FIN357 Exam 3

In the aggregate, debt offerings are much more common than equity offerings and typically much larger as well. Why?

A company's internally generated cash flow provides a source of equity financing. For a profitable company, outside equity may never be needed. Debt issues are larger because large companies have the greatest access to public debt markets (small companies tend to borrow more from private lenders). Equity issuers are frequently small companies going public; such issues are often quite small. Additionally, to maintain a debt-equity ratio, a company must issue new bonds when the current bonds mature.

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.

"Technical analysis is a controversial investment practice. Technical analysis covers a wide array of techniques, which are all used in an attempt to predict the direction of a particular stock or the market. Technical analysts look at two major types of information: historical stock prices from the investor sentiment. A technical analyst would argue these two information sets provide information on the future direction of a particular stock or the market as a whole." What would a technical analyst say about market efficiency?

A technical analyst would argue that the market is not efficient. Since a technical analyst examines past prices, the market cannot be weak form efficient for technical analysis to work. If the market is not weak form efficient, it cannot be efficient under stronger assumptions about the information available.

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 MM 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? A: ???

A: No, it doesn't follow. 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, so the value of the firm does not necessarily fall.

How does the life cycle of a company help explain dividend payments? What evidence is there to suggest that the company's life cycle, at least in part, explains dividend payments?

As a company begins operations, cash is generally at a premium. The cash flows created by young companies are needed for new, potentially profitable investments. These companies are reluctant to raise outside funds because of flotation costs. As the company grows, internally generated cash flows are higher than the cash necessary to fund new investments. Keeping the excess cash can result in agency costs as company management may be tempted to spend this excess cash. Consistent with what we observe, older, more mature companies make dividend payments. These companies are trading off the agency costs of excess cash with the potential costs of raising external equity in the future.

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 it.

List the three assumptions that lie behind the Modigliani-Miller theory in a world without taxes. Are these assumptions reasonable in the real world? Explain.

Assumptions of the Modigliani-Miller theory in a world without taxes: 1) Individuals can borrow at the same interest rate at which the firm borrows. Since investors can purchase securities on margin, an individual's effective interest rate is probably no higher than that for a firm. Therefore, this assumption is reasonable when applying MM's theory to the real world. If a firm were able to borrow at a rate lower than individuals, the firm's value would increase through corporate leverage. As MM Proposition I states, this is not the case in a world with no taxes. 2) There are no taxes. In the real world, firms do pay taxes. In the presence of corporate taxes, the value of a firm is positively related to its debt level. Since interest payments are deductible, increasing debt reduces taxes and raises the value of the firm. 3) There are no costs of financial distress. In the real world, costs of financial distress can be substantial. Since stockholders eventually bear these costs, there are incentives for a firm to lower the amount of debt in its capital structure. This topic will be discussed in more detail in later chapters.

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.

The Durkin Investing Agency has been the best stock picker in the country for the past two years. Before this rise to fame occurred, the Durkin newsletter had 200 subscribers. Those subscribers beat the market consistently, earning substantially higher returns after adjustment for risk and transaction costs. Subscriptions have skyrocketed to 10,000. Now, when the Durkin Investing Agency recommends a stock, the price instantly rises several points. The subscribers currently earn only a normal return when they buy recommended stock because the price rises before anybody can act on the information. Briefly explain this phenomenon. Is Durkin's ability to pick stocks consistent with market efficiency?

Because the number of subscribers has increased dramatically, the time it takes for information in the newsletter to be reflected in prices has shortened. With shorter adjustment periods, it becomes impossible to earn abnormal returns with the information provided by Durkin. If Durkin is using only publicly-available information in its newsletter, its ability to pick stocks is inconsistent with the efficient markets hypothesis. Under the semi-strong form of market efficiency, all publicly-available information should be reflected in stock prices. The use of private information for trading purposes is illegal.

Some people argue that the efficient market hypothesis cannot explain the 1987 market crash or the high price-to-earnings ratio of Internet stocks during the late 1990s. What alternative hypothesis is currently used for these two phenomena?

Behavioral finance attempts to explain both the 1987 stock market crash and the Internet bubble by changes in investor sentiment and psychology. These changes can lead to non-random price behavior.

What factors determine the beta of a stock? Define and describe each.

Beta measures the responsiveness of a security's returns to movements in the market. Beta is determined by the cyclicality of a firm's revenues. This cyclicality is magnified by the firm's operating and financial leverage. The following three factors will impact the firm's beta. (1) Revenues. The cyclicality of a firm's sales is an important factor in determining beta. In general, stock prices will rise when the economy expands and will fall when the economy contracts. As we said above, beta measures the responsiveness of a security's returns to movements in the market. Therefore, firms whose revenues are more responsive to movements in the economy will generally have higher betas than firms with less-cyclical revenues. (2) Operating leverage. Operating leverage is the percentage change in earnings before interest and taxes (EBIT) for a percentage change in sales. A firm with high operating leverage will have greater fluctuations in EBIT for a change in sales than a firm with low operating leverage. In this way, operating leverage magnifies the cyclicality of a firm's revenues, leading to a higher beta. (3) Financial leverage. Financial leverage arises from the use of debt in the firm's capital structure. A levered firm must make fixed interest payments regardless of its revenues. The effect of financial leverage on beta is analogous to the effect of operating leverage on beta. Fixed interest payments cause the percentage change in net income to be greater than the percentage change in EBIT, magnifying the cyclicality of a firm's revenues. Thus, returns on highly-levered stocks should be more responsive to movements in the market than the returns on stocks with little or no debt in their capital structure.

Explain what is meant by business 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.

What are the direct and indirect costs of bankruptcy? Briefly explain each.

Direct costs are potential legal and administrative costs. These are the costs associated with the litigation arising from a liquidation or bankruptcy. These costs include lawyers' fees, courtroom costs, and expert witness fees. Indirect costs include the following: 1) Impaired ability to conduct business. Firms may suffer a loss of sales due to a decrease in consumer confidence and loss of reliable supplies due to a lack of confidence by suppliers. 2) Incentive to take large risks. When faced with projects of different risk levels, managers acting in the stockholders' interest have an incentive to undertake high-risk projects. Imagine a firm with only one project, which pays $100 in an expansion and $60 in a recession. If debt payments are $60, the stockholders receive $40 (= $100 - 60) in the expansion but nothing in the recession. The bondholders receive $60 for certain. Now, alternatively imagine that the project pays $110 in an expansion but $50 in a recession. Here, the stockholders receive $50 (= $110 - 60) in the expansion but nothing in the recession. The bondholders receive only $50 in the recession because there is no more money in the firm. That is, the firm declares bankruptcy, leaving the bondholders "holding the bag." Thus, an increase in risk can benefit the stockholders. The key here is that the bondholders are hurt by risk, since the stockholders have limited liability. If the firm declares bankruptcy, the stockholders are not responsible for the bondholders' shortfall. 3) Incentive to under-invest. If a company is near bankruptcy, stockholders may well be hurt if they contribute equity to a new project, even if the project has a positive NPV. The reason is that some (or all) of the cash flows will go to the bondholders. Suppose a real estate developer owns a building that is likely to go bankrupt, with the bondholders receiving the property and the developer receiving nothing. Should the developer take $1 million out of his own pocket to add a new wing to a building? Perhaps not, even if the new wing will generate cash flows with a present value greater than $1 million. Since the bondholders are likely to end up with the property anyway, why would the developer pay the additional $1 million and likely end up with nothing to show for it? 4) Milking the property. In the event of bankruptcy, bondholders have the first claim to the assets of the firm. When faced with a possible bankruptcy, the stockholders have strong incentives to vote for increased dividends or other distributions. This will ensure them of getting some of the assets of the firm before the bondholders can lay claim to them.

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.

Since it can be shown that share repurchases have exactly the same wealth effect for shareholders in the absence of taxes and are more beneficial when we account for taxes, why don't all companies repurchase shares instead of paying dividends?

Dividends can be used to "signal" their potential growth and positive NPV prospects to the stock market. Once a company begins making dividend payments, investors treat the stock poorly if dividends are decreased or omitted. A dividend payment also signals to the market that the company will not be hording cash, and thus, alleviates the agency problem of excess cash. A fixed repurchase strategy is not the same as a dividend since a company can announce a repurchase and then fail to make the repurchase. If there were a better monitoring mechanism to ensure that announced repurchased were in fact made, a fixed repurchase would become more similar to a regular dividend payment. Additionally, since managers often have information that investors do not have, it may force managers to buy back stock when it is overvalued because the market is not aware of inside information. In effect, this is a negative NPV investment.

Explain why a characteristic of an efficient market is that investments in that market have zero NPVs.

On average, the only return that is earned is the required return—investors buy assets with returns in excess of the required return (positive NPV), bidding up the price and thus causing the return to fall to the required return (zero NPV); investors sell assets with returns less than the required return (negative NPV), driving the price lower and thus causing the return to rise to the required return (zero NPV).

In a world with no taxes, no transactions costs, and no costs of financial distress, is the following statement true, false, or uncertain? If a firm issues equity to repurchase some of its debt, the price per share of the firm's stock will rise because the shares are less risky. Explain

False. A reduction in leverage will decrease both the risk of the stock and its expected return. Modigliani and Miller state that, in the absence of taxes, these two effects exactly cancel each other out and leave the price of the stock and the overall value of the firm unchanged.

In a world with no taxes, no transaction costs, and no costs of financial distress, is the following statement true, false, or uncertain? Moderate borrowing will not increase the required return on a firm's equity. Explain.

False. Modigliani-Miller Proposition II (No Taxes) states that the required return on a firm's equity is positively related to the firm's debt-equity ratio [RS = R0 + (B/S)(R0 - RB)]. Therefore, any increase in the amount of debt in a firm's capital structure will increase the required return on the firm's equity.

When the 56-year-old founder of Gulf & Western, Inc., died of a heart attack, the stock price immediately jumped from $18 a share to $20.25, a 12.5% increase. This is evidence of market inefficiency, because an efficient stock market would have anticipated his death and adjusted the price beforehand. Assume that no other information is received and the stock market as a whole does not move. Is this statement about market efficiency true or false? Explain.

False. The stock price would have adjusted before the founder's death only if investors had perfect forecasting ability. The 12.5 percent increase in the stock price after the founder's death indicates that either the market did not anticipate the death or that the market had anticipated it imperfectly. However, the market reacted immediately to the new information, implying efficiency. It is interesting that the stock price rose after the announcement of the founder's death. This price behavior indicates that the market felt he was a liability to the firm.

On Tuesday, December 12, 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.

Why are the costs of selling equity so much larger than the costs of selling debt?

From the previous question, economies of scale are part of the answer. Beyond this, debt issues are easier and less risky to sell from an investment bank's perspective. The two main reasons are that very large amounts of debt securities can be sold to a relatively small number of buyers, particularly large institutional buyers such as pension funds and insurance companies, and debt securities are much easier to price.

In 1980, a certain assistant professor of finance bought 12 initial public offerings of common stock. He held each of these for approximately one month and then sold. The investment rule he followed was to submit a purchase order for every firm commitment initial public offering of oil and gas exploration companies. There were 22 of these offerings, and he submitted a purchase order for approximately $1,000 in stock for each of the companies. With 10 of these, no shares were allocated to this assistant professor. With 5 of the 12 offerings that were purchased, fewer than the requested number of shares were allocated. The year 1980 was very good for oil and gas exploration company owners: On average, for the 22 companies that went public, the stocks were selling for 80% above the offering price a month after the initial offering date. The assistant professor looked at his performance record and found that the $8,400 invested in the 12 companies had grown to $10,000, representing a return of only about 20% (commissions were negligible). Did he have bad luck, or should he have expected to do worse than the average initial public offering investor? Explain.

He could have done worse since his access to the oversubscribed and, presumably, underpriced issues was restricted while the bulk of his funds were allocated to stocks from the undersubscribed and, quite possibly, overpriced issues.

What is homemade leverage?

Homemade leverage refers to the use of borrowing on the personal level as opposed to the corporate level.

Under what circumstances would it be appropriate for a firm to use different costs of capital for its different operating divisions? If the overall firm WACC was used as the hurdle rate for all divisions, would the riskier divisions or the more conservative divisions tend to get most of the investment projects? Why? If you were to estimate the appropriate cost of capital for different divisions, what problems might you encounter? What are two techniques you could use to develop a rough estimate for each division's cost of capital?

If the different operating divisions were in much different risk classes, then separate cost of capital figures should be used for the different divisions; the use of a single, overall cost of capital would be inappropriate. If the single hurdle rate were used, riskier divisions would tend to receive more funds for investment projects, since their return would exceed the hurdle rate despite the fact that they may actually plot below the SML and, hence, be unprofitable projects on a risk-adjusted basis. The typical problem encountered in estimating the cost of capital for a division is that it rarely has its own securities traded on the market, so it is difficult to observe the market's valuation of the risk of the division. Two typical ways around this are to use a pure play proxy for the division, or to use subjective adjustments of the overall firm hurdle rate based on the perceived risk of the division.

For initial public offerings of common stock, 2015 was a below average year, with about $21.9 billion raised by the process. Relatively few of the 117 firms involved paid cash dividends. Why do you think that most chose not to pay cash dividends?

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.

What are the implications of the efficient market hypothesis for investors who buy and sell stocks in an attempt to "beat the market"?

Ignoring trading costs, on average, such investors merely earn what the market offers; the trades all have zero NPV. If trading costs exist, then these investors lose by the amount of the costs.

Prospectors, Inc., is a publicly traded gold prospecting company in Alaska. Although the firm's searches for gold usually fail, the prospectors occasionally find a rich vein of ore. What pattern would you expect to observe for Prospectors' cumulative abnormal returns if the market is efficient?

In an efficient market, the cumulative abnormal return (CAR) for Prospectors would rise substantially at the announcement of a new discovery. The CAR falls slightly on any day when no discovery is announced. There is a small positive probability that there will be a discovery on any given day. If there is no discovery on a particular day, the price should fall slightly because the good event did not occur. The substantial price increases on the rare days of discovery should balance the small declines on the other days, leaving CARs that are horizontal over time.

Why do we use an aftertax figure for cost of debt but not for cost of equity?

Interest expense is tax-deductible. There is no difference between pretax and aftertax equity costs.

What is the quirk in the tax code that makes a levered firm more valuable than an otherwise identical un-levered firm?

Interest payments are tax deductible, where payments to shareholders (dividends) are not tax deductible.

"Technical analysis is a controversial investment practice. Technical analysis covers a wide array of techniques, which are all used in an attempt to predict the direction of a particular stock or the market. Technical analysts look at two major types of information: historical stock prices from the investor sentiment. A technical analyst would argue these two information sets provide information on the future direction of a particular stock or the market as a whole." What is the investor sentiment index intended to capture? How might it be useful in technical analysis?

Investor sentiment captures the mood of the investing public. If investors are bearish in general, it may be that the market is headed down in the future since investors are less likely to invest. If the sentiment is bullish, it would be taken as a positive signal to the market. To use investor sentiment in technical analysis, you would probably want to construct a ratio such as a bulls/bears ratio. To use the ratio, compare the historical ratio to the market to determine if a certain level on the ratio indicates a market upturn or downturn.

In January 2015, hamburger joint Shake Shack went public. Assisted by investment banks JP Morgan and Morgan Stanley, Shake Shack sold 5 million shares at $21 each, thereby raising a total of $105 million. By the end of the first day of trading, the stock had sizzled to $45.90 per share, down from a high of $52.50. Based on the end-of-day numbers, Shake Shack shares were apparently underpriced by about $24.90 each, meaning that the company missed out on an additional $124.5 million. The Shake Shack IPO was underpriced by about 119%. Should Shake Shack be upset at JP Morgan and Morgan Stanley over the underpricing?

It is clear that the stock was sold too cheaply, so Shake Shack had reason to be unhappy.

A hundred years ago or so, companies did not compile annual reports. Even if you owned stock in a particular company, you were unlikely to be allowed to see the balance sheet and income statement for the company. Assuming the market is semistrong form efficient, what does this say about market efficiency then compared to now?

It is likely the market has a better estimate of the stock price, assuming it is semistrong form efficient. However, semistrong form efficiency only states that you cannot easily profit from publicly available information. If financial statements are not available, the market can still price stocks based upon the available public information, limited though it may be. Therefore, it may have been as difficult to examine the limited public information and make an extra return.

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It would not be irrational to find low-dividend, high-growth stocks. The trust should be indifferent between receiving dividends or capital gains since it does not pay taxes on either one (ignoring possible restrictions on invasion of principal, etc.). It would be irrational, however, to hold municipal bonds. Since the trust does not pay taxes on the interest income it receives, it does not need the tax break associated with the municipal bonds. Therefore, it should prefer to hold higher yield, taxable bonds.

In January 2015, hamburger joint Shake Shack went public. Assisted by investment banks JP Morgan and Morgan Stanley, Shake Shack sold 5 million shares at $21 each, thereby raising a total of $105 million. By the end of the first day of trading, the stock had sizzled to $45.90 per share, down from a high of $52.50. Based on the end-of-day numbers, Shake Shack shares were apparently underpriced by about $24.90 each, meaning that the company missed out on an additional $124.5 million. In the previous two questions, how would it affect your thinking to know that insiders still owned 56% of the company's Class A stock and all of the company's Class B stock?

It's an important factor. Only 5 million of the shares were underpriced. The other 6.4 million were, in effect, priced completely correctly.

Why is the use of debt financing referred to as financial "leverage"?

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

The growing perpetuity model expresses the value of a share of stock as the present value of the expected dividends from that stock. How can you conclude that dividend policy is irrelevant when this model is valid?

Knowing that share price can be expressed as the present value of expected future dividends does not make dividend policy relevant. Under the growing perpetuity model, if overall corporate cash flows are unchanged, then a change in dividend policy only changes the timing of the dividends. The PV of those dividends is the same. This is true because, given that future earnings are held constant, dividend policy represents a transfer between current and future stockholders. In a more realistic context and assuming a finite holding period, the value of the shares should represent the future stock price as well as the dividends. Any cash flow not paid as a dividend will be reflected in the future stock price. As such the PV of the flows will not change with shifts in dividend policy; dividend policy is still irrelevant.

How do the existence of financial distress costs and agency costs affect Modigliani and Miller's theory in a world where corporations pay taxes?

Modigliani and Miller's theory with corporate taxes indicates that, since there is a positive tax advantage of debt, the firm should maximize the amount of debt in its capital structure. In reality, however, no firm adopts an all-debt financing strategy. MM's theory ignores both the financial distress and agency costs of debt. The marginal costs of debt continue to increase with the amount of debt in the firm's capital structure so that, at some point, the marginal costs of additional debt will outweigh its marginal tax benefits. Therefore, there is an optimal level of debt for every firm at the point where the marginal tax benefits of the debt equal the marginal increase in financial distress and agency costs.

Some corporations, like one British company that offers its large shareholders 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.

In January 2015, hamburger joint Shake Shack went public. Assisted by investment banks JP Morgan and Morgan Stanley, Shake Shack sold 5 million shares at $21 each, thereby raising a total of $105 million. By the end of the first day of trading, the stock had sizzled to $45.90 per share, down from a high of $52.50. Based on the end-of-day numbers, Shake Shack shares were apparently underpriced by about $24.90 each, meaning that the company missed out on an additional $124.5 million. In the previous question, how would it affect your thinking to know that the company was incorporated in 2004, had only $118 million in revenues in 2014, with net income of only $2.1 million?

No, but in fairness, pricing the stock in such a situation is extremely difficult.

If you can borrow all the money you need for a project at 6 percent, doesn't it follow that 6 percent is your cost of capital for the project?

No. The cost of capital depends on the risk of the project, not the source of the money.

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.

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, and the last several, questions, 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 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.

A famous economist just announced in "The Wall Street Journal" his findings that the recession is over and the economy is again entering an expansion. Assume market efficiency. Can you profit from investing in the stock market after you read this announcement?

Stock prices should immediately and fully rise to reflect the announcement. Thus, one cannot expect abnormal returns following the announcement.

Both Dow Chemical Company, a large natural gas uses, and Superior Oil, a major natural gas producer, are thinking of investing in natural gas wells near Houston. Both are all equity financed companies. Dow and Superior are looking at identical projects. They've analyzed their respective investments, which would involve a negative cash flow now and positive expected cash flows in the future. Both companies estimate that their projects would have a net present value of $1 million at an 18% discount rate and -$1.1 million NPV at a 22 % discount rate. Dow has a beta of 1.25, whereas Superior has a beta of 0.75. The expected risk premium on the market is 8%, and risk-free bonds are yielding 12%. Should either company proceed? Should both? Explain.

RSup = .12 + .75(.08) = .1800, or 18.00% Both should proceed. The appropriate discount rate does not depend on which company is investing; it depends on the risk of the project. Since Superior is in the business, it is closer to a pure play. Therefore, its cost of capital should be used. With an 18% cost of capital, the project has an NPV of $1 million regardless of who takes it.

What steps can stockholders take to reduce the costs of debt?

Stockholders can undertake the following measures in order to minimize the costs of debt: 1) Use protective covenants. Firms can enter into agreements with the bondholders that are designed to decrease the cost of debt. There are two types of protective covenants. Negative covenants prohibit the company from taking actions that would expose the bondholders to potential losses. An example would be prohibiting the payment of dividends in excess of earnings. Positive covenants specify an action that the company agrees to take or a condition the company must abide by. An example would be agreeing to maintain its working capital at a minimum level. 2) Repurchase debt. A firm can eliminate the costs of bankruptcy by eliminating debt from its capital structure. 3) Consolidate debt. If a firm decreases the number of debt holders, it may be able to decrease the direct costs of bankruptcy should the firm become insolvent.

Imagine that a particular macroeconomic variable that influences your firm's net earnings is positively serially correlated. Assume market efficiency. Would you expect price changes in your stock to be serially correlated? Why or why not?

Serial correlation occurs when the current value of a variable is related to the future value of the variable. If the market is efficient, the information about the serial correlation in the macroeconomic variable and its relationship to net earnings should already be reflected in the stock price. In other words, although there is serial correlation in the variable, there will not be serial correlation in stock returns. Therefore, knowledge of the correlation in the macroeconomic variable will not lead to abnormal returns for investors.

In the mid-to late-1990's, the performance of the pros was unusually poor - on the order of 90% of all equity mutual funds underperformed a passively managed index fund. How does this bear on the issue of market efficiency?

Taken at face value, this fact suggests that markets have become more efficient. The increasing ease with which information is available over the Internet lends strength to this conclusion. On the other hand, during this particular period, large-capitalization growth stocks were the top performers. Value-weighted indexes such as the S&P 500 are naturally concentrated in such stocks, thus making them especially hard to beat during this period. So, it may be that the dismal record compiled by the pros is just a matter of bad luck or benchmark error.

There are several celebrated investors and stock pickers frequently mentioned in the financial press who have recorded huge returns on their investments over the past two decades. Is the success of these particular investors an invalidation of the EMH? Explain.

The EMH only says, within the bounds of increasingly strong assumptions about the information processing of investors, that assets are fairly priced. An implication of this is that, on average, the typical market participant cannot earn excessive profits from a particular trading strategy. However, that does not mean that a few particular investors cannot outperform the market over a particular investment horizon. Certain investors who do well for a period of time get a lot of attention from the financial press, but the scores of investors who do not do well over the same period of time generally get considerably less attention from the financial press.

Today, the following announcement was made: "Early today the Justice Department reached a decision in the Universal Product Care (UPC) case. UPC has been found guilty of discriminatory practices in hiring. For the next five years, UPC must pay $2 million each year to a fund representing victims of UPC's policies." Assuming the market is efficient, should investors not buy UPC stock after the announcement because the litigation will cause an abnormally low rate of return? Explain.

The announcement should not deter investors from buying UPC's stock. If the market is semi-strong form efficient, the stock price will have already reflected the present value of the payments that UPC must make. The expected return after the announcement should still be equal to the expected return before the announcement. UPC's current stockholders bear the burden of the loss, since the stock price falls on the announcement. After the announcement, the expected return moves back to its original level.

How do you determine the appropriate cost of debt for a company? Does it make a difference if the company's debt is privately placed as opposed to being publicly traded? How would you estimate the cost of debt for a firm whose only debt issues are privately held by institutional investors?

The appropriate aftertax cost of debt to the company is the interest rate it would have to pay if it were to issue new debt today. Hence, if the YTM on outstanding bonds of the company is observed, the company has an accurate estimate of its cost of debt. If the debt is privately-placed, the firm could still estimate its cost of debt by (1) looking at the cost of debt for similar firms in similar risk classes, (2) looking at the average debt cost for firms with the same credit rating (assuming the firm's private debt is rated), or (3) consulting analysts and investment bankers. Even if the debt is publicly traded, an additional complication arises when the firm has more than one issue outstanding; these issues rarely have the same yield because no two issues are ever completely homogeneous.

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, which will maximize shareholder wealth.

The bird-in-the-hand argument, which states that a dividend today is safer than the uncertain prospect of a capital gain tomorrow, is often used to justify high dividend payout ratios. Explain the fallacy behind this argument.

The bird-in-the-hand argument is based upon the erroneous assumption that increased dividends make a firm less risky. If capital spending and investment spending are unchanged, the firm's overall cash flows are not affected by the dividend policy.

If the market places the same value on $1 of dividends as on $1 of capital gains, then firms with different payout ratios will appeal to different clienteles of investors. One clientele is as good as another; therefore, a firm cannot increase its value by changing its dividend policy. Yet empirical investigations reveal a strong correlations between dividend payout ratios and other firm characteristics. For example, small, rapidly growing firms that have recently gone public almost always have payout ratios that are zero; all earnings are reinvested in the business. Explain this phenomenon if dividend policy is irrelevant.

The capital investment needs of small, growing companies are very high. Therefore, payment of dividends could curtail their investment opportunities. Their other option is to issue stock to pay the dividend, thereby incurring issuance costs. In either case, the companies and thus their investors are better off with a zero dividend policy during the firms' rapid growth phases. This fact makes these firms attractive only to low dividend clienteles. This example demonstrates that dividend policy is relevant when there are issuance costs. Indeed, it may be relevant whenever the assumptions behind the MM model are not met.

If increases in dividends tends 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.

It is sometimes suggested that firms should follow a "residual" dividend policy. With such a policy, the main idea is that a firm should focus on meeting its investment needs and maintaining its desired debt-equity ratio. Having done so, any leftover, or residual, income is paid out as dividends. What do you think would be the chief drawback to a residual dividend policy?

The chief drawback to a strict dividend policy is the variability in dividend payments. This is a problem because investors tend to want a somewhat predictable cash flow. Also, if there is information content to dividend announcements, then the firm may be inadvertently telling the market that it is expecting a downturn in earnings prospects when it cuts a dividend, when in reality its prospects are very good. In a compromise policy, the firm maintains a relatively constant dividend. It increases dividends only when it expects earnings to remain at a sufficiently high level to pay the larger dividends, and it lowers the dividend only if it absolutely has to.

Consider a levered firm's projects that have similar risks to the firm as a whole. Is the discount rate for the projects higher or lower than the rate computed using the security market line? Why?

The discount rate for the projects should be lower than the rate implied by the security market line. The security market line is used to calculate the cost of equity. The appropriate discount rate for projects is the firm's weighted average cost of capital. Since the firm's cost of debt is generally less that the firm's cost of equity, the rate implied by the security market line will be too high.

McCanless International is planning to raise fresh equity capital by selling a large new issue of common stock. McCanless is currently a publicly traded corporation, and it is trying to choose between an underwritten cash offer and a rights offering (not underwritten) to current shareholders. McCanless's management is interested in minimizing the selling costs and has asked you for advice on the choice of issue methods. What is your recommendation and why?

The evidence suggests that a nonunderwritten rights offering might be substantially cheaper than a cash offer. However, such offerings are rare, and there may be hidden costs or other factors not yet identified or well understood by researchers.

Due to large losses incurred in the past several years, a firm has $2 billion in tax loss carryforwards. This means that the next $2 billion of the firm's income will be free from corporate income taxes. Security analysts estimate that it will take many years for the firm to generate $2 billion in earnings. The firm has a moderate amount of debt in its capital structure. The firm's CEO is deciding whether to issue debt or equity in order to raise the funds needed to finance an upcoming project. Which method of financing would you recommend? Why?

The firm should issue equity in order to finance the project. The tax-loss carry-forwards make the firm's effective tax rate zero. Therefore, the company will not benefit from the tax shield that debt provides. Moreover, since the firm already has a moderate amount of debt in its capital structure, additional debt will likely increase the probability that the firm will face financial distress or bankruptcy. As long as there are bankruptcy costs, the firm should issue equity in order to finance the project.

A stock market analyst is able to identify mispriced stocks by comparing the average price for the last 10 days to the average price for the last 60 days. If this is true, what do you know about the market?

The market is not weak form efficient.

Newtech Corp. is going to adopt a new chip-testing device that can greatly improve its production efficiency. Do you think the lead engineer can profit from purchasing the firm's stock before the news release on the device? After reading the announcement in the "The Wall Street Journal," should you be able to earn an abnormal return from purchasing the stock if the market is efficient?

The market is often considered to be relatively efficient up to the semi-strong form. If so, no systematic profit can be made by trading on publicly-available information. Although illegal, the lead engineer of the device can profit from purchasing the firm's stock before the news release on the implementation of the new technology. The price should immediately and fully adjust to the new information in the article. Thus, no abnormal return can be expected from purchasing after the publication of the article.

Refer to the observed capital structures given in Table 15.3 of the test. 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.

The more capital intensive industries, such as airlines, building construction, hotels, and 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.

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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% flotation cost (the discount), which may be a smaller discount than the market flotation costs of a new issue for some companies.

Assume that markets are efficient. During a trading day, American Golf Inc. announces that it has lost a contract for a large golfing project, which, prior to the news, it was widely believed to have secured. If the market is efficient, how should the stock price react to this information if no additional information is released?

The share price will decrease immediately to reflect the new information. At the time of the announcement, the price of the stock should immediately decrease to reflect the negative information.

The efficient market hypothesis implies that all mutual funds should obtain the same expected risk-adjusted returns. Therefore, we can simply pick mutual funds at random. Is this statement true or false? Explain.

The statement is false because every investor has a different risk preference. Although the expected return from every well-diversified portfolio is the same after adjusting for risk, investors still need to choose funds that are consistent with their particular risk level.

Do you agree or disagree with the following statement: A firm's stockholders will never want the firm to invest in projects with negative NPVs. Why?

The statement is incorrect. If a firm has debt, it might be advantageous to stockholders for the firm to undertake risky projects, even those with negative net present values. This incentive results from the fact that most of the risk of failure is borne by bondholders. Therefore, value is transferred from the bondholders to the shareholders by undertaking risky projects, even if the projects have negative NPVs. This incentive is even stronger when the probability and costs of bankruptcy are high.

How do you think this tax law change affects 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.

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.

Define the three forms of market efficiency.

The three forms of the efficient markets hypothesis are: 1) Weak form. Market prices reflect information contained in historical prices. Investors are unable to earn abnormal returns using historical prices to predict future price movements. 2) Semi-strong form. In addition to historical data, market prices reflect all publicly-available information. Investors with insider, or private information, are able to earn abnormal returns. 3) Strong form. Market prices reflect all information, public or private. Investors are unable to earn abnormal returns using insider information or historical prices to predict future price movements.

What are the sources of the agency costs of equity?

There are two major sources of the agency costs of equity: 1) Shirking. Managers with small equity holdings have a tendency to reduce their work effort, thereby hurting both the debt holders and outside equity holders. 2) Perquisites. Since management receives all the benefits of increased perquisites but only shoulder a fraction of the cost, managers have an incentive to overspend on luxury items at the expense of debt holders and outside equity holders.

Why do noninvestment-grade bonds have much higher direct costs than investment-grade issues?

They are riskier and harder to market from an investment bank's perspective.

The desire for current income is not a valid explanation for preference for high current dividend policy, as investors can always create homemade dividends by selling a portion of their stocks. Is this statement true or false? Why?

This argument is theoretically correct. In the real world, with transaction costs of security trading, home-made dividends can be more expensive than dividends directly paid out by the firms. However, the existence of financial intermediaries, such as mutual funds, reduces the transaction costs for individuals greatly. Thus, as a whole, the desire for current income shouldn't be a major factor favoring high-current-dividend policy.

What rule should a firm follow when making financing decisions? How can firms create valuable financing opportunities?

To create value, firms should accept financing proposals with positive net present values. Firms can create valuable financing opportunities in three ways: 1) Fool investors. A firm can issue a complex security to receive more than the fair market value. Financial managers attempt to package securities to receive the greatest value. 2) Reduce costs or increase subsidies. A firm can package securities to reduce taxes. Such a security will increase the value of the firm. In addition, financing techniques involve many costs, such as accountants, lawyers, and investment bankers. Packaging securities in a way to reduce these costs will also increase the value of the firm. 3) Create a new security. A previously unsatisfied investor may pay extra for a specialized security catering to his or her needs. Corporations gain from developing unique securities by issuing these securities at premium prices.

Your aunt is in a high tax bracket and would like to minimize the tax burden of her investment portfolio. She is willing to buy and sell in order to maximize her aftertax returns, and she has asked for your advice. What would you suggest she do?

To minimize her tax burden, your aunt should divest herself of high dividend yield stocks and invest in low dividend yield stock. Or, if possible, she should keep her high dividend stocks, borrow an equivalent amount of money and invest that money in a tax-deferred account.

What are the advantages of using the SML approach to finding the cost of equity capital? What are the disadvantages? What are the specific pieces of information needed to use this method? Are all of these variables observable, or do they need to be estimated? What are some of the ways in which you could get these estimates?

Two primary advantages of the SML approach are that the model explicitly incorporates the relevant risk of the stock and the method is more widely applicable than is the DCF model, since the SML doesn't make any assumptions about the firm's dividends. The primary disadvantages of the SML method are (1) three parameters (the risk-free rate, the expected return on the market, and beta) must be estimated, and (2) the method essentially uses historical information to estimate these parameters. The risk-free rate is usually estimated to be the yield on very short maturity T-bills and is, hence, observable; the market risk premium is usually estimated from historical risk premiums and, hence, is not observable. The stock beta, which is unobservable, is usually estimated either by determining some average historical beta from the firm and the market's return data, or by using beta estimates provided by analysts and investment firms.

TransTrust Corp. has changed how it accounts for inventory. Taxes are unaffected, although the resulting earnings report released this quarter is 20% higher than what it would have been under the old accounting system. There is no other surprise in the earnings report, and the change in the accounting treatment was publicly announced. If the market is efficient, will the stock price be higher when the market learns that the reported earnings are higher?

Under the semi-strong form of market efficiency, the stock price should stay the same. The accounting system changes are publicly available information. Investors would identify no changes in either the firm's current or its future cash flows. Thus, the stock price will not change after the announcement of increased earnings.

Critically evaluate the following statement:j Playing the stock market is like gambling. Such speculative investing has no social value, other than the pleasure people get from this form of gambling.

Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators provide liquidity to markets and thus help to promote efficiency.

How do you think this tax law change affects 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, which implies stock repurchases are favored. If the dividend tax rate declines, the attractiveness of dividends increases.

If a market is semistrong form efficient, is it also weak form efficient? Explain.

Yes, historical information is also public information; weak form efficiency is a subset of semi-strong form efficiency.

Why is underpricing not a great concern with bond offerings?

Yields on comparable bonds can usually be readily observed, so pricing a bond issue accurately is much less difficult.

If you use the stock beta and the security market line to compute the discount rate for a project, what assumptions are you implicitly making?

You are assuming that the new project's risk is the same as the risk of the firm as a whole, and that the firm is financed entirely with equity.

Your broker commented that well-managed firms are better investments than poorly managed firms. As evidence, your broker cited a recent study examining 100 small manufacturing firms that eight years earlier had been listed in an industry magazine as the best-managed small manufacturers in the country. In the ensuing eight years, the 100 firms listed have not earned more than the normal market return. Your broker continued to say that if the firms were well managed, they should have produced better-than-average returns. If the market is efficient, do you agree with your broker?

You should not agree with your broker. The performance ratings of the small manufacturing firms were published and became public information. Prices should adjust immediately to the information, thus preventing future abnormal returns.

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a. Cap's past behavior suggests a preference for capital gains, while Widow Jones exhibits a preference for current income. b. Cap could show the Widow how to construct homemade dividends through the sale of stock. Of course, Cap will also have to convince her that she lives in an MM world. Remember that homemade dividends can only be constructed under the MM assumptions. c. Widow Jones may still not invest in Neotech because of the transaction costs involved in constructing homemade dividends. Also, the Widow may desire the uncertainty resolution which comes with high dividend stocks.

Which of the following statements are true about the efficient market hypothesis? a) It implies perfect forecasting ability b) It implies that prices reflect all available information c) It implies an irrational market d) It implies that prices do not fluctuate e) It results from keen competition among investors

a. False. Market efficiency implies that prices reflect all available information, but it does not imply certain knowledge. Many pieces of information that are available and reflected in prices are fairly uncertain. Efficiency of markets does not eliminate that uncertainty and therefore does not imply perfect forecasting ability. b. True. Market efficiency exists when prices reflect all available information. To be efficient in the weak form, the market must incorporate all historical data into prices. Under the semi-strong form of the hypothesis, the market incorporates all publicly-available information in addition to the historical data. In strong form efficient markets, prices reflect all publicly and privately available information. c. False. Market efficiency implies that market participants are rational. Rational people will immediately act upon new information and will bid prices up or down to reflect that information. d. False. In efficient markets, prices reflect all available information. Thus, prices will fluctuate whenever new information becomes available. e. True. Competition among investors results in the rapid transmission of new market information. In efficient markets, prices immediately reflect new information as investors bid the stock price up or down.

For each of the following scenarios, discuss whether profit opportunities exist from trading in the stock of the firm under the conditions that (1) the market is not weak form efficient, (2) the market is weak form but not semistrong form efficient, (3) the market is semistrong form but not strong form efficient, and (4) the market is strong form efficient. (a) The stock price has risen steadily each day for the past 30 days. (b) The financial statements for a company were released three days ago, and you believe you've uncovered some anomalies in the company's inventory and cost control reporting techniques that are causing the firm's true liquidity strength to be understated. (c) You observe that the senior management of a company has been buying a lot of the company's stock on the open market over the past week.

a. If the market is not weak form efficient, then this information could be acted on and a profit earned from following the price trend. Under (2), (3), and (4), this information is fully impounded in the current price and no abnormal profit opportunity exists. b. Under (2), if the market is not semi-strong form efficient, then this information could be used to buy the stock "cheap" before the rest of the market discovers the financial statement anomaly. Since (2) is stronger than (1), both imply that a profit opportunity exists; under (3) and (4), this information is fully impounded in the current price and no profit opportunity exists. c. Under (3), if the market is not strong form efficient, then this information could be used as a profitable trading strategy, by noting the buying activity of the insiders as a signal that the stock is underpriced or that good news is imminent. Since (1) and (2) are weaker than (3), all three imply that a profit opportunity exists. Note that this assumes the individual who sees the insider trading is the only one who sees the trading. If the information about the trades made by company management is public information, it will be discounted in the stock price and no profit opportunity exists. Under (4), this information does not signal any profit opportunity for traders; any pertinent information the manager-insiders may have is fully reflected in the current share price.

Suppose the market is semistrong form efficient. Can you expect to earn excess returns if you make trades based on.... (a) Your broker's information about record earnings for a stock? (b) Rumors about a merger of a firm? (c) Yesterday's announcement of a successful new product test?

a. No. Earnings information is in the public domain and reflected in the current stock price. b. Possibly. If the rumors were publicly disseminated, the prices would have already adjusted for the possibility of a merger. If the rumor is information that you received from an insider, you could earn excess returns, although trading on that information is illegal. c. No. The information is already public, and thus, already reflected in the stock price.

The following material represents the cover page and summary of the prospectus for the initial public offering of the Pest Investigation Control Corporation (PICC), which is going public tomorrow with a firm commitment initial public offering managed by the investment banking firm of Erlanger and Ritter. Answer the two following questions: a. Assume that you know nothing about PICC other than the information contained in the prospectus. Based on your knowledge of finance, what is your prediction for the price of PICC tomorrow? b. Assume that you have several thousand dollars to invest. When you get home from class tonight, you find that your stockbroker, whom you have not talked to for weeks, has called. She has left a message that PICC is going public tomorrow and that she can get you several hundred shares at the offering price if you call her first thing in the morning. Discuss the merits of this opportunity.

a. The price will probably go up because IPOs are generally underpriced. This is especially true for smaller issues such as this one. b. It is probably safe to assume that they are having trouble moving the issue, and it is likely that the issue is not substantially underpriced.

Suppose Tom O'Bedlam, president of Bedlam Products, Inc., has hired you to determine the firm's cost of debt and cost of equity capital. (a) The stock currently sells for $50 per share, and the dividend per share will probably be about $5. Tom argues, "it will cost us $5 per share to use the stockholders' money this year, so the cost of equity is equal to 10 percent (=$5/50)." What's wrong with this conclusion? (b) Based on the most recent financial statements, Bedlam Products' total liabilities are $8 million. Total interest expense for the comping year will be about $1 million. Tom therefore reasons, "we owe $8 million, and we will pay $1 million interest. Therefore, our cost of debt is obviously $1 million/8 million = 12.5%." What's wrong with this conclusion? (c) Based on his own analysis, Tom is recommending that the company increase its use of equity financing because, "debt costs 12.5%, but equity only costs 10%, thus equity is cheaper." Ignoring all the other issues, what do you think about the conclusion that the cost of equity is less than the cost of debt?

a. This only considers the dividend yield component of the required return on equity. b. This is the current yield only, not the promised yield to maturity. In addition, it is based on the book value of the liability, and it ignores taxes. c. Equity is inherently riskier than debt (except, perhaps, in the unusual case where a firm's assets have a negative beta). For this reason, the cost of equity exceeds the cost of debt. If taxes are considered in this case, it can be seen that at reasonable tax rates, the cost of equity does exceed the cost of debt.