401 Test 3

Question 1

Distribution Policy

Answer 1

• level of cash distributions to shareholders
• form of distribution (dividend vs repurchase)
• stability of distribution

Question 2

3 preference theories

Answer 2

Dividend irrelevance theory

• investors don’t care what form value comes from
• Modigliani-Miller
• assumptions: no taxes or brokerage costs

Dividend Preference Theory

• less risky
• reduce agency costs

Tax Effect Theory

• capital gains deferred until realized
• lower effective rate than dividends

Question 3

Clientele effect

Answer 3

• different investors prefer different policies

- consistency is most important

Question 4

Signaling hypothesis

Answer 4

• investors view dividend changes as signals for the future
• an increase in dividend leading to an increase in stock may reflect increased EPS rather than desire for dividends
• reduces asymmetric information

Question 5

Residual Dividend Policy

Answer 5

Advantages: minimize new stock issues and flotation costs

Disadvantages: variable dividends, conflicting signals, increases risk, doesn’t appeal to specific clientele

Question 6

Residual Priority

Answer 6

Capital Budget
Capital Structure
Dividend Policy

Question 7

Compromise priorities

Answer 7

Capital budget
Dividend policy
Capital structure

Question 8

Dividend payments

Answer 8

November 21: declaration date
December 17: dividend goes with stock
December 18: ex-dividend date 
December 20: holder-of-record date
January 10: payment date

Question 9

3 ways to repurchase

Answer 9

Broker purchase on open market
Tender offer to shareholders
Block (targeted) repurchase - greenmail

Question 10

Repurchase vs. Dividends

Answer 10

Repurchase:

• stock price doesn’t fall
• number of shares falls

Dividend:

• stock price falls by amount of dividend
• number of shares doesn’t change

Question 11

Repurchases

Answer 11

Advantages:

• stockholder can choose to sell or not
• avoid high dividend that cannot be maintained
• capital gains instead of higher-taxed dividend
• positive signal- stock is undervalued

Disadvantages:

• negative signal- poor investment opportunities
• IRS could impose penalties

Question 12

Optimal Price Range

Answer 12

$20-$80

Leads to stock splits or stock dividends to lower price per share

Question 13

Dividend reinvestment plan

Answer 13

Open market:

• trustee buys shares on open market
• brokerage costs reduced by volume purchases
• convenient

New stock plan:

• firm issues new stock to DRIP enrollees, keeps money and buys assets
• no fees charged, stock sold at discount

Question 14

Business vs. financial risk

Answer 14

Business:
Uncertainty in future EBIT, NOPAT, ROIC
Depends on factors like competition and operating leverage

Financial:
Concentrated on common stockholders when financial leverage is used
Depends on amount of debt and preferred stock financing

Question 15

Zero Taxes

Answer 15

Because FCF and values are equal, WACCs must be equal

-capital structure is irrelevant

Question 16

Corporate taxes

Answer 16

• interest deducted, less taxes
• VL does not equal Vu
• greater the debt use, higher the value of the firm
• rSL increases with leverage at a slower rate when taxes are considered

Question 17

APV model

Answer 17

Assumes rTS = rsU

Question 18

Implications for managers

Answer 18

Take advantage of tax benefits by using debt

Avoid financial distress costs by maintaining excess borrowing capacity

With asymmetric info, avoid issuing equity

Consider impact of capital structure choices on lenders’ and ratings agencies’ attitudes

Question 19

Operating leverage

Answer 19

The change in EBIT caused by change in quantity sold

Higher fixed costs, greater operating leverage

Question 20

6 capital structure theories

Answer 20

M+M
-proposition 1: vl=vu
Pecking Order
-internal funds, debt, equity
Trade off
-at low leverage, tax benefits outweigh bankruptcy costs
-at high levels, bankruptcy costs outweigh tax benefits
Signaling
-sell stock for overvalued and bonds for undervalued
-financial slack
Agency
Over and underinvestment problems
Market timing
-issue equity when mkt is high, debt when it is low