Corporate Finance

Question 1

Explain the Modigliani–Miller propositions (No Taxes) regarding capital structure.

Answer 1

MM Proposition I (No Taxes): says capital structure is irrelevant. Under the assumptions of no taxes, transaction costs, or bankruptcy costs, the value of the firm is unaffected by leverage changes.

MM Proposition II (No Taxes): concerning the cost of equity and leverage says 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 2

Explain the effects on costs of capital under MM Proposition (With Taxes) regarding effect of taxes and debt.

Answer 2

According to MM Proposition I (With Taxes): 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.

MM Proposition II (With Taxes): says that WACC is minimized at 100% debt.

Question 3

Explain factors an analyst should consider in evaluating the effect of capital structure policy on valuation.

Answer 3

Costs of financial distress are the increased costs companies face when earnings decline and the company has trouble paying its fixed costs.

Higher amounts of leverage result in greater expected costs of financial distress.

Question 4

What is the net agency costs of equity?

Answer 4

The net agency costs of equity are the costs associated with the conflict of interest between a company’s managers and owners and consist of three components:

• Monitoring costs.
• Bonding costs.
• Residual losses.

Question 5

What is the cost of asymmetric information and how does it effect Pecking order theory?

Answer 5

Costs of asymmetric information: result from managers having more information about a firm than investors. The cost of asymmetric information increases as more equity is used in capital structure. Hence the pecking order theory.

Pecking order theory: states that managers prefer financing choices that send the least visible signal to investors, with

• internal capital being most preferred
• debt being next
• raising equity externally the least preferred method of financing.

Question 6

What is the static trade-off theory?

Answer 6

The static trade-off 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.

Removing both MM’s assumptions of no taxes and no costs of financial distress, there comes a point where the incremental value added by the tax shield is exceeded by the additional expected costs of financial distress, and this point represents the optimal capital structure.

Managers typically have goals to maintain a certain minimum credit rating when determining their capital structure policies because the cost of capital is tied to debt ratings; lower ratings translate into higher costs of capital.

Question 7

What are some factors an analyst should consider when evaluating a firm’s capital structure?

Answer 7

Factors an analyst should consider when evaluating a firm’s capital structure include:

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

Question 8

What are the major factors that influence international differences in financial leverage?

Answer 8

Major factors that influence international differences in financial leverage include:

• Institutional, legal, and taxation factors.
• Financial market and banking system factors.
• Macroeconomic factors.

Question 9

Describe the expected effect of regular cash dividends, stock dividends, and stock splits on shareholders’ wealth and a company’s financial ratios.

Answer 9

Cash dividend payments: reduce cash as well as stockholders’ equity. This results in a lower quick ratio and current ratio, and higher leverage ratios.

Stock dividends (and stock splits): leave a company’s capital structure unchanged and do not affect any of these ratios.

In the case of a stock dividend, a decrease in retained earnings is offset by an increase in contributed capital, leaving the value of total equity unchanged.

Question 10

Compare the 3 theories investor preference of dividend policy.

Answer 10

MM’s dividend irrelevance theory: holds that in a no-tax/no-fees world, dividend policy is irrelevant since it has no effect on the price of a firm’s stock or its cost of capital, because individual investors can create their own homemade dividend.

Dividend preference theory: says investors prefer the certainty of current cash to future capital gains.

Tax aversion theory: states that investors are tax averse to dividends and would prefer companies instead buy back shares, especially when the tax rate on dividends is higher than the tax rate on capital gains.

Question 11

Describe the signal of information that dividend initiations, increases, and decreases may convey.

Answer 11

The signaling effect of dividend changes is based on the idea that dividends convey information about future earnings from management to investors.

In general, unexpected increases are good news and unexpected decreases are bad news as seen by U.S. investors.

Question 12

What are the two types agency costs and how may they affect a company’s dividend payout policy?

Answer 12

Agency conflict between shareholders and managers: can be reduced by paying out a higher proportion of the firm’s free cash flow to equity so as to discourage investment in negative NPV projects.

Agency conflict between shareholders and bondholders: occurs when shareholders can expropriate bondholder wealth by paying themselves a large dividend. Agency conflict between bondholders and stockholders is typically resolved via provisions in bond indenture.

Question 13

What are the 6 primary factors affect a company’s dividend payout policy?

Answer 13

Investment opportunities: affects the residual income available to pay as dividends.

Expected volatility of future earnings: firms are more cautious in changing dividend payout in the presence of high earnings volatility.

Financial flexibility: Firms may not increase dividends so as not to be forced to continue paying those dividends in the future.

Tax considerations: In the presence of differential tax rate on capital gains versus dividends, companies may structure their dividend policy to maximize investors’ after-tax income.

Flotation costs: increases the cost of external equity as compared to retained earnings and would motivate firms to have a lower dividend payout.

Contractual and legal restrictions: Dividend policy may be affected by debt covenants that the firm has to adhere to. Legal restrictions in some jurisdictions limit the dividend payout of a firm.

Question 14

Calculate and interpret the effective tax rate under double taxation, dividend imputation, and split-rate tax systems.

Answer 14

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

A split-rate system: has different corporate tax rates on retained earnings and earnings that are paid out in dividends.The effective tax rate is computed the same way as double taxation but we use the corporate tax rate for distributed income as the relevant corporate tax rate in the double taxation formula.

Tax imputation system: taxes are paid at the corporate level but are used as credits by the stockholders. Hence, all taxes are effectively paid at the shareholder’s marginal tax rate.

Question 15

Compare stable dividend with a constant dividend payout ratio.

Answer 15

Stable dividend policy: A company tries to align its dividend growth rate with the company’s long-term 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.

Constant payout ratio: Company defines a proportion of earnings that it plans to pay out to shareholders regardless of volatility in earnings.

Question 16

Compare share repurchase methods.

Answer 16

Open market transactions: The firm buys back its shares in the open market.

Fixed price tender offer: The firm buys a predetermined number of shares at a fixed price, at a premium over the current market price.

Dutch auction: A tender offer where the company specifies a range of prices rather than a fixed price. Bids are accepted (lowest price first) until the desired quantity is filled.

Repurchase by direct negotiation: Purchasing shares from a major shareholder, often at a premium over market price.

Question 17

Compare the effect of a share repurchase on earnings per share when:

1. The repurchase is financed with the company’s surplus cash
2. The company uses debt to finance the repurchase.

Answer 17

Repurchases made using a company’s surplus cash: Will lower cash and shareholders’ equity and, therefore, increase the firm’s leverage. Earnings per share may increase because there will be fewer shares outstanding.

The company uses debt to finance the repurchase: EPS will increase if the after-tax funding cost is less than the earnings yield. However, the firm will then also have higher leverage and, therefore, a higher cost of capital, so an increase in EPS will not automatically lead to an increase in share price or in shareholder wealth.

Question 18

Calculate the effect of a share repurchase on book value per share.

Answer 18

After a stock repurchase, the number of outstanding shares will decrease and the book value per share (BVPS) is likely to change as well. If the price paid is higher (lower) than the pre-repurchase BVPS, the BVPS will decrease (increase).

Question 19

What are 5 common rationales for share repurchases versus dividends?

Answer 19

Potential tax advantages: When capital gains are taxed favorably as compared to dividends.

Share price support/signaling: Management wants to signal better prospects for the firm.

Added flexibility: Reduces the need for “sticky” dividends in the future.

Offsets dilution: from employee stock options.

Increases financial leverage: by reducing equity in the balance sheet.

Question 20

Describe broad trends in corporate payout policies.

Answer 20

Global trends in corporate payout policies:

• A lower proportion of U.S. companies pay dividends as compared to their European counterparts.
• Globally, the proportion of companies paying cash dividends has trended downwards.
• Stock repurchases have been trending upwards in the United States since the 1980s and in the United Kingdom and continental Europe since the 1990s.

Question 21

Identify characteristics of companies that may not be able to sustain their cash dividend.

Answer 21

For both dividend and FCFE coverage, ratios that are below industry averages or trending downwards over time indicate problems for dividend sustainability.

Question 22

Describe global variations in ownership structures and the possible effects of these variations on corporate governance policies and practices.

Answer 22

Dispersed ownership: none of the many shareholders has control over the corporation.

Concentrated ownership: controlling shareholders (minority or majority) can exercise control over the company.

Vertical (pyramid) ownership: a company has a controlling interest in multiple holding companies, and those holding companies hold controlling interests in operating companies.

Horizontal ownership: refers to companies with shared business interests that cross-hold the shares of each other.

Dual-class shares: give superior (or sole) voting rights to one share class and lesser (or no) voting rights to another.

Question 23

What are the 2-types of board of directors structures?

Answer 23

The board of directors of a company can be structured either as a

• One-tier board: consisting of internal (executive) and external (non-executive) directors
• Two-tiered board: where the management board is overseen by a supervisory board.

Question 24

What is CEO duality?

Answer 24

CEO duality: is the situation where the CEO is also the company’s chairperson of the board is called CEO duality.

CEO duality raises the concern that, relative to having independent chairperson and CEO roles, oversight and monitoring roles of the board could be compromised.

Question 25

Describe how ESG-related risk exposures and investment opportunities may be identified and evaluated.

Answer 25

There are three main approaches for identifying a company’s ESG factors:

1. ESG data providers
2. industry organizations
3. proprietary methods

ESG information and metrics are inconsistently reported by companies, and such disclosure is voluntary. This makes it difficult for analysts to identify useful and relevant ESG factor data.

In fixed-income analysis: ESG considerations are primarily concerned with downside risk.

In equity analysis: ESG is considered both in regards to upside opportunities and downside risk.

Question 26

Evaluate ESG risk exposures and investment opportunities related to a company.

Answer 26

Analysts evaluate ESG factors and then make corresponding adjustments to estimate a discount rate or risk premium.

ESG factor adjustments: related to income statement and statement of cash flows relate to projected revenues, costs, margins, earnings, capex, or other line items.

ESG adjustments to a firm’s balance sheet often involve evaluating potential impairment of the firm’s assets.

Question 27

What are the 3-Forms of Mergers?

Answer 27

Statutory merger: the target ceases to exist and all assets and liabilities become part of the acquirer.

Subsidiary merger: the target company becomes a subsidiary of the acquirer.

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

Question 28

What are the 3-Types of Mergers?

Answer 28

Horizontal mergers: where firms in similar lines of business combine.

Vertical mergers: which combine firms either further up or down the supply chain.

Conglomerate mergers: which combine firms in unrelated businesses.

Question 29

Explain common motivations behind M&A activity.

Answer 29

Common motivations behind M&A activity include:

• achieving synergies
• more rapid growth
• increasing market power
• gaining access to unique capabilities
• diversification
• personal benefits for managers
• tax benefits
• unlocking hidden value for a struggling company
• achieving international business goals
• bootstrapping earnings

Question 30

Explain common reasons for restructuring “devist”.

Answer 30

Reasons why a company may divest assets include:

• A division no longer fitting into management’s strategy.
• Poor profitability for a division.
• Reverse synergy.
• To receive an infusion of cash.

Question 31

Explain, based on industry life cycles, the relation between merger motivations and types of mergers.

Answer 31

In the embryonic and growth phases: companies look to mergers to provide additional capital or capacity for growth; conglomerate and horizontal mergers are common.

In the shakeout and mature phases: firms are looking for synergies to reduce costs; horizontal and vertical mergers are common.

In the decline phase: companies are typically looking for new growth opportunities to survive; all three merger types are common.

Question 32

What is the difference between a stock purchase or an asset purchase?

Answer 32

A merger transaction may take the form of a stock purchase or an asset purchase.

In a stock purchase: the target’s shareholders receive cash or shares of the acquiring company’s stock in exchange for their shares of the target.

In an asset purchase: payment is made directly to the target company in return for specific assets.

Question 33

What is the differences between a “friendly or hostile” merger?

Answer 33

The target company’s management will either view a merger as being friendly or hostile.

In a friendly merger: the acquirer and target work together to perform due diligence and sign a definitive merger agreement before submitting the merger proposal to the target’s shareholders.

In a hostile merger: the acquirer seeks to avoid the target’s management through a tender offer or proxy battle.

Question 34

What are the differences of the payment methods of a merger transcation?

Answer 34

The method of payment in a merger transaction may be cash, stock, or a combination of the two.

Cash offerings are straight forward.

In a stock offering: the exchange ratio determines the number of the acquirer’s shares that each target company shareholder will receive.

Question 35

Identify and explain pre-offer takeover defense mechanisms.

Answer 35

Pre-offer defense mechanisms to avoid a hostile takeover include:

• poison pills
• poison puts
• reincorporating in a state with restrictive takeover laws
• staggered board elections
• restricted voting rights
• supermajority voting
• fair price amendments
• golden parachutes

Question 36

Identify and explain post-offer takeover defense mechanisms.

Answer 36

Post-offer defense mechanisms to avoid a hostile takeover include:

• the “just say no” defense
• litigation
• greenmail
• share repurchases
• leveraged recapitalizations
• the crown jewel defense
• the Pac man defense
• finding a white knight or white squire

Question 37

Evaluate a takeover bid and its effects on the target shareholders versus the acquirer shareholders.

Answer 37

The value of the combined firm after a merger deal is a function of synergies created by the merger and any cash paid to shareholders as part of the transaction, or VAT = VA + VT + S − C.

In a merger transaction, target shareholders capture the takeover premium, which is the amount that the price paid exceeds the target’s value: GainT = TP = PT − VT.

The acquirer in a merger transaction captures the value of any synergies created in the merger less the premium paid to the target, or GainA = S − TP = S − (PT − VT).

Question 38

Explain how price and payment method affect the distribution of risks and benefits in M&A transactions.

Answer 38

In a cash offer: the acquirer assumes the risk and receives the potential reward from the merger synergies,

In a stock offer: some of the risks and potential rewards from the merger shift to the target firm.

Question 39

Describe characteristics of M&A transactions that create value.

Answer 39

Empirical evidence shows that targets receive the majority of benefits in a merger deal. In the years following a deal, acquirers tend to underperform their peers, which suggests that estimated synergies are not realized.

Acquirers are likely to earn positive returns on a deal characterized by:

• Strong buyer: Acquirers that have exhibited strong performance in the prior three years.
• Low premium: The acquirer pays a low takeover premium.
• Few bidders: The lower the number of bidders, the greater the acquirer’s future returns.
• Favorable market reaction: Positive market price reaction is a favorable indicator for the acquirer.

Question 40

Compare and contrast “divestitures” equity carve-outs, spin-offs, split-offs, and liquidation.

Answer 40

Equity carve-out: Creates a new, independent company by giving an equity interest in a subsidiary to outside shareholders. The subsidiary becomes a new legal entity whose management team and operations are separate from the parent company.

Spin-off: Creates a new, independent company that is distinct from the parent company, but unlike in carve-outs, shares are not issued to the public but are instead distributed proportionately to the parent company’s shareholders.

Split-off: Allows shareholders to receive new shares of a division of the parent company in exchange for a portion of their shares in the parent company.

Liquidation: Breaks up a firm and sells its assets piece by piece. Most liquidations are associated with bankruptcy.

Question 41

How are the cash flows of expansion and replacement capital projects calculated and evaluate how the choice of depreciation method affects those cash flows.

Answer 41

For an expansion project:
Initial outlay = FC_Inv + WC_Inv
CF = (S − C − D)(1 − T) + D = (S − C)(1 − T) + DT
TNOCF = Sal_T + NWC_Inv − T(Sal_T − BV_T)

For a replacement project: the cash flows are the same as the previous 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.
• Depreciation schedules affect capital budgeting decisions because they affect after-tax cash flows. In general, accelerated depreciation methods lead to higher after-tax cash flows and a higher project NPV.

Question 42

Explain how inflation affects capital budgeting analysis.

Answer 42

Inflation is a complication that must be considered as part of the capital budgeting process:

• Nominal cash flows must be discounted at the nominal interest rate.
• Real cash flows must be discounted at the real interest rate.
• Unexpected changes in inflation affect project profitability.
• Inflation reduces the real tax savings from depreciation.
• Inflation decreases the value of fixed payments to bondholders.
• Inflation affects costs and revenues differently.

Question 43

What are the 2-methods to compare projects with unequal lives that are expected to be repeated indefinitely?

Answer 43

The least common multiple of lives: extends the lives of the projects so that the lives divide equally into the chosen time horizon. It is assumed that the projects are repeated over the time horizon, and the NPV over this horizon is used as the decision criterion.

The 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 44

What is Capital Rationing?

Answer 44

Capital rationing: is the allocation of a fixed amount of capital among the set of available projects that will maximize shareholder wealth.

A firm with less capital than profitable (positive NPV) projects should choose the combination of projects it can afford to fund that has the greatest total NPV.

Question 45

Explain how sensitivity analysis, scenario analysis, and Monte Carlo simulation can be used to assess the standalone risk of a capital project.

Answer 45

Sensitivity analysis: involves varying an independent variable to see how much the dependent variable changes, all other things held constant.

Scenario analysis: considers the sensitivity of the dependent variable to simultaneous changes in all of the independent variables.

Monte Carlo Simulation analysis: uses repeated random draws from the assumed probability distributions of each input variable to generate a simulated distribution of NPV.

Question 46

Describe types of real options relevant to a capital project.

Answer 46

Real options allow managers to make future decisions that change the value of capital budgeting decisions made today.

Timing options: allow a company to delay making an investment.

Abandonment options: allow management to abandon a project if the PV of the incremental CFs from exiting a project exceeds the PV value of the incremental CFs from continuing a project.

Expansion options: allow a company to make additional investments in a project if doing so creates value.

Flexibility options: give managers choices regarding the operational aspects of a project. The two main forms are:

• price-setting
• production flexibility options.

Fundamental options: are projects that are options themselves because the payoffs depend on the price of an underlying asset.

Question 47

What are the approaches to evaluating a capital project using real options?

Answer 47

Approaches to evaluating a capital project using real options include:

• Determining the NPV of the project without the option; calculating the project NPV without the option and adding the estimated value of the real option
• Using decision trees
• Using option pricing models.

Question 48

Describe common mistakes capital budgeting process.

Answer 48

Common mistakes in the capital budgeting process include:

• Failing to incorporate economic responses into the analysis.
• Misusing standardized project evaluation templates.
• Having overly optimistic assumptions for pet projects of senior management.
• Basing long-term investment decisions on short-term EPS or ROE considerations.
• Using the IRR criterion for project decisions.
• Poor cash flow estimation.
• Misestimation of overhead costs.
• Using a discount rate that does not accurately reflect the project’s risk.
• Politics involved with spending the entire capital budget.
• Failure to generate alternative investment ideas.
• Improper handling of sunk and opportunity costs.