FNAN 522 Smartbook
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
