Finance final exam

average annual risk premium on small company stock

12.9%

a 15% stock dividend declared would mean a

15 % increase in number of shares outstanding

over the long term, if you are willing to bear risk, you should expect a rate of return of

3-4%

if a risky security has less risk than the overall market, the beta must be

>0 but <1

M&M Proposition II

A firm's cost of equity capital is a positive linear function of its capital structure

changes in capital structure of a firm will generally change the firms

EPS

an all equity firm with a positive net income

PE ratio will decrease if firm pays cash dividends

historical returns on large companies are based on

S&P 500

what had the lowest standard deviation of returns

US treasury bills

rate of return a firm must earn on its existing assets to maintain the current value of its stock.

WACC

use arithmetic average of return on equity and return for capital for capital asset model to find

WACC cost of equity

a stock repurchase has the same effect on a firms market value balance sheet as

a cash dividend

after tax cost of debt and capital is affected by

a change in the firms tax rate

according to an accounting perspective, a firm is considered insolvent when

a firm has a negative net worth

bankruptcy

a legal proceeding for liquidating or reorganizing a business

stock buybacks

a means of obtaining shares for employee stock option grants

beta equals zero when

a portfolio is comprised solely of US treasury bills

cost of capital for a project primarily depends on how

a project uses its funds

decrease in PE ratio will result from

a stock repurchase

where will an underpriced security plot on the SML

above the line

cash dividends signal that

agency costs will be less because of less cash held by firm and the firm is and will continue to be profitable

an increase in cost of debt equals

an increase in firms cost of capital

dividend growth model approach to computing cost of equity

annual dividend used must be year 1 if you are using todays stock price to compute return

unsystematic risk

asset specific risk, diversifiable risk, unique risk

subjective cost of capital

assigning every proposed investment a particular risk class

a decrease in the firms WACC will increase the

attractiveness of firms investment options

in bankruptcy liquidation, the highest priority is generally given to

bankruptcy administrative expenses

normal distribution

bell shaped frequency distribution that is defined by average and its standard deviation

the risk premium on stocks exceeded the risk premium on _____

bonds

as of 2003, individual investors pay a 15% tax on

both dividends and capital gains

core principal of M&M proposition I without taxes

capital structure of a firm is totally irrelevant

increase in market value of common stock affects

capital structure of weights used to compute WACC

regular cash dividend

cash payment by a firm to its owners as part of a firms normal operations

absolute priority rule

claims that earn preference in process of liquidation

what should be placed into tax favored groups

corporate, pension funds, and trust funds

Stock price that declines over the investment period

could cause total return on investment to be negative

dividend policy is irrelvant because

current equilibrium in clientele dividend market

declaration date

date on which board of directors agrees to pay dividends and posses resolution

repurchase of preferred stock will increase the weight of

debt

level of financial risk to which a firm is exposed is dependent on

debt to equity ratio

for a levered firm, a reduction in the risk level will tend to

decrease WACC

the percentage of US industrial firms paying dividends has increased since 2003 because

decrease in number of non paying, maturing young firms, 2003 tax act, and a signal of financial health

to lower overall expected rate of return

decrease in probability of economic boom

reverse split

decrease the number of outstanding shares, doesnt change total equity of a firm

increase expected return by

decreasing risk free rate given a security beta of 1.06

increase dividend yield by

decreasing stock price combined with higher dividend amount

an efficient market is

defined as a market in which security prices reflect available information

date of record

determines who receives the dividends

the higher the expected rate of return, the wider the

distribution of returns

payment date

dividend checks mailed

increase in cost of equity will increase ___

dividend growth rate

the time pattern of dividend payout

dividend policy

The clientele effect states that investors fall into various groups because of differences in their preferences for

dividends

assuming clienteles exist, dividend policy is irrelevant as long as

each group is satisfied

benefits of dividend growth model

easy to understand, model simplicity

% returns are

easy to understand, relay information easier than dollars, not affected by size of investment, easily separated into dividend yield and capital gain yield

financial risk

equity risk arising from capital structure selected by a firm

business risk

equity risk arising from daily operations of a firm

systematic risk principle

expected return on risky assets depends on market risk

tender offer

extra cash and will try to repurchase X amount of stocks

reorganization

file for bankruptcy but continue operations during and after

WACC for risky levered firm will decrease is

firm bonds start selling at a premium rather than discount

stock repurchase

firms buys some of their outstanding shares

drawback of cash dividends

firms may have to forgo positive NPV projects

new news in an efficient market should

force stock price up then remain at that new price

small company stocks had the widest

frequency distribution of returns

portfolio

groups of assets held by an investor

corporate shareholders favor

high dividend payout

financial distress cost

inclusive of both direct and indirect bankruptcy costs

compared to cash dividends, a share repurchase will

increase EPS and decrease PE ratio

stock split

increase number of shares outstanding, but doesnt increase value of owners equity

A firm that uses WACC as required return for all investments will

increase risk level of the firm over time

according to M&M proposition I with taxes, to increase the value of a levered firm

increase value of unleveled firm

an increase in after tax cost of debt will a

increase yield to maturity (YTM) and decrease tax rate

example of an indirect bankruptcy cost

incurred by firm trying to avoid filing for bankruptcy

strong form effient means you cannot benefit from

inside knowledge

a firms value and WACC are

inverses

diversification

investing in a variety of diverse assets to reduce risk

the cost of preferred stock is unaffected by

issuers tax rate

pre-pack

joint filing of both a bankruptcy and creditor approved reorganization plan

weakenesses of dividend growth model

lack of dividends for some firms, sensitivity of model to dividend growth rate

example of a direct bankruptcy cost

legal and accounting fees related to a bankruptcy proceeding

what is the number companies in the US that have consistently increased dividends for at least the last 25 years

less than 75

the beta of a portfolio cannot be.....

less than the lowest individual beta or greater than the highest

security market line

linear line plotted based on relationship between expected return and beta

Long-term government bonds underperformed ____

long-term corporate bonds

high flotation cost for equity issues tend to favor

low dividend payout

tracking range

lowest and highest prices stock is sold for

research of dividends policies shows

managers tend to smooth dividends

slope of security market line

market risk premium

based on the capital asset pricing model, investors are compensated based on

market risk premium, portfolio beta, and risk free rate

pure play primarily seeks rate of return that best....

matches risk level of proposed investment

what will the addition of a risky security to a fully diversified portfolio do to beta

may or may not affect it

beta coefficient

measures amount of systematic risk related to the average risky asset

cost of capital

minimum required rate of return on a new investment that makes investment attractive

security plots to the right and below the SML means

more systematic risk than market and over priced

intermediate terms government bonds had the

narrowest distribution of returns

cost of capital primarily is primarily dependent on ___ for new facility

nature of investment

a fixed stock repurchase plan could be a

negative NPV investment for stock issuer

when will the geometric average return exceed the arithmetic average return

never

stock dividend

noncash payment by a firm, it lessens value of each outstanding share

firms usually believe that once a dividend is increased it should

not be decreased

decrease the number of shares outstanding by

open market purchase, tender offer, and targeted repurchase

interest tax shield

paying interest reduces taxes owed by a firm

distribution

payment by firm from any source other than current or accumulated RE

dividend

payment of either cash or shares of stock that is paid out of earning to shareholders

portfolio weight

percent of your portfolio

if a risky security is correctly prices, expected risk premium will be

positive

if each state of economy produces different expected return then variance must be

positive

the annual nominal rate of return on US treasury bills has had a ____ rate of return

positive

what value stays the same whether the firm pays a dividend or repurchases stock

price earning ratio

level of risk

primary determinant of investments cost of capital

financial leverage magnifies both

profits and losses

composition to avoid bankruptcy

reduce amount of loan payments so they can be paid on time

targeted repurchase

repurchase all shares for higher price than its currently selling

arithmetic average return

return earned in an average year over a mutli year period

if securities are correctly priced....

reward to risk must equal slope of SML

the rate of return on US treasury bills is used as the

risk free rate

expected return on security depends on

risk free rate of return and market rate of return

core principal of M&M proposition II without taxes

risk of equity depends on both degree of financial leverage and riskiness of operations, cost of equity increases as firm increases

US treasury bills had the smallest

risk premium

excess return

risk premium

systematic risk

risk that affects large number of assets

only individuals with private info have a marketplace advantage in a

semistrong efficient market

highest volatility of returns come from

small company stocks

what are most apt to have the largest risk premium in the future?

small company stocks

Liquidating Dividends example

sold storage unit and is distributing proceeds of sale to shareholders

positive square root of the variance

standard deviation

limit amount of dividends paid by leveraged corporation

state laws pertaining to RE and bond indenture covenants

the cost of preferred stock equals

stocks dividend yield

cost of equity for a risk firm increases in direct relation to____

stocks systematic risk in an efficient market according to SML

total returns

sum of dividend yield and capital gains yield

core principal of M&M proposition I with taxes

supports the theory that value of a firm increases as levels of debt decreases, leveraged value of a firm> unleveraged

risk premium for individual security is based on

systematic types of risk

liquidation

termination of the firm as a going concern

geometric average return

the average compound return earned per year over a multiyear period

variance

the average squared difference between actual return and average return

ex-dividend date

the date two business days before the date of record, establishing those individuals entitled to a dividend

if the pretax cost of debt is less than the cost of equity

the firm may change its capital structure is government changes tax policies

the lower the standard deviation of returns

the lower the expected return and lower risk

highest cost of capital is assigned to

the most risky

if the securities market are strong form efficient

the price of each security in that market will fluctuate frequently

the average risk premium on long term government bonds was

the rate of return minus T bill rate

the dollar return on a stock is dependent on

the size of investment while % return is not

Static Theory of Capital Structure

the theory that a firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress, fixed in its assets, firm value is maximized when a firm operates at optimal debt level

capital asset pricing model considers....

the time value of money

homemade leverage

the use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed

M&M Proposition I

the value of a firm is independent of the firms capital structure

semi strong market efficiency states that

the value of a security is based on all publicity available information

standard deviation measures

the volatility of securities over time

a non dividend paying firm is more apt to do a stock repurchase than

to commence paying dividends

opening stock price tomorrow

todays closing price minus an amount equal to after tax value of the dividend

standard deviation measures _______, while beta measures _______

total risk, systematic risk

T/F: a firm can file for chapter 11 bankruptcy even if a firm is solvent

true

T/F: asset sale must occur before a firm can offer a liquidating dividend

true

extra dividend

uncertain if you will keep the increased price for the future

US treasury bills can either _____ or _____ inflation on an annual basis

underperform or outperform

if financial markets are efficient then stock prices should respond only to

unexpected news and events

If you have the exact same firms except one is leveraged and one isnt which will have the higher EBIT and EPS

unleveraged firm will have higher EPS and lower EBIT

WACC is minimized when

value of a firm is maximized

according to efficient market hypothesis, professional investors will earn a dollar return equal to

value paid for investment

risk free rate is the _____ of SML

vertical intercept

WACC

weighted average of a firms cost of equity and its after tax cost of debt

pretax cost of debt is the

weighted average yield to maturity on a firms outstanding debt

expected return

what you anticipate to earn

What percentage of capital gains are excluded from taxation for corporate shareholders

zero

amount of compensation an investor should expect to receive for accepting unsystematic risk is

zero

when expected return for each economic state is the same, variance is

zero