Finance: 12-16 + 19 Concept Questions

Ch 15: What steps can stockholders take to reduce the costs of debt?

1) use protective Covenants -enter into agreements with bondholders that are designed to decrease the cost of debt -Negative covenants prohibit the company from taking actions that would be prohibiting the payment of dividends in excess of earnings -Positive covenants specify an action that the company agrees to take or condition the company must abide by -Ex. Agreeing to maintain its working capital at a minimum level 2) Repurchase Debt -Can eliminate the costs of bankruptcy by eliminating debt from its capital structure 3) Consolidate Debt - If the firm decreases the # of debt holders, it may be able to decrease the direct costs of bankruptcy

Ch 17: What is the difference between american and european options?

American: On or before Euro: On the date

Ch 12: 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?

Assuming that the new project's risk is the same risk as the firm as a whole, and that firm is financed entirely with equity

Ch 19: In the aggregate, debt offerings are much more common than equity offerings and typically much larger as well. Why?

Because debt has a lot of good qualities like it signals to shareholders that the company is doing well and they have assets and are confident in the future. It also benefits their current shareholders more and gives the firm a tax shield. -Debt issues are larger because larger companies have the greatest access to public debt markets (small companies tend to borrow from more private lenders) to maintain the D/E, a company must issue new bonds when the current bonds mature

Ch 14: Why is the use of debt financing referred to as financial "leverage"?

Because many relevant factors such as bankuptcy costs, tax assymmetries, and agency costs cannot be easily identified or quantified. It's practically impossible to determine the precise D/E ratio that maximizes the value of the firm. IF the firm's cost of new debt suddenly becomes much more expensive, it's probably true that the firm is too highly leveraged

Ch 14: 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?

Business risk: the equity risk arising from the nature's of the firm's operating activity, and is directly related to the SYSTEMATIC RISK OF THE FIRM'S ASSETS Financial Risk: equity risk that is due entirely to firms CHOSEN CAP STRUCTURE -As financial leverage increases, so does fin risk and hence the overall risk of the equity Firm B could have a higher cost of equity if it uses greater leverage

Ch 17: You notice that shares of a stock in the Patel Corporation are going for $50 per share. Call options with an exercise price of $35 per share are selling for $10. What's wrong here? Describe how you can take advantage of the mispricing if the option expires today.

Call is selling for less than its intrinsic value and so an arbitrage opportunity exists You've made a riskless $5 profit

Ch 17: What is a call option? A put option? Under what circumstances might you want to buy each? Which one has greater profit potential? Why?

Call option: when you buy something that allows you to buy a stock at a specific price until a specific time Call options allows the right, without the obligation, to buy an asset at a given price on or before a given date. _buy if you expect the price of the asset to increase -Unlimited profit potential Put option: confers the right, without the obligation to sell an asset at a given price on or before a date - buy if you expect the price of the the asset to DECREASe -limited profit potential as the lowest selling price of the asset is 0

Ch 16: If increases in dividends tend to be followed by (immediate) increases in share prices, how can it be said that dividend policy is irrelevant?

Change in price is due to change in dividends NOT DIV POLICY

Ch 12: 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 publically traded? How would you estimate the cost of debt to the firm whose only debt issues are privately held by institutional investors?

Cost of debt is the average YTM of all bond indentures -Cost of debt = interest rate a company would have to pay if it were to issue new debt today If privately place, the firm could still estimate the cost of debt by: -Looking at the cost of debt for similar firms in similar risk classes -Looking at the average debt costs for firms with the same credit rating -Consulting analysts and investment bankers Even if the debt is publicly traded, an additional complication rises when the firm has more than one issue outstanding; these issues rarely have the same yield because no to issues are ever completely the same

Ch 15: What are the direct and indirect costs of bankruptcy?

Direct: lawyers, legal fees, admin Indirect: Cost of avoiding bankruptcy

Ch 16: How is it possible that dividends are so important, but, at the same time, dividend policy is irrelevant?

Dividends are signals to the firm, about how they are doing and a commitment to the shareholders Policy has to do with the timing of the payments, not the amount paid. Irrelevant when the timing of dividend payments doesn't affect the PV of all future divs

Ch 16: 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?

Ex-dividend Date: Dec 29th 12 business days before the payout 13 business days after declaration day If someone buys the stock before the ex-div date, they get the dividend, but if you buy after then you don't get the dividend, but the price is also usually cheaper.

Ch 14: In a world with no taxes, no transaction costs, and not 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

FALSE. MM Prop II with taxes states that the required return on a firm's equity is positively related to the firm's D/E therefore any increase in the amount of debt in a firm's cap structure will INCREASE THE REQUIRED RETURN ON THE FIRM'S EQUITY

Ch 15: Do you agree or disagree with the following statement: A firm's stockholders will never want the firm to invest in projects with negative net present values. Why?

False. If the firm is going towards bankruptcy and a certain project will give them a better expected return than without the project they will vote for the project

Ch 13: What rule should a firm follow when making financial decisions? How can firms create valuable financing opportunities?

Firms should only accept financing proposals with positive NPVs. Can create financing opportunities in 3 ways: -Fool investors (firm can issue a complex security to receive more than the fair market value. -Reduce costs or increase subsidies (firm can package securities to reduce taxes. Such a security will increase the value of the firm -Create a new security

Ch 15: 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?

I would choose to go for equity because the firm might have some trouble getting a loan if they don't have enough. Also they would not get the tax shield benefit if they issued debt

Ch 16: 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?

Investors want somewhat of a predictable cash flow A good compromise is maintaining constant, steady dividends - increase divs only when they expect earnings to remain at a sufficiently high level to pay the larger dividends and lowers ONly if there is a firm-specific problem

Ch 16: The Phew Charitable Trust pays no taxes on its capital gains or on its dividend income or interest income. Would it be irrational for it to have low-dividend, high-growth stocks in its portfolio? Would it be irrational for it to have municipal bonds in its portfolio? Explain

It wouldn't matter if they don't have taxes?? trust does not pay taxes on the interest it receives so it does not need the tax breaks associated with the municipal bonds

Ch 13 What is true about the efficient market hypothesis?

It's hard to beat the market. Usually the market is pretty efficient Market efficiency exists when prices reflect all available information. Competition among investors 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

Ch 15: What are the sources of the agency costs of equity?

Management, conflicts of interest. The manager may have other plans like want to increase the projects of the firm. BUT if the manager is given a share of equity and ownership, they are more likely to make decisions in the actions of the stockholders 1) Shirking. Managers with small equity holdings have a tendency to reduce their work effort, thereby hurting both the debt and outside equity holders 2) Perquisites: Since mgmt 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 and equity holders

Ch 15: Refer to the observed capital structures given in Table 15.3 of the text. 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.

More capital intensive industries, such as airlines, building construction, hotels, and utilities tend to use greater financial leverage Industries with less predictable future earnings, such as computers or drugs tend to use LESS financial leverage -Also have a higher concentration of growth and startup firms General tendency is for firms with identifiable, tangible assets and relatively more predictable future earnings to use MORE DEBT financing. Debt to Equity returns: -Taxes _Types of assets _Uncertainty of Operating Income

Ch 14: Is there an easily identifiable debt-equity ratio that will maximize the value of the firm? Why or why not?

No. 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 and so the value of the firm does not necessarily fall

Ch 13: Explain why a characteristic of an efficient market is that investments in that market have 0 NPVs

On average, the only return that is earned is the required return. Investors buy assets with returns in excess of the required return (+NPV), they bid up the price and thus cause the return to fall to the required return (0 NPV). Investors sell assets with less returns less than the required returns (-NPV) drive the price lower and thus cause the return to rise to the required return (0 NPV)

Ch 13: There are several celebrity 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?

Only within the bounds of increasingly strong assumptions about the information processing of investors, that assets are fairly priced. Implication is that on average, the typical market participant cannot earn excessive profits from a particular trading strategy

Ch 12: 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?

Primary Advantages: Model explicitly incorporates the relevant risk of the stock The method is more widely applicable than the DCF model (since the SML doesn't make any assumptions about the firm's dividends) Disadvantages: 3 Parameters must be estimated (risk-free rate, expected return on the market, beta) Method essentially uses historical information to estimate these parameters Risk-free rate is usually estimated to the the yield on a very short maturity T- bill and is observable Market Risk premium is usually estimated from historical risk premiums and is NOT observable Beta is unobservable and usually estimated 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

Ch 16: What is the impact of a stock repurchase on a company's debt ratio? Does this suggest another use for excess cash?

Reduces equity while leaving debt unchanged. Debt ratios rises Firm could use excess cash to reduce debt instead

Ch 15: 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?

Right to file for bankruptcy is a valuable assets, and the financial manager is acting in the best interest of the shareholders

Ch 14: List 3 assumptions that lie behind the MM theory in a world without taxes. Are these assumptions reasonable in the real world?

Same expectations Same business class Risk class Perpetuals CFs Perfect Capital Markets 1) Individuals can borrow at the same interest rate as which the firm borrows -Since investors can purchase securities on margin, an individual's effective interest rate is probably no higher than for a firm -If a firm were able to borrow at a rate lower than individuals, the firm's value would increase through corporate leverage 2)There are no taxes -In the real world, firms pay taxes -In the presence of corporate taxes, the value of the 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 real world, costs of financial distress can be substantial -Incentives for the firm to lower its amount of debt in its capital structure since stockholders eventually bear the costs

Ch 13: Define the 3 forms of market efficiency

Strong (public and private info - the rarest) Semi-Strong (public Info) Weak (Past info)

Ch 14: What is the quirk in the tax code that makes a levered firm more valuable than an otherwise identical unlevered firm?

TAX SHIELD But payments to shareholders (dividends) are not tax deductible

Ch 13: 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

Ch 19: Why are the costs of selling equity so much larger than the costs of selling debt?

There are a lot of costs of issuance for debt like an underwriter, legal fees, figuring out a good price for the stock, etc You just need investors for the bonds Economies of Scale! Debt issues are easier and less risky to sell -Larger amounts of debt securities can be sold to a small number of buyers (such as large institutions)

Ch 16: For initial public offerings of common stock, 2012 was a below average year, with over $31.8 billion raised by the process. Relatively few of the 103 firms involved paid cash dividends. Why do you think that most chose not to pay cash dividends?

They were probably early or just starting out companies and decide to instead reinvest in the company which will produce higher capital gains

Ch 15: 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?

This is not ethical because it's bullying Interest charge incorporates this possibility

Ch 16: 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)?

This was a surprise to the market because if everyone had known then the price would have already included this Because of the expected drop in future dividends Stock price is PV of all future divs so if expected future divs drop, the price will also drop

Ch 16: Some corporations, like one British company that offers its large shareholders free 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.)

Unless the stock is really good, they probably should not invest No

Ch 14: What is homemade leverage?

Use of borrowing on the personal level as opposed to the corporate level

Ch 15: 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.

Very unethical, other airlines have done this. This hurts people. This helps the airline and is okay for their business to do and save some jobs. 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 simply 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.

Ch 16: The DRK Corporation has recently developed a dividend reinvestment plan, or DRIP. The plan allows investors to reinvest cash dividends automatically in DRK in exchange for new shares of stock. Over time, investors in DRK will be able to build their holdings by reinvesting dividends to purchase additional shares of the company. Over 1,000 companies offer dividend reinvestment plans. Most companies with DRIPs charge no brokerage or service fees. In fact, the shares of DRK will be purchased at a 10 percent discount from the market price. A consultant for DRK estimates that about 75 percent of DRK's shareholders will take part in this plan. This is somewhat higher than the average. Evaluate DRK's dividend reinvestment plan. Will it increase shareholder wealth? Discuss the advantages and disadvantages involved here.

WILL probably have little effect on shareholder wealth -Can now reinvest on their own and taxes will be paid eventually _may benefit due to the discount

Ch 13: Critically Evaluate the following 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.

Well sometimes if the market isn't strong they get lucky. But there has to be a reason they continue to look The stock market is a positive sum game, and everyone can win. Speculators help provide liquidity to markets and thus help promote efficiency

Ch 13: Is a market is semi-strong form efficient, is it also weak form efficient?

Yes

Ch 12: Why do we use an aftertax figure for cost of debt but not for cost of equity?

because cost of equity does not include a tax shield Intexp is tax deductible

Ch 19: Why is underpricing not a great concern with bond offerings?

because there is less incentive to underprice the bond? Because the bond price doesn't change with the firm's value yields on comparable bonds can usually be readily observed, so pricing a bond issue accurately is much less difficult

Ch 19: Why do non-investment-grade bonds have much higher direct costs than investment-grade issues?

because they gotta tranche that shit It is harder to sell non-investment grade bonds, plus they need a higher yield harder and riskier to market

Ch 14: In a world with no taxes, no transaction costs, and not 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

false. It doesn't change -Reduction in leverage will decrease both the risk of the stock and the expected return -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

Ch 14: What is the basic goal of financial management with regard to capital structure?

maximize value TO THE SHAREHOLDERS

Ch 12: If you can borrow all the money you need for a project at 6%, doesn't it follow that 6% is your cost of capital for the project?

no? that is the cost of debt The Cost of capital depends on the RISK OF THE PROJECT, not the source of the money

Ch 19: 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?

nonunderwritten rights offering might be a lot cheaper than a cash option there might be hidden costs though

Ch 13: What are the implications of the efficient market hypothesis for investors who buy and sell stocks in an attempt to "beat the market"?

they supposedly know more about the market than the rest of the market Such investors merely earn only what the market offers. The trades still have 0 NPV. If trading costs exist, then they lose by the amount of the costs

Ch 15: How do the existence of financial distress costs and agency costs affect Modigliani and Miller's theory in a world where corporations pay taxes?

they take a toll on the value of the levered firm. The PV of financial distress is subtracted from the Value of the unlevered firm and the debt tax shield At some point, the marginal costs of a additional debt will outweigh its marginal tax benefits There is an optimal level of debt where the marginal tax benefits of the debt equals the marginal increase in financial distress and agency costs