05. Corporate Finance

Question 1

What are the calculations for the yearly cash flows of expansion capital projects?

Answer 1

• Initial outlay = FCInv + WCInv
• CF = (S − C − D)(1 − T) + D = (S − C)(1 − T) + DT
• TNOCF = SalT + NWCInv − T(SalT − BT)

Question 2

What is the calculation for the yearly cash flows of replacement capital projects?

Answer 2

Same as expansion projects, except:

• Current after-tax salvage value of the old assets reduces the initial outlay.
• Depreciation is the change in depreciation if the project is accepted compared to the depreciation on the old machine.

Question 3

What are the two methods to compare projects with unequal lives that are expected to be repeated indefinitely?

Answer 3

1. Least common multiple of lives approach: Extends the lives of the projects so that the lives divide equally into the chosen time horizon.
2. Equivalent annual annuity of each project is the annuity payment each project year that has a present value (discounted at the WACC) equal to the NPV of the project.

Question 4

What are three common risk analysis approaches for capital budgeting purposes?

Answer 4

1. Sensitivity analysis: Varying an independent variable to see how the dependent variable changes, all other things held constant.
2. Scenario analysis: Considers the sensitivity of the dependent variable to simultaneous changes in all of the independent variables.
3. Simulation analysis: Uses repeated random draws from the assumed probability distributions of each input variable to generate a simulated distribution of NPV.

Question 5

What is the CAPM calculation used to determine the appropriate discount rate for a project?

Answer 5

R_project = R_f + β_project [E(R_M) − R_f]

Question 6

What does the Modigliani-Miller proposition I (no taxes) infer about capital structure?

Answer 6

Under the assumptions of no taxes, transaction costs, or bankruptcy costs, the value of the firm is unaffected by leverage changes (ie. capital structure is irrelevant).

Question 7

What does the Modigliani-Miller Proposition II (No Taxes) say about capital structure?

Answer 7

That increasing the use of cheaper debt financing serves to increase the cost of equity, resulting in a zero net change in the company’s WACC. Again, the implication is that capital structure is irrelevant.

Question 8

What does Modigliani-Miller Proposition I(w/taxes) say about capital structure?

Answer 8

The tax deductibility of interest payments creates a tax shield that adds value to the firm, and the optimal capital structure is achieved with 100% debt. WACC is minimized at 100% debt.

Question 9

What is the Pecking Order Theory?

Answer 9

States that managers prefer financing choices that send the least visible signal to investors, with internal capital being most preferred, debt being next, and raising equity externally the least preferred method of financing.

Question 10

What is the static trade-off theory?

Answer 10

The theory seeks to balance the costs of financial distress with the tax shield benefits from using debt and states that there is an optimal capital structure that has an optimal proportion of debt.

Question 11

What three factors should an analyst consider about a company’s capital structure?

Answer 11

1. Changes in the firm’s capital structure over time.
2. Capital structure of competitors with similar business risk.
3. Factors affecting agency costs such as the quality of corporate governance.

Question 12

What are the six main factors that affect a company’s dividend payout policy?

Answer 12

1. Investment opportunities
2. Expected volatility of future earnings
3. Financial flexibility
4. Tax considerations
5. Flotation costs
6. Contractual and legal restrictions

Question 13

What is the formula for the effective tax rate under double taxation?

Answer 13

Effective rate under double taxation = corporate tax rate + (1 − corporate tax rate) × (individual tax rate)

Question 14

Stable Dividend Policy:

Answer 14

• When a company tries to align its dividend growth rate with the company’s LT earnings growth rate to provide a steady dividend.
• A firm with a stable dividend policy could use a target payout adjustment model to gradually move towards its target payout.

Question 15

Constant payout ratio:

Answer 15

When a company defines a proportion of earnings that it plans to pay out to shareholders regardless of volatility in earnings (and consequently in dividends).

Question 16

Describe the Residual dividend approach:

Answer 16

When dividends are based on earnings less funds the firm retains to finance the equity portion of its capital budget

Question 17

What are the advantages of the residual dividend aproach?

Answer 17

1. Easy for the company to use;
2. Maximizes allocation of earnings to investment.

Question 18

What are the disadvantages of the residual dividend aproach?

Answer 18

1. Dividend fluctuates with investment opportunities and earnings;
2. Uncertainty causes higher required return and lower valuation.

Question 19

Longer-term residual dividend:

Answer 19

When a company forecasts its capital budget over a longer time frame and attempts to pay out the residual in steady dividend payments.

Question 20

There are five common rationales for share repurchases (versus dividends)?

Answer 20

1. Potential tax advantages(favorable caital gains tax)
2. Share price support/signaling: Management wants to signal better prospects for the firm.
3. Added flexibility: Reduces the need for “sticky” dividends in the future.
4. Offsets dilution from employee stock options.
5. Increases financial leverage by reducing equity in the balance sheet.

Question 21

True/False: A lower proportion of U.S. companies pay dividends as compared to their European counterparts.

Answer 21

True

Question 22

True/False: Globally, the proportion of companies paying cash dividends has trended upwards

Answer 22

False! Globally, the proportion of companies paying cash dividends has trended downwards.

Question 23

True/False: Stock repurchases have been trending upwards in the United States since the 1980s and in the United Kingdom and continental Europe since the 1990s.

Answer 23

True

Question 24

For both dividend and FCFE coverage, what do ratios that are below industry averages or trending downwards over time indicate?

Answer 24

Problems for dividend sustainability.

Question 25

Define Corporate Governance:

Answer 25

“the system of principles, policies, procedures, and clearly defined responsibilities and accountabilities used by stakeholders to overcome conflicts of interest inherent in the corporate form.”

Question 26

What are the two objectives of corporate governance?

Answer 26

• Eliminate/reduce conflicts of interest.
• Use the company’s assets in a manner consistent with the best interests of investors and other stakeholders.

Question 27

An effective corporate governance system will:

Answer 27

1. Define the rights of shareholders.
2. Define and communicate to stakeholders the oversight responsibilities of managers and directors.
3. Provide clear and measurable accountability for managers and directors.
4. Provide for fair and equitable treatment in all dealings between managers, directors, and shareholders.
5. Have complete transparency and accuracy in disclosures regarding operations, performance, risk, and financial position.

Question 28

What are the responsiilities of a corp’s board of directors?

Answer 28

1. Institute corporate values/governance mechanisms that will ensure business is conducted in a proficient, ethical, and fair manner.
2. Ensure firm compliance with all legal and regulatory requirements in a timely manner.
3. Create LT strategic objectives for the company that are consistent with the shareholders’ best interests.
4. Determine management’s responsibilities and how they will be held accountable. Performance should be measured in all areas of a company’s operations.
5. Evaluate the performance of the CEO.
6. Require management to supply the board with complete and accurate information in order for the board to make decisions for which it is responsible
7. Meet regularly to conduct its normal business, and meet in extraordinary session if necessary.
8. Ensure that board members are adequately trained

Question 29

What corporate governance policies should investors/analysts assess?

Answer 29

1. Codes of ethics.
2. Directors’ oversight, monitoring, and review responsibilities.
3. Management’s responsibility to the board.
4. Reports of directors’ oversight and review of management.
5. Board self-assessments.
6. Management performance assessments.
7. Director training

Question 30

In addition to traditional business risk exposures, what three additional risk factors that must be considered to get a full picture of a firm’s long-term risks?

Answer 30

1. Environmental risk: Ex, greenhouse gas emissions that may cause climate change.
2. Social risk: Such as labour rights or occupational safety.
3. Governance risk: The effectiveness of the firm’s governance structure.

Question 31

Statutory merger:

Answer 31

When the target ceases to exist and all assets and liabilities become part of the acquirer.

Question 32

Subsidiary merger:

Answer 32

When the target company becomes a subsidiary of the acquirer.

Question 33

Describe Consolidation:

Answer 33

When both companies cease to exist in their prior form and come together to form a new company.

Question 34

Describe a horizonal merger:

Answer 34

When firms in similar lines of business combine.

Question 35

Describe vertical mergers:

Answer 35

When firms combine either further up or down the supply chain.

Question 36

What is bootstrapping?

Answer 36

• A technique whereby a high P/E firm acquires a low P/E firm in an exchange of stock.
• Total earnings of the combined firm are unchanged, but the total shares outstanding are less than the two separate entities.
• The result is higher reported earnings per share, even though there may be no economic gains