Corporate Finance Flashcards

Question

MM Proposition 1

Answer 1

(No taxes): value of a firm is unaffected by it's capital structure 1. Capital markets are perfectly competitive (no taxes or transactions costs) 2. Investors have the same cash flow expectations 3. Riskless borrowing and lending 4. VL = VU (value of levered firm = value of unlevered firm)

Answer 2

(No taxes): cost of equity increases linearly as a company increases debt 1. Still assumes a perfect market 2. Debt cost is lower than equity cost but it increases equity cost **3. No change in the firms WACC**

Answer 3

(with taxes): value is maximized at 100% debt 1. Get a tax shield provided by debt

Answer 4

(With Taxes): WACC is minimize at 100% Debt 1. WACC declines as leverage increases

Answer 5

Definition: managers know more about the company than the creditors 1. Issuing bonds is a good sign 2. Issuing equity is typically viewed as a negative signal that managers believe a firm’s stock is overvalued.

Answer 6

Purpose: Balancing the equity and debt to obtain the optimal structure **Formula: VL = VU + (t x d) - PV** a. Optimal level is when the cost of financial distress = the benefits of the tax shield

Answer 7

_Use of Total Debt Maturity of Debt_ Strong legal system Lower Longer Less asymmetry info Lower Longer Low dividend taxes Lower N/A More liquid stock mkt N/A Longer Reliance on bank system Higher N/A Higher inflation Lower Shorter

Answer 8

1. **MM Dividend Irrelevance;** in a perfect world without taxes dividends don't matter. You can take dividends and purchase more stock if you want. 2. **Bird-in-Hand (dividend preference theory)**: investors prefer the certainty of cash over capital gains 3. **Tax aversion**: Investors prefer to not receive dividends because they are taxed at a higher rate

Answer 9

1. Increase = good 2. Decrease = bad 3. Initiation = could be negative/positive

Answer 10

Definition: Different groups of investors desire different levels of dividends 1. High-tax-bracket investors want low dividend payouts 2. Institutional investors want high paying dividends (may be required)

Answer 11

∆P = D(1 - Td) / (1 - Tcg)

Answer 12

Managers may have an incentive to overinvest because increasing dividends would limit their free cash

Answer 13

1. Investment Opportunities: many high NPV projects would keep dividends low 2. Expected Volatility of future earnings: more volatile earnings less likely of an increase to dividends 3. Financial flexibility: firm may purchase back stocks instead of dividends 4. Tax considerations: capital gains (only taxed when sold) vs dividends (tax immediately) 5. Flotation costs: new stock issues have 3-7% of fees (retained earnings have no fee)

Answer 14

Effective tax rate = corporate tax rate + (1 - corporate tax rate)(individual tax rate) Imputation tax system: all taxes are effectivey paid at the shareholder rate

Answer 15

1. Stable dividend: expected dividend = prev D + (expected increase in EPS \* payout ratio \* adj factor) a. Adj factor = 1 /# of years 2. Constant dividend payout ratio: a specific payout ratio is applied to all earnings (seldom used) 3. Residual Dividend Model

Answer 16

**Purpose:** dividends are based on earnings minus the funds retained to finance equity **Step 1**: identify the optimal capital budget **Step 2**: Use earnings to fund the amount of equity needed to remain optimal **Step 3**: Pay out dividends with the "residual" earnings (what is left) Example: Debt-to-equity ratio of 0.5, $1,000 earnings, $900 of planned capital spending 1. Debt-to-equity ratio of 0.5 implies 1/3 debt and 2/3 equity 2. Need to spend 900: so 300 is debt and 600 is equity 3. Then take earnings - equity (1000 - 600) so 400 could be paid out for dividends

Answer 17

a. Potential tax advantages b. Share price support/signaling c. Added flexibility d. Offset dilution from employee stock options e. Increased financial leverage

Answer 18

Dividend payout ratio = dividends / net income Analysis: higher = bad, most likely will cut dividend

Answer 19

Dividend coverage ratio = net income / dividends

Answer 20

FCFE coverage ratio = FCFE / (dividends + share repurchases) Analysis: Less than one is unsustainable

Answer 21

only social responsibility of a business is to increase profits within the rules

Answer 22

1. Predictability: how accurately a company can forecast industry factors 2. Malleability - can the company and its competitors influence the industry

Answer 23

Strengths 1. Not dependent on a TV 2. It is a minority position 3. Works for non-dividend payers and negative CF Weakness 1. Data can be manipulated

Answer 24

business must weigh the consequences to society for their actions. Seeks to produce the highest good for the largest number of people. Think cost-benefit analysis (but some difficult to measure)

Answer 25

1. People deserve dignity and respect 2. People are different from other factors of production

Answer 26

1. Cannot violate the rights of others. 2. People have fundamental rights and privileges.

Answer 27

focus on distribution of economic output. Justice is met if all participants would agree the rules are fair. Under the "veil of ignorance". A sweatshop may be illegal in the US but an improvement for those in a poor country

Answer 28

Eliminate or reduce conflicts of interest use assets for the best interests of investors

Answer 29

1. Define the rights 2. Define the oversight responsibilities of managers and directors 3. Provide fair treatment between managers, directors, and shareholders 4. Transparency and accuracy

Answer 30

1. Complies with all legal and regulatory requirements 2. Create long-term strategic objectives 3. Determine managements responsibilities 4. Evaluate the CEO 5. Ensure board members are adequately trained

Answer 31

1. 75% of board members should be independent 2. CEO should not be chairman 3. Directors are not on more than 2-3 boards 4. Board elections are NOT staggered and done annually 5 Most senior manager pay is tied to performance 6. Have an audit committee with only independent members and meets with auditors annually 7. Should hire independent legal counsel 8. Responding to shareholder proxy votes

Answer 32

a. Horizontal: both in the same industry b. Vertical Merger: moving up or down the supply gain (restaurant buying a farm) c. Conglomerate Merger: both in different industries

Answer 33

the combined firmed has less shares so it increases EPS even though nothing was added

Answer 34

1. Pioneer/development: early stages a. Horizontal and conglomerate mergers 2. Rapid Growth: higher profit margins and rapid growth. a. Horizontal and conglomerate mergers 3. Mature Growth: more competition, lower profit margins, above average growth a. Looking for synergies so vertical and horizontal mergers 4. Stabilization: Growth is close to GDP a. seeking mergers to generate economies of scale and lower costs. b. Look to acquire small companies 5. Decline phase

Answer 35

1. Submit a proposal to the BOD - this is called a bear hug 2. If doesn't work go directly to the shareholders i. Tender offer: the acquirer offers to buy the shares ii. Proxy battle: try to vote in new board of directors

Answer 36

a. Poison Pill: gives shareholders the right to purchase shares at a discount. b. Poison Put: gives the bondholders the option to demand immediate repayment c. Restrictive takeover laws: some states are more strict than others d. Staggered board e. Restrictive voting rights f. Supermajority voting g. Fair price amendment: fair price based on a formula h. Golden parachutes

Answer 37

a. Greenmail: buying back the stock the acquirer has at a premium b. Share repurchase: tendering an offer to purchase its own shares back c. Leveraged recapitalization: leveraging to purchase shares back d. Crown Jewel: selling a major asset to a third party e. Pac-man: take over the acquirer instead f. White Knight Defense: a friendly third party starts a bidding war g. White squire defense: friendly third party buys a minority stake

Answer 38

Analysis: \< 1000 means industry is competitive 1,000 - 1,800 = moderately concentrated, if the move was over 100 points it will be challenged 1,800 = 1,800 concentrated and it will be challenged, any move over 50 points wont be allowed

Answer 39

**_Advantages_** 1) Easy to model cash flows 2) Model is easy to customize 3) Based on forecasts **_Disadvantages_** 1) Hard when cash flow is negative 2) Estimating cash subject to error 3) Discount rate changes over time

Answer 40

1) Assumes other companies valuations were accurate 2) May not be enough transactions 3) Hard to account for synergies

Answer 41

Vat = Va + Vt + S - C

Answer 42

GAINt = TP = Pt - Vt

Answer 43

GAINa = S - TP = S - (Pt - Vt)

Answer 44

a. Equity carve-outs: create a new, independent company by giving away equity interest and will do an IPO b. Spin-offs: also create a new company but are distributed proportionately to the current shareholders c. Split-offs: allows shareholders to receive new shares of a division in exchange for a portion of their shares in the main company

Answer 45

Formula: n(MS \* 100)² Example: supposed 20 firms, each have 5% market share. 19 and 20 decide to merge Pre-Merger: 20 (.05 \* 100)² = 500 Post-Merger: 18(.05 \* 100)² + 1(.10 \* 100)² = 550