV of $3,200 B) Project B has a modified internal rate of return on 9.5% C) Project C requires an up-front expenditure of $1,000,000 and generates a positive IRR of 9.7% D) Project D has an IRR of 9.5% E) None of the above projects should be accepted
A) Project A describes an up-front expenditure of $1,000,000 and generates a NPV of $3,200
How to make project decisions based on the profitability index: When do you accept a project? The higher the PI, the higher the...?
Accept is PI > 1.0 Higher PI, Higher the Projects ranking
What are some advantages of informal liquidation? What are the benefits to the assignee? What are the benefits to the creditors?
Advantages In terms of time, legal formality, and expense Assignee has more flexibility in disposing off property than a federal bankruptcy trustee Assignee is often familiar with the debtor's business, better results may be achieved Action can be taken sooner, before inventory becomes obsolete or machinery rusts So, creditors get more and quicker
IPO: Spinning -
Allocating IPO shares to the personal brokerage account of a corporate or venture-capital executive (who then flips the shares) in a bid to get future business from the executive's company.
When comparing two mutually exclusive project with different lives, how can you get a fair comparison of NPV and IRR?
Analyze both projects using a common life (Replacement chain analysis)
What is the common pool problem regarding bankruptcy proceedings?
Automatic stay provision: Limits the ability of creditors to foreclose to collect their individual claims
The corporate valuation model cannot be used unless a company doesn't pay dividends. a) True b) False
B
What are some of the main reasons for higher dividend payout policies? What theory goes with each?
Bird-In-the-hand theory: Uncertain Lower agency costs - Capital markets as a monitoring device - Less cash flow for wasteful spending Desire for current income - clientele effect Information Asymmetry - dividends as a signaling effect of firms future performance
This type of risk is avoidable through proper diversification: A) Market risk B) Systematic Risk C) Idiosyncratic Risk D) Student Risk
C) Idiosyncratic Risk
To compute the requires rate of return for equity in a company using CAPM, it is necessary to know all of the following EXCEPT: A) The Risk Free Rate B) The Beta for the Firm C) The earnings for the next period D) The market return expected for the time period
C) The earnings for the next period
If the intrinsic value of a stock is greater than its market value, which of the following is a reasonable conclusion? A) The stock offers a high dividend payout ratio B) The stock offers a low dividend payout ratio C) The market is undervaluing the Stock D) The market is overvaluing the stock D)
C) The market is undervaluing the Stock
What are the potential effects of switching a payout policy? So, is frequent switching advisable?
Can change the firms clientele, which could cause many shareholders to sell and push the stock price down And in some cases, the new policy may not attract new clientele, keeping stock price down It is better to keep a stable policy and avoid switching
What chapter of Bankruptcy law id the most important concerning a financial management point of view? What does this chapter deal with?
Chapter 11, deals with business reorganization, most important section from a financial management viewpoint
What chapter of Bankruptcy law deals with liquidation?
Chapter 7
When choosing Mutually Exclusive projects based on the NPV rule, how do we decide what to take? And what if using the IRR rule?
Choose highest NPV Highest IRR
When choosing independent projects based o the NPV rule, how do we decide what to take? And what about IRR rule?
Choose the ones with positive NPVs Choose projects with IRR > WACC
What has been the general trend with company payout policies regarding dividends and repurchases?
Companies have been trending more towards repurchases and less toward dividends
Which of the following statements is most correct? a) Portfolio diversification reduces the variability of the returns on the individual stocks held in the portfolio. b) If an investor buys enough stocks, he or she can, through diversification, eliminate virtually all of the nonmarket (or company-specific) risk inherent in owning stocks. Indeed, if the portfolio contained all publicly traded stocks, it would be riskless. c) The required return on a firm's common stock is determined by its systematic (or market) risk. If the systematic risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return. d) A security's beta measures its non-diversifiable (systematic, or market) risk relative to that of an average stock. e) A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock.
D
When does conflicts between NPV and IRR rules arise with Mutually Exclusive Projects regarding the crossover point?
Conflicts between NPV and IRR arise when the cost of capital is below the crossover point.
What rate does the adjusted PV model use? Does it matter if the capital structure changes? What corporate structures is it best for?
Cost of the un-levered firm (all equity firm) Doesn't matter if capital structure changes Dynamic Capital Structures
What is the holdout problem regarding bankruptcy proceedings? What does it do to creditors? When is each class considered to have accepted the reorganization plan? When will the plan be approved?
Cramdown: - Lump creditors into classes - Each class is considered to have accepted a reorganization plan if two-thirds of the amount of debt and one-half the number of claimants vote for the plan - Plan will be approved by the court if "fair and equitable" to the dissenting parties
What is the creditors line of action in an informal reorganization? What do creditors prefer? What happens in the case of composition?
Creditor's line of action: - Prefer extension as it promises eventual payment in full - Postpone the date of payment - Subordinate existing claims to vendors willing to extend new credit during workout period Accept lower interest rate on loans during the extension In case of composition creditor's would agree to reduce claims - Cash and/or new securities with combined market value less than the amounts owed them Creditors will bargain with the firm to part with the savings that result from avoiding the costs of legal bankruptcy: administrative costs, legal fees, investigative costs, and so on...
What is the cross over rate regarding project decision rules? What is it used to show?
Crossover Rate is the rate of return at which the Net Present Values (NPV) of two projects are equal. It represents the rate of return at which the net present value profile of one project intersects the net present value profile of another project. In capital budgeting analysis exercises, crossover rate is used to show when one investment project becomes superior to another as a result of a change in the rate of return (cost of capital).
Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the following statements must be true about these securities? (Assume the market is in equilibrium.) a) When held in isolation, Stock A has greater risk than Stock B. b) Stock B would be a more desirable addition to a portfolio than Stock A. c) Stock A would be a more desirable addition to a portfolio than Stock B. d) The expected return on Stock A will be greater than that on Stock B. e) The expected return on Stock B will be greater than that on Stock A.
D
Which of the following is an example of an agency problem a) A CEO is awarded $100,000 worth of executive stock options, which he exercises two years later for $1,000,000. b) A company borrows $1,000,000 for investment in equipment, but uses the money instead to repurchase stock. c) A company declares bankruptcy, but instead of being liquidated, it is reorganized and one set of bondholders who are owed $10 million accept $3 million in payment for the debt. d) A CEO orders the headquarters moved just so he can have a nicer office. e) A group of institutional stockholders votes to oust management.
D
True of False: If stock held till expiry (of the owner)... beneficiaries are liable to any capital gains tax
False
True or False: distribution via repurchases reduces the shares outstanding... but stock price of a repurchasing company doesn't grow any faster than a dividend-paying company
False
Which of the following statements is most correct? a) The weighted average cost of capital for a given capital budget level is a weighted average of the marginal cost of each relevant capital component which makes up the firm's target capital structure. b) The weighted average cost of capital is calculated on a before-tax basis. c) An increase in the risk-free rate is likely to increase the marginal costs of both debt and equity financing. d) Answers a and c are correct. e) All of the answers above are correct.
D
Which of the following statements is most correct? A) The WACC for a given capital budget is a weighted average of the marginal cost of each relevant capital component which makes up the firms target structure B) The WACC is calculated on a before tax basis C) An increase in the risk-free rate is likely to increase the marginal cost of both debt and equity financing D) Answers A and C are correct E) None of the above are correct Explain
D) Answers A and C are correct Risk free rate is directly input into the equity formula and interest rates generally trend with the risk free rate for cost of debt
Which of the following is an agency cost? A) Cost of Auditing B) Cost of monitoring management C) Cost of hiring board members D) All of the above E) None of the above
D) all of the above
In the time of distress, who has more to lose when it comes to bankruptcy?
Debt holders, so the shareholders are more likely to take a bigger risk to regain capital and have a big payoff, even if the probability is very low
True or False: Firms that are harder for outsiders to evaluate or face less information asymmetry tend to go public rather than get acquired.
False, "easier to evalaute"
Dividend Theory: Taxes and Clientele. What do investors in higher tax brackets want? What about lower tax bracket individuals or institutions?
Different tax rates among different clientele will affect the preference for dividends Individuals in higher tax brackets prefer low dividend payers... want reinvestment Individuals / Institutions that are in zero to low tax brackets may prefer current income
Which of the following statements is most correct? a) Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihood of unfavorable events. b) Portfolio diversification reduces the variability of returns on an individual stock. c) When company-specific risk has been diversified, the inherent risk that remains is market risk which is constant for all securities in the market. d) A stock with a beta of -1.0 has zero market risk. e) The SML relates required returns to firms' market risk. The slope and intercept of this line cannot be controlled by the financial manager.
E
Which of the following statements is most correct? a) The slope of the security market line is beta. b) A stock with a negative beta must have a negative required rate of return. c) If a stock's beta doubles its required rate of return must double. d) If a stock has a beta equal to 1.0, its required rate of return will be unaffected by changes in the market risk premium. e) None of the above statements is correct
E
Which of the following statements is most correct? a) The NPV and IRR rules will always lead to the same decision in choosing between mutually exclusive projects, unless one or both of the projects are "non-normal" in the sense of not having only one change of sign in the cash flow stream. b) The Modified Internal Rate of Return (MIRR) compounds cash outflows at the cost of capital. c) Conflicts between NPV and IRR rules arise in choosing between two mutually exclusive projects (that each have normal cash flows) when the cost of capital exceeds the crossover point (that is, the point at which the NPV profiles cross). d) The discounted payback method overcomes the problems that the payback method has with cash flows occurring after the payback period. e) None of the statements above is correct.
E) None of the statements above is correct.
Jefferson City Computers has developed a forecasting model to determine the additional funds needed in the upcoming year. All else being equal, which of the following factors is likely to increase its additional funds needed? A) A sharp increase in its forecasted sales given the company's fixed assets are at full capacity B) A reduction in its dividend payout ratio C) The company reduces its reliance on trade credit that sharply reduces its accounts payable D) Statements A and B are correct E) Statements A and C are correct
E) Statements A and C are correct
How does value of equity move as more debt is issued and shares are repurchased? How does total wealth of shareholders change?
Equity Value declines Total value of the shareholders is not affected by the share repurchases since it is the value of stock after the recap plus the cash received in repurchase
Regarding the FCFE formula on the formula sheet, what is the calculation essentially doing? What discount rate is used in this calculation?
FCFE = FCF - Interest(1-T) + Change in Debt Use levered cost of equity
A call provision gives bond holders the right to demand or "Call for" repayment of a bond. Typically, calls are exercised if interest rates rise, because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at a higher interest rate: A) True B) False
False
If a company's expected return on invested capital is less than its cost of equity, the the company must also have a negative market value added
False
When buying back shares, what is generally used for the share repurchase?
Financed through liquidating short- term investments
What does the corporate valuation model find? What is it discounted at?
Finds the FCF to all investors in the firm Discounted at Rate of Target Firm (WACC)
IPO: Underwriter
Firm that buys an issue of securities from a company and resells it to the public.
After a company issues a dividend, does the firm value change? How is stock price affected?
Firm value traditionally doesn't change so the stock price changes instead as more shares are now outstanding at a the same value
What can following the distribution model strictly lead to? What should the model be used for?
Following the model strictly leads to an unstable dividend policy Use the model to set a long-term stable payout ratio
What equation must be used to find the beta of a levered firm?
Hamada's Equation: BL = BU [1 + (1 - T)(D/S)]. Where D = weight of debt and S = weight of equity
When estimating optimal capital structure, what is the ultimate goal?
Have the lowest WACC and highest Value of Firm
Formal Liquidation: Who are some of the claimants with highest priority? Lowest?
Highest: - Past due property tax - Secured Creditors - Legal Fees and other expenses to administer and operate the bankrupt firm Lowest: - Unfunded Pension Plan Liabilities - Unsecured Creditors - Preferred Stock - Common Stock
Historically, how were taxes on capital gains versus dividends? Has it changed?
Historically lower tax rates for capital gains versus dividends -In 2003 tax rate on dividend income made the same as on capital gains
Define Horizontal Merger and Vertical Merger
Horizontal: ¡One firm combines with another in its same line of business... Vertical: ¡Steel producer's acquisition of one of its own suppliers, such as a coal mining firm ¡Oil producer's acquisition of a petrochemical firm that uses oil as a raw material
What is the idea behind a homemade dividend?
Idea is that yo can create your own desired dividend by selling a certain amount of shares ex-dividend to essentially come out with the same cash and stock holdings as if they company paid the dividend you required. Essentially, the stock holdings after selling would be as if the company issued the required dividend and the stock price fell. But instead, the investor is selling a certain amount of shares to make up the amount
What is informal liquidation? What is the procedure called? Where is the title transferred? What do they do with the assets?
If it makes more sense to close out firm's operations Informal procedure used is called assignment Title to the debtor's assets transferred to a third party, known as an assignee or trustee Assignee liquidates the assets through a private sale or public auction Distributes the proceeds among the creditors on a pro rata basis
What is informal reorganization? What does the company management and creditors do? What are these plans called and what do they involve and what can the restructuring involve?
If the firm is economically sound and is facing temporary cash flow problems... - Company management and creditors work together to chalk out plans to recover the company from the downturn - Such plans are called Workouts which involve restructuring the firm's debt - And restructuring can involve extension and / or composition
How is interest expense and overhead treated in capital budgeting cash flow projections?
Ignore interest expense and discount CFs at cost of capital given in the risk of the project, we judge a project based on its own merit, not how it will be financed Overhead: Only consider incremental overhear, not "allocated" overhead
What is the implication if one projects NPV profile curve decreases NPV faster than the other as the discount rate increases, assuming same initial cost?
Implies that bigger cash flows are occurring later in time, thus a longer payback period. On the other hand, if a projects curve compared to another project isn't as steep, the NPV isnt decreasing as fast possibly because the cash floes are closer to the point of discount and thus are not discounted in value as much. Faster payback
If a perfect world, how would stock price adjust on the ex-dividend date? How does it adjust in reality? Why is this?
In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date. In reality, the actual price drop is less than the dividend and occurs within the first few minutes of the ex-dividend date. Believed to be because of tax effects.
Where are project externalities such as Cannibalization, accounted for in the incremental cash flow?
Include it in the incremental earnings by subtracting the estimated amount from Sales Revenue and subtracting the costs from COGS
How is opportunity cost, incidental cost, and sun costs treated in incremental CF projections of capital budgeting?
Include: Opportunity costs and Incidental costs (Cannibalization/erosion of other product lines) Ignore: Sunk Costs as they have already been incurred and cannot be changed by the decision to accept or reject the project
What are the two main types of project decisions?
Independent - if taking one project does not rule out the possibility of taking the other project. Mutually Exclusive - if we can choose either, or we can reject both, but we cannot accept both projects.
Given interest expense, how do you find Tax Shield Cash Flow
Interest * (1-Tax rate)
What is a congeneric merger?
Involves related enterprises but not producers of the same product (horizontal) or firms in a producer-supplier relationship (vertical)
What is a stock if its expected return is lower than its required return?
It is overvalued
What is composition regarding informal reorganization? What is it related to and what does it do?
It is related to face value / interest on debt - Accept lower principal amounts - Reduce interest rate on debt - Take equity in exchange of debt Combination
When Beta is 1, what is the expected return?
It is the market expected market return
A larger stock issue has ... underpricing?
Less
An older firm has ... Underpricing?
Less
All in all, is a project with a shorter payback period more or less risky?
Less risky
NPV of projects with earlier cash flows are more or less sensitive to changes in the discount rate?
Less, because because earlier cash flows are less sensitive to changes in discount rates...
What constitutes a payout policy of a firm? What does the stability of the payout policy depend on?
Level - What should target distribution ration be? Form - What should the target payout ration be? Stability - Can the payout policy affect the firm value? Depends on investors preference for dividend yield/Capital gain
What is the equation for the Leverages Value of a Firm?
Leverage Value = Unlevered Value + Present Value of the Tax Shield - PV of distress costs - PV of net agency costs
What is "Cashing Out"?
Liquidating Dividends Suppose our firm paid out a $200 dividend to the shareholders Leaves the firm insolvent and nothing is left for the bondholders
What should equal what to determine the optimal capital structure of a firm?
Marginal tax benefits = Marginal Bankruptcy-Related Costs
What is market value added?
Market value added (MVA) is a calculation that shows the difference between the market value of a company and the capital contributed by all investors, both bondholders and shareholders. In other words, it is the sum of all capital claims held against the company plus the market value of debt and equity.
Are projects with steeper NPV profiles more or less sensitive to changes in the discount rate?
More
NPV profile tradeoff, if discount rate is high, early CF is more or less valuable?
More
The more informationally inefficient a firm, the more or less chance of underpricing?
More
How does debt relate to the probability of distress?
More debt = Higher probability of distress
NPV of projects with later cash flows are more or less sensitive to changes in the discount rate?
More, because later cash flows are more sensitive to changes in discount rates
Formula for Earnings per share
NI/Shares Outstanding
What is unlevered net income also known as? How is it calculated?
NOPAT (Revenues - costs - depreciation) * (1-Tax Rate)
Main advantages of going public:
New capital and lower cost of capital Greater liquidity Measure of performance readily available Diversification and ease of transferring ownership such as mergers and acquisitions More efficient employee compensation
IPO: Follow-on (seasoned) Offering -
Newly issued shares sold to investors by an already public company. Also called a seasoned or an add-on offering (SEO). It is used by the company to raise additional capital.
Do share repurchases increase stock prices themselves?
No
If projects are the same size in terms of total cash flow amount, but one project recovers its capital earlier than the other, assuming same discount rate, which will have higher NPV?
Project that recovers capital earlier
Ignoring tax effects, does the form of distribution affect shareholder wealth?
No, it doesn't
When assessing a project, what discount rate do we use? Do we use the firms WACC?
Not firm-wide WACC, but project's own risk-adjusted cost of capital
What is a projects payback period? Shorter payback -> ? -> ?
Number of years required to recover the funds invested in a project Shorter payback = Quicker recovery of invested funds = better project
What happens if no demand for stock?
Offering is withdrawn
How is NWC treated in an incremental CF projection?
Only include the changes from year over year int he year they changed
Formula for Profit Margin
PM = NI/Sales
Regarding incremental cash flows of a project, when should research and development be included?
Past R&D should be treated at a sunk cost and shouldn't be included the decision should be based on incremental costs and benefits going forward, so New/Incremental R&D should be included
What is the equation for finding the price of preferred stock into perpetuity?
Pps = Dps/Rps
What does the levered value of a firm minus the un-levered value of the firm give you?
Present Value of the Tax Shield
What is the firms market value added (MVA)?
This is the sum of all its projects NPVs
What do dividends provide to the market? How should firms follow a sensible dividend policy? What should take priority to paying a dividend? What should they avoid as a means to pay a dividend? What should they consider when there are few better uses for cash?
Provide info to the markets - Don't forgo positive NPV projects just to pay a dividend. -Avoid issuing stock to pay dividends. -Consider share repurchase when there are few better uses for the cash.
What is recapitalization? What do you need?
Recapitalization is the process of restructuring a company's debt and equity mixture, often to make a company's capital structure more stable. -Resulting value of debt to be issued -Resulting market value of equity -Price per share -Number of shares repurchased (and remaining shares)
What some shortcut equations that can be used to find the following after a share repurchase: S or value of equity P or price of share and n or Number of shares
S = (1 - wd) Vop P = [S + (D - D0)] / n0 n = n0 - (D - D0)/P
Walk through each income statement line item starting with sales and ending with NI
Sales - COGS = EBITDA - Depr & Amort = EBIT - Interest Expense = EBT - Taxes = NI
How do you calculate discounted payback period?
Same process as traditional payback period, but all CFs are discounted with cost of capital before calculation is performed
What are the two main reasons that NPV profiles cross? How is the Size of the CFs demonstrated on the IRR and NPV graphs? How is Timing of the CFs demonstrated on the IRR and NPV graphs? What does the slope tell regarding sensitivity?
Sizing of CFs Timing of CFs Size: vertical distance Timing: slope (sensitivity of NPV to change in r)
What are the types of payout policies? Is a dividend always monetary?
Some companies declare a dividend of some sort - Can even be gum like in the example of Wrigley's
What is systematic risk and what else is it called? Can it be diversified away?
Systematic risk refers to the risk inherent to the entire market or market segment. Systematic risk, also known as "undiversifiable risk," "volatility" or "market risk," affects the overall market, not just a particular stock or industry. It cannot be mitigated through diversification, only through hedging or by using the correct asset allocation strategy.
TRUE OR FALSE: NEVER use the historical market return in conjunction with current risk free rate to estimate market risk premium
TRUE
TRUE or FALSE: More generally taking on risker projects has the potential benefit shareholders at the expense of bondholder
TRUE
TRUE or FALSE: Firms with many investment opportunities should maintain reserve borrowing capacity, especially if they have problems with asymmetric information (which would cause equity issues to be costly).
TRUE Firms should allow room in their capital structure to pursue these opportunities without issuing new stock
Where is opportunity costs added into an incremental Cash Flow?
Take the income that could be earned with the next best option and add it to the SG&A
How are synergistic benefits found?
Take the market value of the target firm's equity and subtract it from the value that the acquiring firm estimates the value of the equity to be to them This will be the expected synergy value that the acquiring firm believes can be attained
What is the adjusted present value? What is the assumption or when is it best to use?
The adjusted present value is the net present value (NPV) of a project or company if financed solely by equity plus the present value (PV) of any financing benefits, which are the additional effects of debt. By taking into account financing benefits, APV includes tax shields such as those provided by deductible interest. Assumes or used for project financed solely through equity, that is why Un-levered Cost of Equity is Used
Formal reorganization regarding bankruptcy: Why go this route when informal is cheaper and quicker?
The common pool problem the Holdout Problem Absolute/Relative priority Fairness Feasibility
What are flotation costs? What is underpricing? What are some direct flotation costs?
The costs incurred when a firm issues new securities to the public Underpricing is an indirect flotation cost. - The preparation of the registration statement and prospectus involves management, legal counsel, accountants, as well as underwriters and their advisers.
What is the record date regarding cash dividends what is decided here?
This is the threshold date when the company decides which shareholders qualify for dividends List of all individuals believed to be stockholders as of the specified record date
Friendly Merger:
The merger is supported by the managements of both firms.
What is the modified internal rate of return? What does the MIRR more accurately project?
The modified internal rate of return (MIRR) assumes that positive cash flows are reinvested at the firm's cost of capital and that the initial outlays are financed at the firm's financing cost. By contrast, the traditional internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR itself. The MIRR, therefore, more accurately reflects the cost and profitability of a project.
What is an underwriting spread? For issues between $20-$80 million, what is the spread usually?
There is also the underwriting spread. (Underwriters make their profit by selling the issue at a higher price than they paid for it.) For most issues between $20 million and $80 million, the underwriting spread is 7%.
Assume you are comparing 2 mutually exclusive projects. Which of the following statements is most correct? A) The NPV and IRR rules will always lead to the same decision unless one or both of the projects are "non -normal" in the sense of not having only one change of sign in the cash flow stream, i.e., one or more initial cash outflows (the investment) followed by a series of cash inflows. b)If a conflict exists between the NPV and the IRR, the conflict can always be eliminated by dropping the IRR and replacing it with the MIRR. c)There will be a meaningful (as opposed to irrelevant) conflict only if the projects' NPV profiles cross, and even then, only if the cost of capital is to the left of (or lower than) the discount rate at which the crossover occurs. d)Statements a, b, and c are tru
There will be a meaningful (as opposed to irrelevant) conflict only if the projects' NPV profiles cross, and even then, only if the cost of capital is to the left of (or lower than) the discount rate at which the crossover occurs.
Dividend Theories: Preference for Dividends. What is the idea? What are the implications of a high payout? All in all, what does it say is reduced and what is increased?
This addresses a preference for payout in a time of agency conflicts High Payout: - Less cash on hand for managers to squander cash - More external financing which leads to more manager scrutiny which can deter manager from making wasteful purchases High payout Decrease agency cost and increases firm value
To whom is underpricing a cost?
This is a cost to the existing owners of the firm. They could have sold the firm's shares at a much higher price! Money is left on the table.
TRUE OR FALSE: Low P(Distress) firms can take still take on debt without significantly increasing P(distress)
True
True of False: Firms that are backed up by VC or bank loans tend to go public rather than get acquired.
True
True or False: Horizontal / Vertical mergers produce maximum synergistic benefits but are anti-competitive
True
True or False: It is easier to "time" the IPO relative to the earnings cycle of your firm than to the market
True
True or False: Valuation of target firm gives the value of target after it's acquired, so may be different from its current (true) value: need to consider synergies and tax benefits!
True
True or False: while IPO stocks are underpriced on average, about a third have negative initial returns.
True
What is targeted repurchase? What does the company do? What have share repurchases recently become?
Type of share repurchase: Purchase a block of shares from one large holder on a negotiated basis •Share repurchases have become an increasingly important way of distributing earnings to shareholders.
What is open market repurchase?
Type of share repurchase: Buy back its own stock through a broker on the open market
What is a tender offer?
Type of share repurchase: permits stockholders to send in shares in exchange for a specified price per share
When should overhead expense be included in incremental CFs? Where should it be added
Typically, overhead costs are fixed, so if they are not incremental, do not include them BUT, include them if they are incremental and add them to SG&A
What is unsystematic risk and what else is is called? Can it be diversified away?
Unsystematic risk is unique to a specific company or industry. Also known as "nonsystematic risk," "specific risk," "diversifiable risk," "Idiosyncratic risk," or "residual risk," in the context of an investment portfolio, unsystematic risk can be reduced through diversification.
How to take NPV of potential risky project taken by Manager with probabilities?
Use direct capitalization and for the cash flows, multiply the payoff by the probability it happens
What components make up a firms value?
Value of operations and S-T investments
What does the FCFE calculate?
Values the available capital to only shareholders
NPV profile tradeoff, if discount rate is low, the early recapture of capital through CF is or is not valuable?
early CF is not as as valuable
How do you figure how many shares are repurchased?
take the initial debt and subtract it from the new debt to get how much capital is available to use towards repurchases. Then divide that number by the after debt current price of the shares
What Capital structure theories imply about changes in beta?
that beta changes with leverage
How do dividends and firm earnings correlate?
they generally do not. for example, Gm kept pretty consistent dividends throughout 1985-2006 while their earnings were all over the place
Firm-commitment offering: What does underwriter guarantee? How do the underwriters get paid?
underwriter agrees to guarantee that a certain amount of capital will be raised. Thus, underwriter buys all the stock in effect. The underwriters receive payment in the form of a spread— that is, they are allowed to sell the shares at a slightly higher price than they paid for them
What is a conglomerate merger?
when unrelated enterprises combine
Discounted pay back period: How does it differ from traditional payback period?
works with discounted cash flows now... so, we are accounting for the cost of invested capital now...
What is the Pecking Order Theory? What is the end result of this stock issuance? Is it similar for debt issuance? How can managers avoid this?
•It can be shown that only the most overvalued firms have any incentive to issue equity. -Even if a moderately overpriced firm issue equity, investors will infer it is highly overpriced and cause the stock to fall more than it deserved. •Similar but less severe skepticism about debt issue. - The only way for managers to get out of this box is to finance projects out of retained earnings
What is the main idea behind Asymmetric Info and Signaling regarding stock price and issuance between managers and shareholders? How do investors view additional stock issuances?
•Managers know the firm's future prospects better than investors. •Managers would not issue additional equity if they thought the current stock price was less than the true value of the stock (given their inside information). •Hence, investors often perceive an additional issuance of stock as a negative signal, and the stock price falls.
How do managers act when issuing securities? When do they like to issue securities? When do they Issue debt?
•Managers try to "time the market" when issuing securities. •They issue equity when the market is "high" and after big stock price run ups. •They issue debt when the stock market is "low" and when interest rates are "low."
What are the majority of Debt/Asset ratios like for US corps? What is the average? Do any use no debt?
•Most US corporations have low Debt-Asset ratios. -The average D/A ratio is about 50% for US firms -A number of firms use no debt.
What are the rules of the Pecking order theory? What are the implications?
•Rule #1: Firm will first use internal financing • •Rule #2: If internal financing is not available, firm will issue debt before issuing equity. Implications: - there are no target D/E ratios -Profitable firms use less debt. -Companies like financial slack (cash).
