Capital and Financing

Question 1

What is capital budgeting?

Answer 1

Choosing how to invest one’s capital – usually, choosing how to maximize the return on investment among available opportunities

Question 2

What are independent capital projects and mutually exclusive capital projects?

Answer 2

Some available projects can be dependent in the sense that their cash flows affect each other, which can influence decisions

Also, some can be mutually exclusive, in that the nature of a project might prohibit taking a related project simultaneously

Question 3

How are post-project audits relevant to capital budgeting?

Answer 3

These audits compare the actual results of the project with its forecasted results and find reasons for any differences

Helpful both for future projects and (if the audit is known of in advance) motivating the project to be done well

Question 4

What is an important factor when considering the tax consequences of a capital project?

Answer 4

Not merely the taxes due for increased earnings, but also the “tax shield” provided by depreciation expenses on any purchased assets

Question 5

In what calculations for capital budgeting is depreciation expense included or excluded?

Answer 5

• included for the calculation of the accounting rate of return (ARR)
• excluded for calculations of payback period, internal rate of return (IRR), and net present value (NPV)

This assumes that the above calculations aren’t also including tax considerations, because then depreciation would automatically be relevant

Question 6

What is the accounting rate of return (ARR)?

Answer 6

Avg. annual accounting profit / initial investment

The accounting profit is the additional net income expected for each year of the investment – the total profit divided by the number of years
-thus, accounting profit must account for expenses like depreciation and income tax

Question 7

What are the advantages of using the accounting rate of return (ARR) for investment decisions?

Answer 7

(i) easy to calculate and understand

(ii) accounts for all the revenue over the life of the project

Question 8

What are the disadvantages of using the accounting rate of return (ARR) for investment decisions?

Answer 8

(i) neglects the time value of money

(ii) depends upon accrual basis (because it is financial income), when capital budgeting should normally use cash flows

Question 9

What is the payback method?

Answer 9

Evaluates an investment solely by measuring its “payback period,” i.e. the time it would take to recover the initial cash outflow

E.g. if purchased equipment cost $20,000 and generated $4,000 of incremental cash each year, then its payback period would be 5 years

Question 10

What are the advantages of using the payback method for investment decisions?

Answer 10

(i) easy to calculate and understand
(ii) based on cash flows
(iii) helpful if the firm values the quick return of funds

Question 11

What are the disadvantages of using the payback method for investment decisions?

Answer 11

(i) neglects the time value of money
(ii) neglects all cash flows after the payback period
(iii) neglects all profitability

Question 12

What is the internal rate of return (IRR) for an investment?

Answer 12

The rate at which the sum of future cash flows for an investment can be discounted to the initial cost of the investment

Basically, it is a time-value-of-money problem where the FV (the future cash flows) and PV (initial investment cost) are already known, and one must solve for the discount rate at which those amounts are equivalent

This discount rate is then the rate of return on the investment, and can be used to determine if the investment is sufficiently profitable

Question 13

What are the advantages of calculating the internal rate of return (IRR) for an investment?

Answer 13

(i) calculates the exact rate of return for the investment
(ii) recognizes the time value of money
(iii) accounts for all the investment’s cash flows

Question 14

What are the disadvantages of calculating the internal rate of return (IRR) for an investment?

Answer 14

(i) more difficult to calculate (can involve trial and error)
(ii) assumes that cash flows are reinvested at the rate earned by the project, which isn’t necessarily accurate

Question 15

How do you calculate an investment option’s net present value (NPV)?

Answer 15

Calculates the present value of all future cash inflows from the investment and subtracts the initial investment

This is similar to the IRR, except that a discount rate is already provided – called the “cost of capital”

Question 16

How do calculations for NPV and IRR differ?

Answer 16

They are both time-value-of-money calculations – but the IRR method starts with PV (initial investment cost) and FV (future cash flows) to calculate the discount rate, while the NPV method starts with FV (future cash flows) and the discount rate (cost of capital) to calculate the PV

Question 17

What is the desired NPV?

Answer 17

At the very least, since NPV is the present value of all future cash flows less the initial investment, it must be a positive amount for it to be profitable – otherwise the firm could just invest the money at that discount rate and make more

Question 18

What are the advantages of calculating NPV?

Answer 18

(i) assumes cash flows are reinvested at the cost-of-capital rate, which is generally accurate
(ii) recognizes the time value of money
(iii) accounts for all the investment’s cash flows

Question 19

What are the disadvantages of calculating NPV?

Answer 19

(i) more difficult to calculate

(ii) merely measures the investment against the cost of capital, without saying how much of a return it will provide

Question 20

How do you calculate an investment’s profitability index?

Answer 20

(PV of future cash flows) / (initial investment)

More meaningful for comparing alternative options than simply comparing NPVs, since NPV is the absolute amount of PV cash flows over initial investment, rather than a %

Question 21

What is the cost of capital?

Answer 21

A firm’s cost for the total capital funds it has, whether they are debt or equity

Usually calculated as the weighted average cost of capital (WACC), which takes into account the relative proportions of debt and equity

Question 22

What is the equation for a firm’s weighted average cost of capital (WACC)?

Answer 22

WACC = (E/V x Re) + (D/V x Rd x (1-Tc))

E = total equity
D = total debt
V = total value of company (debt + equity)
Re = cost of equity
Rd = cost of debt
Tc = corporate tax rate

Question 23

Why is the WACC formula structured the way it is?

Answer 23

Imagine a company funded entirely by equity; to calculate cost of capital, it would simply determine how much it costs to fund its equity (e.g. how much it must pay out in dividends), which is Re, and that would be its total cost of capital

But if it is funded by both debt and equity, then it needs to calculate the rates for each of those and appropriately weight them according to the total amount of equity and debt that the firm actually has

Moreover, since the cost of debt is interest and since interest is tax-deductible, the cost of debt must be multiplied by (1 minus the tax rate)

Question 24

In the WACC formula, how is the value of a company’s debt or equity measured?

Answer 24

Measured at market value

Question 25

In the WACC formula, how is the cost of equity or debt measured?

Answer 25

Cost of equity = includes the dividends (common and preferred) paid during the year

Cost of debt = includes the interest expense paid during the year

Question 26

What is residual income (RI)?

Answer 26

The remaining income a firm (or operating unit) has after costs of capital are subtracted

RI = operating income - (WACC x avg. invested capital)

WACC in this formula is sometimes termed an “imputed interest rate,” since it’s effectively the interest a company pays on the funds it uses to generate income

Question 27

What is economic value added (EVA)?

Answer 27

The net operating profit after taxes (NOPAT) minus the opportunity cost of capital

Essentially the same as RI, though there are sometimes very technical differences among experts

Question 28

What are investment banks?

Answer 28

Financial institutions which help with issuing securities in primary markets (e.g. as underwriters) and with selling securities in secondary markets (e.g. as brokers)

Question 29

How do investment banks aid issuers with new security issues?

Answer 29

As underwriters, they can provide consulting on what features to include in securities and what quantity to issue, and they can buy and re-sell the securities for the issuing company

Question 30

When investment banks aid issuers, how do costs compare for different types of issues?

Answer 30

As a % of proceeds, costs for smaller issues are greater than for larger issues, and costs are greater for stocks than for bonds

Question 31

If an investment bank underwrites an issue with a “best efforts” agreement, what does that mean?

Answer 31

The underwriter is obligated to make a full attempt in good faith to sell all the securities he bought from the issuer, but if he fails to do so, he is no longer responsible for them – usually these occur for higher-risk securities or markets

Different from other underwriting agreements, where the underwriter obtains full responsibility to sell the securities at the point of purchase

Question 32

What is a risk which underwriters must account for when dealing with new issues?

Answer 32

The risk that new stock might dilute the value of outstanding stock

This is usually counteracted by seeking to increase the demand for the new issue through promotion

Question 33

Why is it so important for underwriters to properly estimate the equilibrium price for a corporation’s first issuance of stock?

Answer 33

Because, though it can be difficult to estimate, a too-high price would hurt the new shareholders (as the value would later drop), while a too-low price would hurt the corporation (as it would get less paid-in capital than it should have)

Question 34

How do investment banks deal with the significant risk of underwriting large issues of stock?

Answer 34

By forming an underwriting syndicate, spreading the risk out among several underwriters

The syndicate is organized and led by a lead underwriter

Question 35

What does a lead underwriter often do for OTC stocks that he is responsible to re-sell?

Answer 35

He keeps an inventory of them (i.e. “makes a market” for them) so that the stock is easily tradeable on the secondary market

One big reason for this is because it improves relations with the original issuer

Question 36

What is the difference between privately owned and publicly owned corporations?

Answer 36

Privately owned = the total stock for the corporation is held by a small number of shareholders – also called “closely held”

Publicly held = held by a large number of shareholders

Publicly held corporations have stricter requirements

Question 37

When is a closely held corporation said to “go public”?

Answer 37

Whenever its stock is offered to the public for the first time, whether through a new issue or through the sale of such stock on the secondary market

Question 38

What are the first three of six advantages of going public?

Answer 38

(i) closely-held corporation shareholders can diversify
(ii) better disclosures (e.g. of lavish vacation or salary) can cause the corporation to behave more responsibly
(iii) diluting the original shareholders’ voting power can induce others to invest (outsiders are more willing to join en masse than individually)

Question 39

What are the last three of six advantages of going public?

Answer 39

(iv) stricter regulations (e.g. regarding audits or annual reports) can induce investors
(v) public stock is more liquid (and thus more valuable)
(vi) the company and its stock are more objectively valued, which can be helpful for many things (using stock as collateral for loans, estate tax valuation, etc.)

Question 40

What are some relevant differences in trading stock through a national exchange rather than over the counter (OTC)?

Answer 40

Stock on an exchange (“listed stock”) has to pay a listing fee but otherwise receives publicity and an improved reputation just by being listed, which can both improve the stock’s value and increase sales

Moreover, listed stock can usually be sold through a broker, whereas OTC stock is generally sold to a dealer who then resells it at a profit (rather than taking a commission, as the broker does)

Question 41

What is a term loan?

Answer 41

A type of loan with a definite repayment schedule – usually equal periodic principal payments with a variable interest rate

Ordinarily done without any intermediary – just between the borrower and the bank (or other institution)
-because of its simplicity, it does not require filing with the SEC, and later negotiated changes are simple and easy

Question 42

What is an indenture (i.e. bond indenture)?

Answer 42

A contract between an issuer and a bondholder specifying the terms of the bond
-includes a trustee responsible for ensuring the bondholder upholds its end of the bargain

Must be filed with SEC

Question 43

As regards bonds, what is a restrictive covenant?

Answer 43

A feature of an indenture that usually involves restrictions on the issuer from issuing more bonds or declaring dividends, and includes conditions of financial health that the issuer must maintain (e.g. a high current ratio)

Question 44

What is a debenture and a subordinated debenture?

Answer 44

Debenture = a bond unsecured by any collateral

Subordinated debenture = ranks lower than other creditors’ claims on corporate assets, and so is paid only after other debts are settled

Question 45

What are mortgage bonds, and do they involve subordination?

Answer 45

Mortgage bonds are bonds with real estate for collateral

Senior/primary/first mortgages have a superior claim than do junior/secondary (or tertiary, etc.) mortgages

Question 46

How do zero-coupon bonds work?

Answer 46

Zero-coupon bonds sell at a discount from their par value, so that the bondholder effectively earns interest equal to the discount over the term of the bond

Thus, though the issuer pays no cash outflow until the maturity date, it can still deduct interest expenses for tax purposes as it effectively accrues

Question 47

Who are the usual purchasers of zero-coupon bonds?

Answer 47

Pension funds and life insurance companies – based on the fact that their actuarial services are based on assumed reinvestment rates, but zero-coupon bonds do not actually have to go through the process of reinvesting any interest payments

Thus zero-coupon bonds tend not to compete with other bonds in the ordinary bond market

Question 48

What are callable, redeemable, and convertible bonds?

Answer 48

(1) callable = issuer has the right to call the bond early, i.e. shorten its maturity
(2) redeemable = bondholder has the right to redeem the bond at a particular price
(3) convertible = bondholder has the right to convert the bond to common stock

Question 49

What are coverage ratios?

Answer 49

Financial ratios showing an issuer’s ability to pay back (i.e. cover) the interest and principal on outstanding debt, in this case bonds

Question 50

What is a common coverage ratio?

Answer 50

The times interest earned (TIE) ratio
TIE = EBIT / interest payable

EBIT = earnings before interest and taxes

Thus, TIE measures how able a firm is to pay off its interest expenses with pretax income

Question 51

How do bond ratings affect the bonds market?

Answer 51

Naturally, lower bond ratings will decrease the number of investors willing to purchase such bonds

This is especially true for institutions that often have policies concerning which ratings are acceptable – and thus would not want to accept bonds barely surpassing the threshold for a given rating, since they would have to sell it if it were downgraded while they held it

Question 52

If a company fears it might receive a poor rating for its bonds, what is one action it might be able to take?

Answer 52

Before issuing bonds, it can finance itself with other short-term debt to try to regain its financial status, then undergo a review and issue bonds

Question 53

In what way does preferred stock have characteristics of both equity and debt?

Answer 53

Equity = because it involves a claim to assets – in fact, a higher (“preferred”) claim than common stock

Debt = because it can be entitled to fixed payments (dividends), if it is cumulative (as it usually is)

Question 54

How do preferred stock dividends work?

Answer 54

Cumulative preferred stock entitles its holders to yearly dividends – any unpaid dividends from one year are “in arrears” for later years, though they do not accrue interest

Further, unless preferred dividends are paid, common-stock dividends cannot be paid

Question 55

How does the yield for preferred stock ordinarily compare to bonds of a similar grade?

Answer 55

Ordinarily it is higher – which is partly to offset the risk for preferred stockholders that the fixed dividend payment will not be paid annually

Question 56

Can preferred stock be callable or convertible?

Answer 56

Yes to both – if callable, the issuer has the option to call it; if convertible, the holder can convert it to common stock

Question 57

What is participating preferred stock?

Answer 57

Preferred stock with a fixed amount of dividends to which holders are entitled plus a participation in any further dividends to which common stockholders are entitled beyond this fixed amount

E.g. 3% fully participating preferred stock will earn 3% dividends yearly, but in years where common stockholders gain dividends of 5%, the fully participating preferred stockholders will also gain 2% more in dividends
-if there were 3% partially participating preferred stock, then such stockholders would be entitled to a portion of the common stock dividends exceeding 3%, not all of it

Question 58

How should the risk for a firm’s capital structure be distinguished?

Answer 58

Between business risk and financial risk

Business risk = risk in operations independent of debt, i.e. risk in predictions for EBIT

Financial risk = additional risk due to debt

Question 59

What are some factors which influence a company’s EBIT, and thus its business risk?

Answer 59

(i) level of demand
(ii) volatility in sales prices
(iii) volatility in input prices
(iv) operating leverage

Question 60

What is operating leverage?

Answer 60

The degree to which changes in sales affect changes in EBIT – depends on how much of a company’s costs are fixed costs

Higher operating leverage –> higher business risk

Question 61

What is the formula for the degree of operating leverage (DOL) a company has?

Answer 61

DOL = Δ EBIT / Δ sales

Both of these changes are % changes, not absolute

Question 62

What is financial leverage?

Answer 62

The degree to which changes in EBIT affect changes in common stockholders’ return – depends on how much capital is financed by debt and preferred stock (i.e. fixed-income securities) rather than common stock

Higher financial leverage –> higher financial risk

Question 63

What is the formula for the degree of financial leverage (DFL) a company has?

Answer 63

DFL = Δ EPS / Δ EBIT

Both of these changes are % changes, not absolute

Question 64

What is the formula for the degree of combined leverage (DCL) a company has?

Answer 64

DCL = DOL x DFL = Δ EPS / Δ sales

Because DOL includes Δ EBIT in the numerator and DFL includes it in the denominator, they cancel out for DCL

Question 65

How do stock prices behave in relation to the debt a corporation assumes?

Answer 65

They tend to first rise as the company begins borrowing, then they peak and decrease as the debt becomes too high

The key is to find a balance between the benefits of debt (including that interest is tax-deductible) and the increased risks of default as debt increases

Question 66

How does the stability of sales influence the decision to assume debt?

Answer 66

More stable sales –> less risk in assuming debt

E.g. it is riskier for a car dealership to assume debt than for a utilities company

Question 67

How does the presence of assets influence the decision to assume debt?

Answer 67

The more valuable assets that are offered to creditors as collateral, the more favorable debt a business can acquire

Question 68

How do tax rates influence the decision to assume debt?

Answer 68

Because interest expenses are tax-deductible, higher tax rates improve the benefits of assuming debt rather than obtaining equity financing

Question 69

How does a desire for control over a corporation influence the decision to assume debt?

Answer 69

If a corporation is funded entirely by equity, it is more prone to a takeover or to a shift in voting power – but this risk is decreased by debt financing

Question 70

What are the two risks to balance concerning a company’s dividends?

Answer 70

If too few dividends are paid out, stockholders are displeased and will feel less certain about the stock’s value

If too many dividends are paid out, the corporation will not retain enough earnings to grow

Question 71

As regards dividend policy, what are the payout ratio and the plowback ratio?

Answer 71

Payout ratio = amount of dividends paid out, as a % of earnings

Plowback ratio = amount of earnings retained (i.e. NOT distributed as dividends), as a % of earnings

Question 72

What is the residual theory for dividend management?

Answer 72

Basically holds that a corporation should first utilize whatever equity is necessary to support its optimal capital structure, paying dividends out of whatever is left over (residual)

There are many things it doesn’t properly account for, however

Question 73

What are some different constraints within which a dividend policy should be placed?

Answer 73

(i) bond indentures may limit dividend distributions
(ii) accumulated earnings taxes may require dividends to be paid out (as the tax forbids hoarding of retained earnings)
(iii) dividends cannot exceed retained earnings

Question 74

As regards a corporation’s dividends policy, what is the clientele effect?

Answer 74

Different investors will want a different dividends policy, and investors who like a corporation’s dividends policy will naturally desire to buy that firm’s stock – i.e. become that corporation’s “clientele,” so to speak

Question 75

What other factors is the clientele effect related to?

Answer 75

Investors cannot change stocks for free (e.g. capital gains taxes, brokerage fees), so even if they see a company with a dividend policy they prefer, they may not necessarily be willing to acquire it

Further, if a smaller number of investors like a corporation’s dividend policy, the decreased demand for the stock will lower the stock’s value and make all investors less willing to acquire it

Question 76

What are legal lists, and how do they relate to dividends?

Answer 76

Each state can make a list of approved corporations in which certain fiduciary institutions are legally required to invest, if they choose to invest
-because presence on a legal list means the company is a safe investment, other investors also choose to follow these lists too

A characteristic which helps companies get and stay on these lists is that they don’t decrease dividends – which obviously provides a big incentive for companies not to do so

Question 77

Why are dividend increases good predictions of future success for a business?

Answer 77

Management is ordinarily very unwilling to decrease dividend prices, so if they decide to increase them, it must be (or should be) with a lot of confidence

Question 78

What is a stable dividend policy?

Answer 78

A policy that rarely or never decreases dividends and decides to increase them only when there is confidence in future income to do so

Often increases dividends (when it does) only by a set percentage

Question 79

For dividends, what is a constant payout ratio?

Answer 79

A policy to pay out the same % of earnings in dividends yearly

A very uncommon policy

Question 80

What are extra dividends?

Answer 80

Infrequent (or less frequent) dividends that a company pays out only when it has exceptional earnings

Often done on top of a more consistent amount of regular dividends which are paid out more frequently

Question 81

What are residual dividends?

Answer 81

Dividends paid out only when all other equity needed for expansion has already been reinvested in the company

More common for startup and high-growth businesses

Question 82

What are the four significant dates for dividends?

Answer 82

(1) declaration date – formally declared by board of directors, dividends become a liability
(2) record date – establishes recipients of dividends
(3) ex-dividend date – the market price decreases by the price of the dividend (since the next buyer wouldn’t be entitled to the dividend)
(4) payment date – dividends are actually paid

Question 83

What is a dividend reinvestment plan (DRIP)?

Answer 83

A plan whereby stockholders can automatically choose to reinvest dividends in more stock – thus forgoing some or all of the costs of such a transaction

Question 84

What is the difference between an outstanding stock DRIP and a new stock issue DRIP?

Answer 84

Outstanding = a trustee purchases the outstanding stock and then sells them to stockholders participating in the DRIP, giving them reduced brokerage costs

New issue = new stock is issued to the stockholders participating in the DRIP, done without any brokerage fees and sometimes with a discount too

Question 85

How might corporations provide cash to stockholders as an alternative to dividends?

Answer 85

Stock repurchases – buying some (or all) of stockholders’ shares, allowing them to benefit from the lower tax rate on capital gains than on dividends

Question 86

What are options?

Answer 86

Derivatives involving a right to buy or sell a given asset in the future

Because they are based on a price’s remaining available to an investor for a period of time, they are thus valuable for volatile stocks or in a volatile market

Question 87

What are call options and put options?

Answer 87

Call options give the holder a right to buy an asset, while put options give the holder a right to sell an asset

Question 88

What are two types of options which corporations sell?

Answer 88

Convertible securities and warrants

Technically, it is the conversion feature of convertible securities that is the option, not the security itself

Question 89

What are convertible securities?

Answer 89

Securities which the holder has the right to exchange for another kind of security

Common kinds are convertible bonds and convertible preferred stock

Question 90

Do convertible securities, when converted, increase the capital of the issuing corporation?

Answer 90

No, since convertible securities simply become other securities, there is no additional inflow of capital for the corporation – just a transfer of capital from one category to another (e.g. debt to equity)

Question 91

What is an advantage of selling convertible securities?

Answer 91

The issuer can effectively use them to sell common stock at above-market price, since the price of a security convertible to common stock will necessarily be higher than a mere common stock

However, this can backfire if stock prices increase a lot

Question 92

What is a stock warrant?

Answer 92

A right to purchase an amount of stock (and thus a call option)

Different from convertible securities, in that warrants can be “detached” (though not always) from stocks with which they are sold, sold by themselves on the market – and also in that warrants provide new capital

Question 93

Do warrants have any value if the stock price is currently lower than the warrant’s exercise price?

Answer 93

Yes, because (a) the stock could still increase in value in the future, and because (b) an investor’s loss, if he is depending on such an increase, would be minimized to the warrant’s value rather than the stock’s value

In other words, even warrants that would not rationally be exercised at present have intrinsic value due to (a) a potential for capital gain and (b) a loss limitation

Question 94

Can corporations benefit from warrant holders who exercise their warrants to get stock for below the market price?

Answer 94

Yes, since growing companies often need new capital, and thus still stand to benefit from warrants being exercised

Question 95

What is the difference between a warrant’s exercise value and its actual value?

Answer 95

Exercise = value of a warrant due to the difference between the exercise price and the market price of the stock, multiplied by the number of shares
-this would be negative if the exercise price is above the market price

Actual = the market price of the warrant itself

Question 96

How does the actual value of a warrant relate to the stock’s market price?

Answer 96

It increases as the stock’s market price increases – yet the sum of the warrant’s actual value + the warrant’s exercise price will not exceed the stock’s market price as much

Question 97

What is an example of the sum of a warrant’s actual value and exercise price decreasing in relation to a rising stock market price?

Answer 97

Yr. 1 = stock is worth $18/share, warrant is worth $3/share, and warrant exercise price is $20/share
Yr. 2 = stock is worth $36/share, warrant is worth $19/share (warrant exercise price must remain the same)

Sum of yr. 1 warrant actual value + exercise price = $23/share –> $5 greater than market price
Sum of yr. 2 warrant actual value + exercise price = $39/share –> $3 greater than market price

This sum will always be greater than the market price (since the warrant always provides more value than purchasing the stock immediately), but the degree to which it exceeds the market price will lower as the stock price increases

Question 98

Why does the sum of a warrant’s actual value and exercise price decrease in a relation to a rising stock market price?

Answer 98

Due to both (a) decreased leverage and (b) an increased risk of loss

Question 99

How does decreased leverage cause the sum of a warrant’s actual value and exercise price to decrease in relation to a rising stock market price?

Answer 99

Since an increasing stock market price would require an investor to pay more for a warrant, the return on investment for the warrant is less likely to be as high – the increase in stock price (i.e. the return) would not be as great in relation to the increase in the investment cost (i.e. the cost of the warrant)

Question 100

How does an increased risk of loss cause the sum of a warrant’s actual value and exercise price to decrease in relation to a rising stock market price?

Answer 100

As the actual value of a warrant increases, the investor in that warrant would have that much more money to lose

E.g. if a warrant is worth $1/share, then the investor can only lose $1/share if the market price remains too low, but if the warrant is worth more, this hurts the investor more