FIN 601 Exam 1
Because bankruptcy costs declined
Changes in bankruptcy code make bankruptcy less costly to firms, then firms typically increase their financial leverage because...
Coefficient of variance (CV) = St. dev / Expected value risk for a unit of value
Coefficient of variance formula
MM Irrelevance Theorem
Capital structure doesn't matter; firm value is determined by cash flows; capital structure is just a way to divide a firm's free cash flows between debt holders and shareholders
Clientele effect
impede changing dividend policy; different groups of investors, or clientele, prefer different dividend policies; firm's past dividend policy determines its current clientele of investors; groups of similar investors tend to flock to stocks that have dividend policies consistent with their needs
Tax advantage of debt
interest is tax-deductible but dividends are not
Financial options
investors have no influence on underlying cash flows
Real options
managers can influence the size and risk of a project's cash flows by taking actions during the project's life in response to changing market conditions
1 (most simple) - use discounted cash flow valuation and ignore any real options by assuming their values are 0 2 - use discounted cash flow valuation and include qualitative recognition of any real option's value 3 - use decision tree analysis 4- use the standard model for a financial option 5 - develop a unique, project-specific model by using financial engineering techniques
name the 5 possible methods for real option and valuing them (simple to most difficult)
Optimal cost structure
obtains where a balance is struck between tax benefits and bankruptcy costs; where firm value is maximized
Deposit
one cash flow
risk aversion --> risk premium
positive relationship between risk and required return
-explicitly identify the embedded options
pros of decision tree
Treasury stock
repurchases shares will be retired or become ___________ (for future re-issuance)
stocks more risky than bonds
stock are ___ risky than bonds
-high tax rate -low business risk
take advantage of tax benefits by issuing debt especially if the firm has...
Abandonment options
terminate the project for salvage value
Financial risk
the additional risk as a result of using debt
Free Cash Flow (FCF)
the amount of cash flow available to investors (creditors and owners) after the firm has met all operating needs and paid for investments in net fixed assets and net current assets
the distribution policy defines the level of distribution to shareholders and the form of distribution
the distribution policy defines...
Yield to maturity and Internal rate of return
the expected rate of return, estimated based on future cash flows
Capital structure
the mix of debt and equity; how a firm finances its assets
A real option
the right (but not the obligation) to undertake certain initiatives to alter the cash flows of an investment project; should be taken into consideration for capital budgeting or you may be underinvesting
Business risk
the risk a firm's stockholders would face if the firm had no debt; inherent risk in the operations; varies from industry to industry and firm to firm; a concern of the COO
Present Value
the sum of discounted future cash flows
1. have broker / trustee purchase on open market over a period of time 2. make a tender offer to shareholder 3. make a block (targeted) repurchase
the three ways to repurchase stock
Dividend payout rates have fallen, stock repurchases have increased; repurchases now total more dollars in distributions than dividends; a smaller percentage of companies now pay dividends; when young companies first begin making distributions, it is often in the form of repurchases
trend in dividend / repurchases
Abandonment option
type of real option that allows a firm to shut down a project if its cash flows are lower than expected
time value of money
underlies the discounted cash flows method
investment project
uneven cash flows during the lifetime of the project
corporation
uneven free cash flows til infinity
Financial leverage
use of debt creates _________
-there is a long time before you must make the decision -the underlying project is very risky
value of real option if likely high if...
Investment timing options
wait to make a better - informed decision or wait to take advantage of lower cost of capital
Replication method
what you would implement only if demand turns out high enough
-net income belongs to shareholders -retain only if reinvestment produces better return
why distributions
Dividends
Stock price down, # of shares doesn't change
Repurchases
Stock price no change, # of shares down
True
T/F: In general, investment timing options make it less likely for a project to be immediately accepted today
False
T/F: The presence of managerial, or real, options decreases the value of an investment or project
Higher equity ratio --> lower payout
Target capital structure: Higher equity ratio --> ____ payout
Tradeoff theory
Tax benefits vs bankruptcy costs should take advantage of tax benefits - use debt Avoid high bankruptcy costs - do not use too much debt
Decision tree analysis
a tree like graph or model of decisions and their possible consequences; decisions made at stages, not all at once
discount rates
all are required rates of return, the minimum acceptable rate of return determined by the riskiness of cash flows
Flexibility
alter the use of the production line
as weight of debt increases, cost of equity increases
as weight of debt increases, cost of equity....
Dividends
cash distributions to all shareholders
stock repurchases
cash distributions to some shareholders in exchange for their shares
-using the project's cost of capital is probably inappropriate -discrete scenarios
cons of decision tree
Amortized loan
constant cash flows for a finite time
Perpetuity
constant cash flows for ever
Annuity
constant cash flows for finite time
bond
constant coupons and an extra en-of-period payment
Stable dividend
constant dividends or dividends growing at the long-run growth rate
Regular dividends plus extras
constant dividends, or constant growth dividends plus nonrecurring extras in case of windfall earnings; another variation of residual dividend policy
stock
dividends, probably constant, til infinity
Expansion or contraction options
expand or contract capacity of production line; a type of growth option
-the option term to expiration is longer -the return volatility of underlying assets is greater
financial options more valuable if..
Debt to equity ratio
for ever dollar of equity from shareholders, how much is borrowed
A call (put) option
gives its holders the right, but not the obligation to buy (sell) an asset at a predetermined price within a specified period of time
tax rate cut = tax benefits declines
holding all else equal, the Trump Administration's tax reform would typically cause the firm to use less debt because...
Bankruptcy costs
if debt holders don't get paid; direct costs (assessment costs, attorney fees, fire sale...)
Default
if debt holders don't get paid; shareholders lose the firm
Exercise value
Call: Max (0, stock price - strike price)
Signaling
Investors perception of future Free Cash Flows change; Cut/termination - future free cash flows decline Initiation/increase - future free cash flows rise
Minimize cost of capital
Maximize firm value means minimizing ________
Recapitalization
Modifying capital structure without changing the firm size; issue debt, using proceeds to repurchase stock
Income Statement
A financial statement showing the revenue and expenses for a fiscal period.
Balance Sheet
A financial statement that reports assets, liabilities, and owner's equity on a specific date.
-high business risk -many potential investment opportunities (future growth potential) *small high tech companies*
Avoid bankruptcy costs by maintaining excess borrowing capacity, especially if the firm has...
unstable dividends conflicting signals doesn't appeal to any specific clientele
Cons of residual dividend policy
Irrelevance theory
Distribution doesn't influence the firm value. But could change the perception of expected FCF's; Dividends vs capital gains: different implications
Distribution = Net Income - (Target equity ratio) (total capital budget)
Distribution formula
Dividend cut / termination --> share price decline
Dividend cut / termination --> share price ___________
Dividend initiation / increase --> share price rise
Dividend initiation / increase --> share price ________
Bird in the hand theory
Dividends are less risky than capital gains; dividends reduce cash flow at manager's discretion; investors would value dividend payers more and value high-payout firms more
Tax effect theory
Dividends taxed immediately; capital gains taxes are deferred until shares sold - lower effective tax rate; also capital gains are taxed at a time of the investor's choice - more flexibility; taxes are avoided if stock held til death; investors value non-dividend-payers more
Usually no
Does distribution policy influence cost of capital?
No
Does it influence free cash flow?
Residual distribution model
First, determines the optimal capital budget; find the reinvested earnings needed for the capital budget; pay out after any leftover earnings (the residual) as either dividends or stock repurchases
Debt issue and stock repurchase do not affect price
How does debt issuance and stock repurchase affect stock price
Stock price rises after announcement of recapitalization but doesn't change in debt issuance or stock repurchase
How is stock prices affected by announcement of recapitalization
Then issue equity or pay back debt
If actual debt ratio is above the optimal level, .....
Then issue debt or repurchase stock
If actual debt ratio is below the optimal level, ....
neither influences firm value
In the absence of informational content or agency implication, how is firm value influenced
More good projects --> lower payout
Investment opportunities: More good projects --> ____ payout
Managers pros and cons
Repurchases are more flexible, avoiding sending out negative signals of dividend cut/termination Can use repurchases to achieve other goals But stable dividends attractive to some investors
Investors pros and cons
Repurchases have a tax advantage over dividends Dividends are more dependable
Higher net income --> higher payout
Profitability: Higher net income --> ______ payout
minimizes new stock issues and flotation costs (do not issue new stock as long as net income >= required equity
Pros of residual dividend policy
When managerial actions can alter a project's cash flow stream and hence its value
Real options exist when which of the following occurs?
Target Capital Structure
The optimal mix of debt, preferred stock, and common equity with which the firm plans to finance its investments. May change over time Trade-off between risk and return to achieve goal of maximizing the price of the stock
risk aversion
The tendency to prefer a sure gain of a moderate amount over a riskier outcome, even if the riskier outcome might have a higher expected payoff.
Those who need cash income prefer dividend payers
Those who need cash income prefer ________ payers
Those who want to reinvest prefer non-dividend payers
Those who want to reinvest prefer _________ payers
Time value = option price - exercise value
Time value formula
Raise capital with the same mix of debt and equity
To maintain the optimal capital structure, the firm should...
Certain real options allow companies to change capacity output in response to changing market conditions
What is most accurate about real options
It assumes capital investment is a one-time decision; in reality a a manager can take actions after the project is accepted to increase its value
Why is NPV not good enough for capital budgeting
Beta
a measure of risk
Long run distribution
a potential remedy to residual dividend policy; estimate average payout ratio 5-10 years based on average projected data