FINA 440 Exam 2

Steps to Preparing a Cash Budget

1) Forecast the sources of cash. 2) Forecast uses of cash. 3) Calculate whether the firm is facing a cash shortage or surplus.

Stock Repurchase (5 Methods)

1) Open-market repurchase. 2)Tender offer. 3)Auction (Dutch auction). 4)Direct negotiation. 5)Accelerated share repurchase.

The Dividend Decision: Senior Executive Dividend Policy Features (How Dividends are Determined)

1.Managers are reluctant to make dividend changes that might have to be reversed 2.Managers "smooth" dividends and hate to cut them. Dividends changes follow shifts in long-run, sustainable levels of earnings 3.Managers focus more on dividend changes than on absolute levels

Loan Covenant

Agreement between firm and lender requiring the firm to fulfill certain conditions to safeguard the loan.

The Financial Planning Process

Analyzing the investment and financing choices open to the firm Projecting the future consequences of current decisions Deciding which alternatives to undertake Measuring subsequent performance against the goals set forth in the financial plan

Payout Policy

Best payout policy reflects firm characteristics: The need for free cash depends on the maturity of the firm (and industry), earnings variation, and the need for new investment. Once dividends are set, firms do not cut the dividend. Firms generally use predictable, stable, recurring income to pay cash dividends. Over time the trend toward repurchases in place of cash dividends has strengthened.

Financing Games

Bet the Bank's Money. Don't Bet Your Own Money. These games demonstrate an inherent conflict between shareholders and debtholders.

Modigliani and Miller Assumptions

By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if: Investors do not need choice OR there are sufficient alternative securities.

Dividends Decrease Value: Tax Consequences

Companies can convert dividends into capital gains by shifting their dividend policies If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably In such a tax environment, the total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid

Cost of Financial Distress

Costs arising from bankruptcy or distorted business decisions before bankruptcy.

Costs of Financial Distress

Costs arising from bankruptcy or distorted business decisions before bankruptcy.

Ex-Dividend Date

Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend.

Trade-Off Theory

Debt levels are chosen to balance interest tax shields against the costs of financial distress.

Stock Dividend

Distribution of additional shares of a corporation's own stock to its shareholders.

Modigliani and Miller Proposition 2

Expected rate of return on the equity of a levered firm increases in proportion to the D/E ratio.

Stock Repurchase

Firm distributes cash to stockholders by repurchasing shares.

Risk Shifting

Firms threatened with default are tempted to shift to riskier investments.

Debt Overhang

Firms threatened with default may pass up positive-NPV projects because bondholders capture part of the value added.

Summary: Payout Policy

Firms with many good investment projects will have low cash payouts. Shareholders rely on management's discretion about investment selection. Firms with few good projects will have high payout (dividends or share repurchases). Changes in the dividend payment may signal information about the firm's future growth potential. The formation of dividend clienteles makes it important for firms to maintain relatively stable and predictable payout policies.

% Sales Pitfalls

Fixed costs Changes in CA may lag sales growth Additions to FA are generally not incremental, i.e. some new sales can be absorbed with current capacity, but beyond some sales level, new capacity must be added

Setting Dividend Policy

Forecast capital needs over a planning horizon, often 5 years. Set a target capital structure. Estimate annual equity needs. Set target payout. Generally, some dividend growth rate emerges. Maintain target growth rate if possible, varying capital structure somewhat if necessary.

Flexibility vs Discipline

In some cases flexibility is crucial (use less debt, have lower dividend payouts, hold more cash). In other cases, market discipline is more important (use more debt, pay higher dividends, hold less cash).

Information Content

Information content of dividends: Dividend increases convey managers' confidence about future cash flow and earnings. Dividend cuts convey lack of confidence and therefore are bad news Information content of repurchases: Repurchase announcements signal managers' optimism. Repurchase announcements may indicate managers believe the share price is undervalued

Financial Planning Models

Inputs: Current financial statements. Forecasts of key variables (such as sales or economic conditions). Planning Model: Equations specifying key relationships. Outputs: Projected financial statements (pro forma). Sources and uses of funds. Financial ratios (Recall: liquidity, profitability, efficiency, leverage, and market value ratios).

Stock Splits

Issue of additional shares to firm's stockholders.

Leverage and Payout

Leverage and dividends are jointly determined: Both reflect the stage in a firm's "life cycle" "Growth Firms": Have lots of good NPV projects. Therefore, can earn more on retained earnings than investors "Value firms" aka "Cash Cows": Have few remaining good investment opportunities. Shareholders have the ability to earn at least as good a return as the firm can.

Dividends Increase Value

Market Imperfections (SEE PPT.) Dividends as Signals (SEE PPT.)

Disadvantages of Repurchases

May be viewed as a negative signal (firm has poor investment opportunities). IRS could impose penalties if repurchases were primarily to avoid taxes on dividends. Selling stockholders may not be well informed, hence be treated unfairly. Firm may have to bid up price to complete purchase, thus paying too much for its own stock.

Distress Costs

Need external funds to invest in CapEx or market share. Financially strong competitors. Customers or suppliers care about your financial position. Assets cannot be easily redeployed.

Asset vs Equity Returns - No Taxes

No matter how much the firm borrows, the expected return on the package of debt and equity, Rassets, remains unchanged.

Taxation

One advantage to investors: capital gains taxes are deferrable. One advantage to corporations: corps. pay corporate income tax on only 50% of any dividends received from investments in other corporations.

Summary: Capital Structure

Optimal capital structure is not something which can be explicitly calculated. However, we do have a good understanding of the factors that matter. Firms with different asset properties and different profit volatilities choose to operate with different leverage ratios. Information asymmetries probably influence firm financing decisions in the short run, but eventually the tradeoff target comes to dominate the leverage choice. Optimal target leverage balances the costs and benefits of leverage: tax savings, bankruptcy costs, managerial incentive effects, and potential investment distortions. Target leverage is more like a range than an exact number.

Managers are often asked to model different possible outcomes

Optimistic Expected Pessimistic Financial plans help managers ensure that their financial strategies are consistent with their capital budgets. They highlight the financial decisions necessary to support the firm's production and investment goals.

Cash Dividend

Payment of cash by the firm to its shareholders.

Record Date

Person who owns stock on this date received the dividend.

Percentage of Sales Method

Planning model in which sales forecasts are the driving variable and most other variables are proportional to sales.

Cash Budget

Primary tool in short-run financial planning: Identify short-term needs and opportunities. Identify when short-term financing may be required How it works: Forecast sources and uses of cash. Subtract uses from sources and determine investing and financing needs Used to plan loans needed or funds available to invest. Can be daily, weekly, or monthly, forecasts: Monthly for annual planning and daily for actual cash management.

Restructuring

Process of changing the firm's capital structure without changing its real assets. NO change in the total asset size or composition of assets.

Pro Formas

Projected financial statements. Generally conducted as multi-year financial projections of a project or business' operating income, expenses, and cash flow. They are used to determine the economic viability of a project.

Financial Slack

Ready access to cash or debt financing.

BETH COOPER MERGERS AND ACQUISITIONS

SEE PPT.

Dividend Policy is Irrelevant

Since investors do not need dividends to convert shares to cash, they will not pay higher prices for firms with higher dividend payouts. In other words, dividend policy will have no impact on the value of the firm.

Advantages of Repurchases

Stockholders can tender or not. Helps avoid setting a high dividend that cannot be maintained. Repurchased stock can be used in takeovers or resold to raise cash as needed. Income received is capital gains rather than higher-taxed dividends. Stockholders may take as a positive signal--management thinks stock is undervalued.

Factors in the Dividend Decision Process

Target payout ratios Repurchase decisions Information content of dividends and repurchases

Pecking Order Theory

Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient.

Practical Implications

There is an optimal capital structure. Companies with low expected distress costs should load up on debt to get the tax benefits. Companies with high expected distress costs should be more conservative.

Planning Horizon

Time horizon for a financial plan.

Accounts Receivable and Accounts Payable (Trade Credit)

Trade credit is credit furnished by a firm's suppliers: From the supplier perspective, this is accounts receivable. From the purchaser's perspective, this is accounts payable. Terms of sale are therefore similarly expressed Trade credit is often the largest source of short-term credit, especially for small firms. Spontaneous, easy to get, but cost can be high.

M&M Payout Policy Irrelevance

Under the assumption of perfect capital markets, the payout policy of a company does not matter.

Balancing Item

Variable that adjusts to maintain the consistency of a financial plan. Also called plug.

Modigliani and Miller

When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure (MM Prop. 1) In other words, financial managers cannot increase value by changing the mix securities used to finance the company.

Working Capital Terminology

Working Capital: current assets Net Working Capital: current assets minus current liabilities Net Operating Working Capital: current assets minus (current liabilities less notes payable) Working Capital Management: controlling cash, inventories, and A/R, plus short-term liability management.

Why Build Financial Plans?

contingency planning considering options forcing consistency