Fin 431 Quiz 2 Review
Limitations of Pecking Order Theory:
It implies that firms have no target capital structure and that the debt ratios observed in the real world ought to fluctuate randomly. Under pecking order theory, firms only issue equity as the last resort. But in practice, more than 10% of the firms have no debt at all. More than 20% of the firms have leverage ratios less than 20%.
Implications of the Trade-off Model
Profitable firms should borrow more than unprofitable firms because they are more likely to benefit from interest tax shields. Firms that own tangible, marketable assets should borrow more than firms whose assets are intangible or highly specialized. Safer firms should borrow more than riskier firms. Companies should have a target debt ratio.
How do you estimate the cost of debt for a firm if its debt is not publicly traded?
Take a "spread" over a risk-free benchmark based on the firm's risk/credit profile, for instance, you may use the firm's current (or implied) credit ratings. Obtain a quote from the debt capital market (DCM) professionals. If the firm recently borrowed money from a corporate bank, you can find out what the interest rate was. Look to see if a comparable firm has publicly traded debt or has had a recent debt issuance. Sometimes people also estimate the cost of debt on the basis of the atissuance coupons. However, you have to be cautious as this method is backward-looking and may not reflect the firm's cost of raising debt capital under prevailing market conditions.
(M&M) The Perfect Capital Market (PCM) Assumptions
The firm's investment decisions are pre-determined. There are no corporate or personal taxes. There are no costs of financial distress. Shareholders, creditors, and managers all have equal access to the same information. (No information asymmetry) There are no transaction or issuance costs. Competitive Markets: Individual and firms are price-takers. All agents are rational. Individual and Firms can undertake financial transactions at the same prices (e.g., borrow at the same rate).
the relevant risk is the
"systematic" risk (beta risk) for well diversified shareholders. So: Step 1: Identify project and riskiness of projected cash flows Step 2: estimate the r that best reflects that risk (that may or may not be the firm's overall risk and therefore may or may not be the firm's overall cost of capital)
If a firm has $100 in inventories, a current ratio equal to 1.2, and a quick ratio equal to 1.1, what is the firm's Net Working Capital?
$200
Regular Cash Dividends (Public firms typically pay quarterly)
- Constant payout amount - Constant payout ratio
Non-Cash Dividends (i.e., No cash leaves the firm)
- Stock Dividends - Stock Split - Dividend in Kind (e.g., Wrigley's Gum sends a box of chewing gum)
Ole Miss Inc. has a net profit margin of 12%, a total asset turnover of 1.2 times, and a financial leverage multiplier of 1.2 times. Ole Miss' ROE is:
12% x 1.2 x 1.2 = 17.3%
A firm with a P/E ratio of 10 wants to take over a firm half its size with a P/E ratio of 25. What will be the P/E ratio of the merged firm?
12.5 Suppose the acquirer has a value of $100, then it needs to have earnings of $10. The target has a value of $50, so it needs to have earnings of $2. This means that the combined firm will have earnings of $12 and value of $150. Its P/E ratio will thus be 150/12 = 12.5
An analyst collects the following information about Oxford Corporation: The firm expects to pay a dividend, D1, of $4 at the end of the coming year, 2019. The market price, P0, of its common stock is $50 per share. The growth rate of dividends is expected to be = 5% What is Oxford Corporation's cost of equity?
= $50 = $4/(Re - .05) Re = 13%
An analyst collects the following information about Ole Miss Corporation: Risk-free rate = 7% The Firm's β = 1.5 Market Return = 11% What is Ole Miss Corporation's cost of equity?
= 7.0% + [1.5 × (11.0% - 7.0%)] = 7.0% + 6.0% = 13.0%
Re =
= Rf + [B x (Rm - Rf)] or = D1/(Re - g) or P0 = D1 / (Re - g)
XYZ Inc. has 2M shares outstanding at $15 per share. The company declares a 50% stock dividend. • How many shares will be outstanding after the dividend is paid? • And what will be the new price per share?
A 50% stock dividend will increase the number of shares by 50%: 2 million×1.5 = 3 million shares The value of the firm was 2m× $15 per share = $30m. After the dividend, the value will remain the same. Price per share = $30m/3m shares = $10 per share
MM Proposition II (MM 1958)
A firm's cost of equity increases with its debt-equity ratio.
MM Proposition I (MM 1958)
A firm's total market value is independent of its capital structure. Vl = Vu (not affected by leverage) popularly known as the "irrelevance proposition." the firm's market value equals the present value of the cash flows it generates regardless of the capital structure it chooses.
Dividend Irrelevance (MM 1961)
A firm's total market value is independent of its dividend policy
The IRR Rule
Accept, if IRR > cost of capital Reject, if IRR < cost of capital
Independent Projects:
Accept/Reject decision for a project is not affected by accept/reject decisions of other projects
Profitability Ratios:
Answers the question...how well the firm generates operating profits and net profits from its sales? (e.g., net profit margin, operating profit margin, ROE, etc.)
Apple, Einhorn, and iPrefs Case: Do You Give a Dividend? Buy Back Shares?
Apple should continue to pay the dividends that they were already paying (without increasing them) so that they can keep shareholders happy while also retaining enough cash to invest in other projects. If they were to increase dividends, this would signal to investors that they are running out of ideas for growth which is why increasing them would be a bad idea. They should use this excess cash that they have to buy back more shares. It is reasonable to buy back more shares when the company can purchase the stock at a discount.
Swedish Match Case: Is Swedish Match's Low Debt Policy Appropriate?
Based on the information given, we have concluded that the company's low debt policy is inappropriate. According to the case, by 2005, Swedish Match was a leader in the industry of smokeless tobacco products; therefore, we can assume that bankruptcy risk would not be a huge issue for the company. Also, the smokeless tobacco industry was rapidly growing at the time, so if Swedish Match was able to correctly capture more of the growing market share, they would continue to be a leader in the industry. In addition, institutional investors prefer companies to pursue a more aggressive debt policy. Thus, it is appropriate to assume that the company can increase their leverage and reap the benefits that come from adding more debt to their capital structure.
An analyst collects the following information about Oxford Corporation: • It has issued one-year, $1,000 par value bonds with a 7% annual coupon and are currently selling for $972.73. What is Oxford Corporation's cost of debt?
Bond Price = $1,000 x (1 + 7%) / (1 + YTM) = $972.73 YTM = 10%
What types of companies are more likely to have high leverage?
Companies in stable, predictable industries with reliable cash flows
Cross-Sectional Analysis:
Comparing firm to other firms or to industry.
Time-Series Analysis:
Comparing same firm across time
Value of a firm: V =
D + E or D/D+E
Home Depot, a home improvement supply store, issued $2 billion in debt in late 2016. What is the main difference between debt and other liabilities, like accounts payable?
Debt carries an explicit interest rate
Firm value increases if it issues different securities tailored for different clienteles of investors!
False
Firms should choose their financial policy to maximize EPS.
False
Debt is cheaper than equity.
False Debt is less risky than equity
Firms should choose their financial policies to maximize EPS.
False EPS Fallacy
Firm value increases if it issues different securities tailored for different clienteles of investors.
False Win-Win Fallacy
Incremental Cash Flows =
Firm's CFs with Project - Firm's CFs without Project
Pecking Order Theory when the firms need money, they should use:
First, INTERNAL FUNDS (e.g., retained earnings) Then, NEW DEBT Finally, NEW EQUITY
Which of the following statement about NPV and IRR is FALSE? A. The discount rate that gives an NPV of zero is the project's IRR. B. The IRR is the discount rate that equates the present value of the cash inflows with the present value of outflows. C. For mutually exclusive projects, if the NPV method and the IRR method give conflicting rankings, you should use the IRRs to select the project. D. The NPV method assumes that cash flows will be reinvested at the cost of capital, while IRR rankings implicitly assume that cash flows are reinvested at the IRR.
For mutually exclusive projects, if the NPV method and the IRR method give conflicting rankings, you should use the IRRs to select the project.
Debt
Formal legal contract Fixed maturity date Fixed periodic payments Security in case of default No voice in management Interest expense Interests are tax-deductible
How do you decide which project to accept?
Higher NPV
Swedish Match Case: Would You Ever Consider Increasing Leverage Simply Because Debt is "Cheap"?
If your company is liquid enough to pay off the monthly interest payments, you should increase the leverage position. Leveraging increases the firm's total value and helps managers maximize shareholder wealth in the long-term by being able to finance more positive NPV projects.
which one (Equity or Debt or Preferred Shares) do you think is most risky and which one the least risky?
In general, Common Shares (Equity) are riskier than Preferred Shares which in turn are riskier than Debt.
Liquidity Ratios:
Indicate the ability to pay short-term obligations. (current ratio, quick ratio, etc.)
Activity Ratios
Indicate the efficiency of a firm in utilizing its various assets. (e.g., asset turnover, inventory turnover, etc.)
Investor Indifference (Stiglitz 1969)
Individual investors are indifferent to the firms' financial policies.
The cash flows of any project may include three basic components:
Initial investment Operating cash inflows Terminal cash flow
Repurchase Price is
Irrelevant. Because they are the ones receiving the cash from the buyback
Which ratio is a distinguishing feature of retail companies?
Low receivables collection period
Conflicting project rankings
NPV method is preferred
Return on Assets =
Net Profits / Total Assets how effectively a company's assets are generating profits.
Equity
No legal contract No fixed maturity date Discretionary dividends Residual asset interest Vote - board of directors Dividends reduce RE Dividends are not tax-deductible
Is a high ROE always a good thing?
No, while a high ROE is desirable, it is not always a good thing...the elements that make up that ROE can help to determine whether that ROE is sustainable or built on a foundation that will destroy the company. For example, a high ROE can be created by leverage, rather than profitability.
Apple, Einhorn, and iPrefs Case: Imagine That You Are Managing Apple. Einhorn Has Created a Revolt Over the iPrefs, and Your Shareholders Are Demanding That You Do Something. Do You Agree With The iPref Idea?
No. If iPrefs were issued, then the net income for shareholders would decrease because of the payment of preferred dividends. Also, because preferred stocks are prioritized over Apple's common stock, the preferred shareholders would get paid first. This means that $50 billion would be taken from the value if Apple was liquidated tomorrow before common shareholders could even receive anything. In addition, if a company is in a cash crunch then payment of preferred dividends can be suspended. However, preferred dividends are cumulative meaning that if this happened with Apple then Apple would have to make up all of the missed preferred dividends before paying out any cash to the common stockholders.
Swedish Match Case: Two Reasons Why A Zero/Low Debt Policy is Optimal
One of the main reasons a zero/low debt policy would be optimal for the company is the reduction of solvency risk and the increase of firm flexibility. If a lot more competition were to enter the market due to the growing popularity of smokeless tobacco, then Swedish Match would not have to worry about these risks as much if they are unable to gain more market share. Another reason why this policy would be optimal for Swedish Match is that their net income would increase because they would not have to pay any or very low, interest expenses. This increase in net income would signal an increase in profitability which would be looked at favorably by stockholders.
Ways to repurchase shares
Open market repurchase Fixed price tender offer Dutch Auction
What is capital structuring?
Process of interchanging debt and equity - Enables one to "optimize" the value of a firm or its WACC by finding the "best mix" for the amounts of debt and equity on the balance sheet - Provides a signal that the firm is following proper rules of corporate finance to "improve" its balance sheet. This signal is central to valuations provided by market investors and analysts
Solvency Ratios
Provide information on the firm's financial leverage and ability to meet its longer-term obligations. (e.g., D/E, avg. TA/avg. TE, etc.)
Limitations of Ratio Analysis
Ratios that reveal large deviations from the norm merely indicate the possibility of a problem. A single ratio does not generally provide sufficient information from which to judge the overall performance of the firm. The ratios being compared should be calculated using financial statements dated at the same point in time during the year. It is preferable to use audited financial statements. The financial data being compared should have been developed in the same way. Results can be distorted by inflation. Management could potentially manipulate earnings.
Valuation Ratios:
Ratios used in Relative Valuation. (e.g., P/E, P/S, EPS etc. We have already seen them in firm valuation lectures)
Swedish Match Case: What Are The Pros and Cons of Such A Move?
Some of the pros of repurchasing are a reduction in taxes, reduction in the cost of capital, consolidated ownership, and benefits from temporary undervaluation of the stock. Repurchasing could also be seen as a sign of strength for the company. One of the major cons of repurchasing, financed by a debt issue, is that bankruptcy risk increases because you are leveraging more. As stated earlier, if more competition enters the industry then your ability to pay interest payments or principal may be wary. Some others cons are lower net income and reduction in financial flexibility going forward. Repurchasing may even push book equity value below zero.
Project Sequencing
Some projects must be undertaken in a certain order, or sequence, so that investing in a project today creates the opportunity to invest in other projects in the future.
Which of the following companies is most likely to have the highest inventory turnover?
Subway, a fast-food restaurant company
Which of the following constituencies care most about a company's current ratio?
Suppliers
Which of the following statement about NPV and IRR is FALSE? A. The IRR can be positive even if the NPV is negative B. The NPV method is not affected by the multiple IRR problem. C. When the IRR is equal to the cost of capital, the NPV will be zero. D. The NPV will be positive if the IRR is less than the cost of capital
The NPV will be positive if the IRR is less than the cost of capital
An analyst collects the following information about Ole Miss Corporation: The firm is contemplating the issuance of a 10% preferred stock that they expect to sell for $87 per share. The cost of issuing and selling the stock is expected to be $5 per share. What is Ole Miss Corporation's cost of preferred shares?
The dividend is = 10% x $87 = $8.70 The net proceeds, Nps = $87 - $5 = $82 Rps = $8.70/$82 = 10.6%
Impact of Taxes on Firm Value
The levered firm pays less in taxes than does the all-equity firm Vl = Vu + PV(Tax Shield) the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.
EPS can go up when a firm increases its leverage.
True
Investors differ in their preferences and needs, and thus want different cash flow streams.
True
Some investors like debt while others prefer equity
True
if Tax Shield increases firm value, what would help maximize the firm valuation?
Use more debt
- Equity Max Corp. is an all-equity firm, K0 = 10% - Future cash flows are known: $10,000 at t = 0, $10,000 at t = 1 - The firm will dissolve at t = 1 - The firm has no additional positive NPV project - The firm has 1,000 shares outstanding - The firm value is
V0 = CF0 + CF1/(1 + K0) = $10,000 + $10,000/1.1 = $19,090.91 Price per Share = $19,090.91 / 1,000 = $19.09
Trade-off Theory of Debt (incorporating taxes and bankruptcy costs)
Vl = Vu + PV(Tax shields) - PV(Bankruptcy costs)
Trade-off Theory of Debt (incorporating taxes, bankruptcy costs and agency costs)
Vl = Vu + PV(Tax shields) - PV(Bankruptcy costs) - PV(Agency costs)
If debt is good, why do we not see firms taking on 100% debt?
We see that the debt structure varies from firm to firm and industry to industry.
Swedish Match Case: Which Is Most Important: Zero/Low Debt or High Leverage?
We think that it is more important for Swedish Match to have high leverage rather than zero/low debt because the tax shield would allow them to pay out less in taxes; however, they need to be mindful of how they are leveraging because the tax shield only lowers taxes to the extent that the firm is profitable. Zero/Low debt is not as important in this case because Swedish Match is a well-established company, so the pros of taking on low debt is not very beneficial to the firm. One of the main reasons people want to have low debt is so that they could have higher net income, ultimately resulting in more cash. Since Swedish Match is already a leader in their industry, they do not need to hold as much cash as a start-up firm.
Swedish Match Case: Two Reasons Why A Zero/Low Debt Policy Would Be Bad
With the absence of debt or a very small amount, the firm risks paying out more money in taxes. Another reason a low amount of debt is not encouraged is because with the absence of large interest payments, companies tend to hoard their cash, which is not ideal in the eyes of active investors who would like to see the firm to take on new projects, in turn generating more wealth
Swedish Match Case: Should Dahlgren Recommend A Large Repurchase, Financed By A Debt Issue, To The Board?
Yes, he should recommend a large repurchase financed by a debt issue. Several large shareholders expressed their support for an increase in repurchasing, so doing this would make shareholders happy, which is one of our goals as a company. Also, repurchasing would ultimately increase their leverage, in turn, increasing firm value because less money is being paid out in taxes.
Swedish Match Case: How Much Weight Should You Put on Debt Cost and Rating Considerations When Making the Decision to Increase Leverage?
You should put some weight into debt cost and rating considerations when making the decision to increase leverage, but you should not base your whole leveraging decision on these two factors. Ultimately, how much weight you put into each of these depends on where the company is in its life cycle. For example, a mature, established company with a lot of cash would probably put more weight into the cost of debt while a younger, start-up company with less cash would probably rather finance through equity than debt.
Managers make repurchase decisions
after investment decisions are residual decision
Jensen and Meckling (1976) :
agency cost theory of financial structure
Management:
are concerned with all aspects of the firm's financial situation, and attempt to produce financial ratios that will be considered favorable by both owners and creditors
Current and Prospective Shareholders:
are interested in the firm's current and future level of risk and return, which directly affect share price.
Creditors
are interested in the short-term liquidity of the company and its ability to make interest and principal payments.
The Market-Timing Theory of Capital Structure Baker and Wurgler (2002)
argues that firms time the market by issuing equity when share prices are high and issuing debt when they are low
Ratios must be compared to a
benchmark
Using the WACC means that you are comfortable with the assumption that D/E will be
constant in the future. If you believe that D/E level will vary predictably in the future, then, you cannot use the WACC formula.
bankruptcy costs become a
deterrent to using leverage
Bankruptcy costs refer to
direct and indirect costs of the bankruptcy process itself.
Bankruptcy costs are
distinct from the decline in firm value that leads to financial distress.
Does Dividend Policy Matter?
dividends do not matter, and dividend policy does not affect value.
Sunk costs
do not matter. are costs that cannot be avoided, even if the project is not undertaken.
Cash flows are NOT
earnings (profits, net income,...)
Bondholders begin taking on an increasing fraction of the firm's risk as
firms use more debt.
capital rationing
have to prioritize the projects it will be able to undertake
Apple, Einhorn, and iPrefs Case: What Are iPrefs?
iPrefs are perpetual preferred stocks that are intended to unlock significant amounts of shareholder value and return cash to its shareholders. This idea was brought to Apple's attention by David Einhorn, founder of Greenlight Capital. Einhorn presented Apple with the proposal of a cumulative preferred share with a $50.00 face value, paying a 4% annual dividend totally to $2.00 annually. With this Einhorn believed Apple would be able to tap into a new demographic increasing total value of each common share to $480.
Using more debt financing
increases the probability that the firm will experience losses.
What is Ratio Analysis?
involves methods of calculating and interpreting financial ratios to analyze and monitor the firm's performance. • Interested Parties:
What is Capital Budgeting?
involves the analysis of potential projects (usually over a period longer than a year), as these long-term decisions of whether to accept or reject a project often involve large expenditures and can be very important to the firm's future.
Under some assumptions, corporate financial policy is
irrelevant! • Capital structure is irrelevant. • Dividend policy is irrelevant. • Cash management is irrelevant. • Risk management policy is irrelevant. • Cross shareholdings are irrelevant. • Diversification is irrelevant. • Private or public equity is irrelevant. • And, others...
Asset turnover
is a measure of the firm's asset use efficiency - how well it manages its assets?
Equity multiplier
is a measure of the firm's financial leverage
Net Profit margin
is a measure of the firm's operating efficiency - how well it controls costs?
DuPont Equation
is a way to decompose ROE, to better see what changes are driving the changes in ROE. For instance, a firm could have a high volume/low margin strategy, which would be reflected in high asset turnover but low profit margins or the reverse.
Overinvestment
is the promise to invest in a safe asset to obtain an interest rate reflecting low risk, and then substituting a riskier asset promising a higher expected return.
In equilibrium, firms signal good news by
issuing debt
Higher taxes lead to
lower ROE
Timing of cash flows
matter. One should not forget to account for time value of money while making capital budgeting decisions.
Taxes
matter. Remember it is not how much you make but how much you get to keep that is important. Hence, cash flows are analyzed on an after-tax basis.
Side effects of the project
matter. are also sometimes known as externalities are the effects the acceptance of the project may have on other firm cash flows.
Opportunity costs
matter. are cash flows that a firm will lose by undertaking the project under analysis
Making good capital budgeting decisions is consistent with management's primary goal of
maximizing shareholder value.
Mutually Exclusive Projects:
means that only one project in a set of possible projects can be accepted and that the projects compete with each other.
How you raise the money to finance the project should
not matter. Remember to separate investment from financing decisions. Note that the discount rate used in capital budgeting analysis takes account of the firm's cost of capital.
Underinvestment
occurs when a firm's shareholders refuse to invest in a positive-NPV project because most of the benefits would be realized by bondholders.
Leverage Ratios
one of the most powerful concepts in finance. The easiest way to understand the power of leverage is to recall the power of a lever in an engineering context. So managing leverage is critical because it enables you to do things you couldn't otherwise do and because it magnifies your returns. Ex: Debt to Assets, Debt to Cap, Assets to Shareholders' Equity, & Interest Coverage Ratios
Cash flows are
operating cash flows (NOT financing cash flows) (i.e. "free" of capital structure / financing considerations)
A firm's managers can adopt a heavily leveraged capital structure, committing the firm to
pay out large sums to bondholders.
Poor management, unfavorable movements in input and output prices, and recessions can
push a firm into bankruptcy, but they are not examples of bankruptcy costs.
Weighted Average Cost of Capital (WACC)
reflects the expected average future cost of capital over the long run; found by weighting the cost of each specific type of capital by its proportion in the firm's capital structure.
The discount rate must be appropriate for the
riskiness of the cash flows that you are discounting
Net Present Value (NPV)
s the present value of all the after tax cash flows associated with a project (subtracting a project's initial investment), using the cost of capital (usually WACC) as the discount rate.
Typically, firms use a
target leverage range rather than a single value.
Internal Rate of Return (IRR)
that discount rate that causes the NPV of the project to equal zero.
Terminal cash flow:
the after-tax non-operating cash flow occurring in the final year of a project. It is usually attributable to liquidation of the project.
For Applying the WACC Formula, the D/E level that should be used is
the anticipated market value leverage ratio (book value of D is sometimes OK; book value of E never!)
Clientele Effect (catering theory):
the argument that different payout policies attract different types of investors but still do not change the value of the firm
The bird-in-the-hand view:
the belief, in support of dividend relevance theory, that investors see current dividends as less risky than future dividends or capital gains.
Operating cash inflows:
the incremental after-tax cash inflows resulting from implementation of a project during its life
the term "capital structure" refers to
the mix of debt and equity securities that a firm uses to finance its activities.
Payback Period
the number of years it will take to recover the original investment. The disadvantage is that it ignores the time value of money and the cash flows received after the payback period
How to evaluate a new investment project?
the only cash flows that should matter and are relevant are the incremental cash flows contributed by the project.
Initial investment:
the relevant cash outflow for a proposed project at time zero
Rd is
the required rate of return on debt (i.e. the cost of debt). In other words, it is the financing cost associated with raising new funds through long-term borrowing. AnD YTM on the firm's existing bonds or bonds of similar risk issued by other companies. aNd the cost of debt (before tax) based on the risk of the debt (which depends on the debt ratio).
re is
the required rate of return on equity (i.e. the cost of equity or the cost of common stock). You can get it from CAPM or Gordon Growth Model.
Rps is
the required rate of return on preferred shares (i.e. the cost of preferred shares). It is the ratio of the preferred stock dividend to the firm's net proceeds from the sale of preferred stock = Div of preferred stock / Net proceeds from sale of preferred stock
think as a CEO → firms will issue equity only when
they are overvalued by the market. If they do so, and the market understands this, the firms will be penalized when they issue equity.
To implement the target capital structure:
• Undertake all positive NPV projects. • Issue equity when leverage rises above the target range. • Buy back stock (or pay dividends) or issue new debt when leverage falls below the target range.
What are the implications of the Pecking Order Theory?
• based on asymmetric information between managers and the markets • Managers know more about the firm value than investors. • Managers signal company's prospects to the external market. Therefore, this helps form a basis for selection of cheaper financing.
