FNAN 522 Smartbook

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including preferred stock in the WACC adds the term:

(P/V) x RP

in the absence of taxes, the value of a firm is the same with debt financing as it is with equity financing because _________

- MM demonstrated that debt financing is neither better nor worse than equity financing in the absence of taxes - the asset to be financed is the same

What are consequences of nonpayment of debt obligations?

- a firm may be forced to file for bankruptcy - the firm will encounter some form of financial distress

which tactics, designed to deter a hostile takeover, are instituted prior to any takeover attempt?

- a poison pill - a golden parachute

what are the components used in the construction of the WACC?

- cost of common stock - cost of preferred stock - cost of debt

a firm's overall cost of capital will include what?

- cost of debt - equity capital

preferred stock pays ______ and _____

- dividends in perpetuity - a constant dividend

what can be said about the dividends paid to common and preferred stockholders?

- dividends to preferred stockholders are fixed - dividends to common stockholders are not fixed

a firm's cost of debt can be...

- estimated earlier than its cost of equity - obtained by checking yields on publicly traded bonds - obtained by talking to investment bankers

voluntary arrangements to restructure a company's debt to avoid bankruptcy may be beneficial to all involved parties. this may involve _________ & ________

- extension (postpones the date of payment) - composition (involves a reduced payment)

what are some opportunities for marketing gains in a merger?

- improved distribution networks - improved product mix

which of the following hold true when acquiring stock in a tender offer? - in an acquisition neither a shareholder meeting nor a vote is required - the bidding firm can deal directly with the shareholders of the target firm - targeted managers often resist acquisition and increase the cost of acquisition - complete absorption is necessary when acquiring stock

- in an acquisition... - the bidding firm... - targeted managers.. complete absorption is NOT necessary when acquiring stock

increased revenues form a merger can come from what?

- marketing gains - strategic benefits - market power

bankruptcy is very valuable due to what?

- payments to creditors cease pending the outcome of the bankruptcy process - it can be used strategically to improve a firm's competitive position

to estimate the expected return on a risky asset, we need to know the ________

- risk-free rate - stock's beta - market risk premium

frequent managerial resistance to a takeover attempt may include which tactics?

- solicitation of competing bids - press releases - mailings to shareholders

what are nonmarketed claims to the firms cash flows?

- taxes - legal fees interest payments and dividend payments are claims of shareholders, so they can be marketed

the general requirements for tax-free status include what?

- the acquisition must be for a business purpose - there must be a continuation of equity interest by the target's shareholders in the acquiring firm - the purpose of the acquisition must not be to avoid taxes

what is synergy?

- the difference between the value of a merged firm and the sum of the values of the firms as separate entities - the increase in value due to mergers

what are the two components of the static theory?

- the tax benefits of debt - the costs of financial distress

a firm has a target debt-equity ratio of 0.5, but it plans to finance a new project with all debt. what debt-equity ratio should be used when calculating the project's flotation costs?

.5 when calculating flotation costs, the target debt-equity ratio should be used

Rank each of the following in order of priority of payment starting with highest priority item to lowest priority item: - consumer claims - bankruptcy administrative expenses - payment to common shareholders - wages, salaries, and commissions

1. bankruptcy administrative expenses 2. wages, salaries, and commissions 3. consumer claims 4. payment to common shareholders

what are the two broad types of costs of financial distress?

1. direct costs 2. indirect costs

MM Proposition II tells us that the cost of equity depends on what three things?

1. the required rate of return on the firm's assets 2. the firm's cost of debt 3. the firm's debt-equity ratio

in 2019, the net interest deduction is limited to what percent of EBITDA?

30%

Sigma Corporation consists of two divisions: A and B. Division A is riskier than Division B. If Sigma Corporation uses the firm's overall WACC to evaluate both Division's projects, which Division will probably not receive enough resources to fund all of its potentially profitable projects?

Division B. Division A is riskier, so its cash flows should be discounted at a higher right. Because they're not, the projects in Division A will look better than those in Division B. Division B's cash flows will be discounted using a higher rate than should be used, so they will appear less appealing and will be more often rejected.

from the stockholder's viewpoint, a ______ is a takeover because the shareholders are bought out

LBO (leveraged buyout)

why is MM's assertion about the positive relationship between firm value and leverage not observed in the real world?

MM does not consider bankruptcy costs

what is the required return on a stock (RE), according to the constant dividend growth model, if the growth rate (g) is zero?

RE = D1/P0

The formula for calculating the cost of equity capital that is based on the dividend discount model is:

RE = D1/P0+g

an investor who invests in the stock of a leveraged firm rather than an all-equity firm will require _______

a higher expected return

what does horizontal acquisition involve?

a merger between firms in the same industry

when a firm avoids a hostile acquisition by turning a friendly bidder, that friendly bidder is referred to as what?

a white knight

the best way to include flotation costs is to ___________

add them to the initial investment

a standstill agreement is an ____________

agreement made by the acquiring firm to limit its holdings in the target firm

the discount rate for the firm's projects equals the cost of capital for the firm as a whole when ________________

all projects have the same risk as the current firm

stockholders and bondholders are/are not the only claimants to the cash flows of the firm

are not

the costs of financial distress depend mostly on how easily the ownership of the firm's ________ can be transferred

assets in bankruptcy, they will be transferred

Some risk adjustment to a firm's WACC for projects of differing risk, even if it is subjective, is probably ___________

better than no risk adjustment

during bankruptcy, the ownership of the firm's assets is transferred from stockholders to _________

bondholders

flotation costs are costs incurred to _______

bring new security issues to the market

the equity risk that comes from the nature of a firm's operating activities is known as _____________

business risk

the main difference between marketed and nonmarketed claims is that marketed claims can/cannot be bought and sold in financial markets and nonmarketed claims can/cannot

can cannot ** marketed claims can be bought and sold in financial markets ** nonmarketed claims cannot be bought and sold in financial markets

if an acquisition is taxable, the target firm's shareholders may demand a higher price as compensation for the ______________ effect

capital gains

_____________ can be interpreted just like portfolio weights

capital structure weights

WACC is used to discount what?

cash flows

a ski equipment store merging with a tennis equipment store is an example of improving operating through what?

complementary resources

the articles of incorporation and corporate bylaws governing a firm make up the what?

corporate charter

the cost of ___________ can be observed because it is the interest rate the firm must pay on new loans

debt

the cost of ____________ can be observed because it is the interest rate the firm must pay on new loans

debt

the cost of debt will begin to increase as the __________

degree of leverage increases

when an individual adds securities to their portfolio that are less than perfectly positively correlated, they benefit from what?

diversification

According to M&M Proposition I, a firm's capital structure choices ________

do not affect the value of the firm

an acquisition of assets (does/does not) require a vote of the shareholders of the selling firm

does

according to critics of Modigliani and Miller (M&M), their capital structure theory ___________

does not work when real-world issues are factored in

if an acquisition does not create value, then the _________

earnings per share may increase by the stock price of the acquiring firm may remain the same or decline

the return an investor in a security receives is __________ the cost of the security to the company that issued it

equal to

when a firm turns a division into a separate entity and then sells shares in the division to the public, it is referred to as an ____________

equity carve-out

in a tax-free acquisition, the shareholders of the acquired firm are considered to have done what?

exchanged their old shares for new ones at equal value, so no capital gain or loss occurs at the time of the transaction

acquisition by __________ is generally tax-free

exchanging stock

t/f MM's assertion of a positive relationship between firm value and leverage is widely observed in the business world

false MM's conclusions were based on very restrictive assumptions and do not generally hold true in the real world

t/f in determining the optimal capital structure, managers should keep in mind that lower effective tax rates lead to greater incentives to borrowing

false higher effective tax rates lead to greater incentive to borrowing

t/f in general, if the buying firm offers the selling firm cash for its equity, then it will be classified as a tax-free acquisition

false it will be a taxable acquisition

t/f projects should always be discounted at the firm's overall cost of capital

false projects' discount rates should reflect their particular level of risk

the equity risk that comes from the financial policy or capital structure decisions of the firm is known as __________ risk

financial

_________ describes the capital structure when debt is used to finance assets

financial leverage

equipment and buildings are examples of what kind of capital?

fixed

the issuance of bonds and stocks are referred to as ________ costs

flotation

an important advantage to a firm raising equity internally is not having to pay _________

flotation costs

the strategy of creating a generous severance package for a firm's top management in defense of a takeover is referred to as a _________

golden parachute

what is the name for the excess of the purchase price over the sum of the fair market values of the assets acquired?

goodwill

the cost of a stock-for-stock acquisition is __________ a cash-for-stick acquisition

greater than

financial slack helps firms to avoid _________

having to rely on external financing

in the presence of corporate taxes, the tax shield effect will ______ the value of the firm

increase

in reality, most firms cover the equity portion of their capital spending with _______

internally generated cash flow

the manager of a firm should change the capital structure if and only if _________

it increases the value of the firm

the risk of too much _______ is bankruptcy

leverage

a going-private transaction where the outstanding shares of stock are purchased largely with borrowed money is referred to as a __________

leveraged buyout

M&M Proposition I does not work with corporate taxes because ________

levered firms pay lower taxes than unlevered firms

the value of a levered firm will be greater than the value of an identical unlevered firm because the levered firm's taxes will be _________

lower

under the pecking order theory, profitable firms will tend to have _________ levels of debt

lower under the pecking order theory, profitable firms will use internal equity and thus not need debt

based on static theory, what should the managers attempt to maximize and minimize while developing capital structure policy?

maximize the tax shield benefit of debt and minimize financial distress costs

a company should select the capital structure that _______

maximizes the company's value

the benefits of debt financing __________ the costs of financial distress

may be more than offset by

the absorption of one firm by another, where the acquiring firm retains its identity and the acquired firm ceases to exist as a separate firm is called:

merger

what are the ways that a firm can be acquired?

merger consolidation acquisition of stock acquisition of assets

historically, how have mergers affected the stockholders?

mergers have benefitted the target's stockholders

the value of the firm is maximized when the weighted average cost of capital (WACC) is ________

minimized

the avoidance of hold out ____________ shareholders is an advantage of acquiring another firm by purchasing its assets

minority

shareholders in bidder firms on average __________ from a takeover

neither win nor lose

the absolute priority rule establishes priority ________

of claims in liquidation

acquisition by __________ usually results in a taxable transaction

paying cash

the value of a levered firm in MM Proposition I with corporate taxes equals the value of an all-equity firm __________

plus the tax rate times the value of debt

the expected return on equity is ___________ to leverage

positively related

when a group of shareholders attempts to gain control of a firm by soliciting votes from other stockholders are engaged in a _________

proxy contest

the _________________ approach is the use of a WACC that is unique to a particular project, based on companies in similar lines of business

pure play

other companies that specialize only in projects similar to the project your firm is considering are called ___________

pure plays

if an all-equity firm discounts a project's cash flows with the firm's overall weighted average cost of capital even though project's beta is less than the firm's overall beta, it is possible that the project might be

rejected, when it should be accepted if the project's beta is less than the firm's overall beta, its cost of capital will be less than the overall cost of capital, and if the overall cost of capital is used, the project's cash flows will be discounted too severely, leading to the possible rejection of a value creating project

according to the pecking order theory, what is the preferred source for firms seeking to raise capital?

retained earnings tends to use internal equity, rather than external

volatility or ______ increases for equity holders when leverage increases

risk

the most basic type of divestiture is the _______ of a division

sale

costs are generally higher in a stock acquisition because the acquiring firm's shareholders must __________

share the acquisition gains with the target firm's shareholders

the market value cost of debt is often __________ to/than the book value cost of debt

similar to

the _______ theory is the dominant theory of capital structure

static

with the use of the _________ approach to estimating WACC, the firm's WACC may change through time as economic conditions change

subjective

a change in the corporate charter increasing the required percentage of shareholder votes necessary to approve a merger is referred to as a ________

super majority amendment

what risk will not be eliminated by mergers?

systematic risk

one of the important reasons why firms choose to raise capital by issuing debt is because of the _________ benefits of debt

tax

how does the level of debt affect the weighted average cost of capital (WACC)?

the WACC initially falls and then rises as debt gets very highwho is li

it is often in everyone's best interest to devise a "workout" strategy that avoids bankruptcy because of what?

the bankruptcy process can be long and expenseive

MM Proposition II shows that _________

the cost of equity rises with leverage

who is likely to have the most information about a firm's future prospects?

the firm's manager

CH 16 starts a firm's capital structure refers to ________

the firm's mix of debt and equity

a beneficial rule to follow is to set the firm's capital structure so that ________

the firm's value is maximized

which capital structure theory suggests that profitable firms will use less debt?

the pecking order theory

when the assets, liabilities, and any non-controlling interest of an acquired firm are required to be reporting at their fair market value, which method is being used?

the purchase accounting method

which variables is not required to calculate the expected return on a risky asset?

the rate of inflation

what does a proxy give to a shareholder?

the right to vote on behalf of another shareholder

the NPV of a merger =

the total value of the acquired firm - the cost of the acquisition to the bidder

finding a firm's overall cost of equity is difficult because __________________

there is no way of directly observing the return that the firm's equity investors require on their investment

if a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will accept ______ projects.

too many high risk

t/f economic value added (EVA) is a means of evaluating corporate performance

true

t/f in the extended pie model, bankruptcy costs are a claim on cash flows of the firm

true

t/f nonpayment of periodic interest on debt can lead to bankruptcy

true

t/f one firm should acquire another firm only if doing so generates a positive NPV for the acquiring firm's shareholders

true

t/f the return an investor in a security receives is equal to the cost of security to the company that issued it

true

t/f the return an investor in a security receives is equal to the cost of the security to the company that issued it

true

the cost of capital depends primarily on the ________ of funds

use

the value of the firm is given by the following expression:

value of equity + value of debt

what does WACC stand for?

weighted average cost of capital

a reduction in the total level of inventory after a merger is an example of a reduction of __________ capital

working

inventory is an example of what kind of capital?

working


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