Corporate Finance

Question 1

Capital budgeting process

Answer 1

The capital budgeting process is the process of identifying and evaluating capital projects; that is, projects where the cash flow to the firm will be received over a period longer than a year.

Question 2

Categories of capital budgeting projects

Answer 2

• Replacement projects to maintain the business are normally made without detailed analysis.
• Replacement projects for cost reduction determine whether equipment that is obsolete, but still usable, should be replaced. A fairly detailed analysis is necessary in this case.
• Expansion projects are taken on to expand the business and involve a complex decision-making process since they require an explicit forecast of future demand. A very detailed analysis is required.
• New product or market development also entails a complex decision-making process that will require a detailed analysis due to the large amount of uncertainty involved.
• Mandatory projects may be required by a governmental agency or insurance company and typically involve safety-related or environmental concerns.
• Other projects. Some projects are not easily analyzed through the capital budgeting process.

Question 3

Principles of Capital Budgeting

Answer 3

• Decisions are based on cash flows, not accounting income
  
  • Incremental cash flows: Changes in cash flows that will occur if the project is undertaken
  • Sunk costs: costs that cannot be avoided even if the project is not undertaken. Should not be included in the analysis.
  • Externalities: effects the acceptance of a project may have on other firm cash flows (cannibalization).
• Cash flows are based on opportunity costs
• The timing of cash flows is important
• Cashflows are analyzed on an after-tax basis
• Financing costs are reflected in the project’s required rate of return

Question 4

Modified Accelerated Cost Recovery System (MACRS)

Answer 4

• In the United States, most companies use straight-line depreciation for financial reporting and the modified accelerated cost recovery system (MACRS) for tax purposes.
• For capital budgeting purposes, we should use the same depreciation method used for tax reporting since capital budgeting analysis is based on after-tax cash flows and not accounting income.

Question 5

How inflation affects capital budgeting analysis

Answer 5

• Analyzing nominal or real cash flows.
• Changes in inflation affect project profitability.
• Inflation reduces the tax savings from depreciation.
• Inflation decreases the value of payments to bondholders.
• Inflation may affect revenues and costs differently.

Question 6

Real Options

Answer 6

Real options allow managers to make future decisions that change the value of capital budgeting decisions made today. They give the option holder the right, but not the obligation, to make a decision. Real options are based on real assets and are contingent on future events. Real options offer managers flexibility that can improve the NPV estimates for individual projects.

Question 7

Type of real options

Answer 7

• 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
  
  • Price-setting options allow the company to change the price of a product.
  • Production-flexibility options may include paying workers overtime, using different materials as inputs, or producing a different variety of product
• Fundamental options are projects that are options themselves because the payoffs depend on the price of an underlying asset

Question 8

Economic income

Answer 8

economic income = cash flow + (ending market value − beginning market value)

Question 9

Accounting income

Answer 9

Accounting income will differ from economic income because:

• Accounting depreciation is based on the original cost (not market value) of the investment.
• Financing costs (e.g., interest expense) are considered as a separate line item and subtracted out to arrive at net income. In the basic capital budgeting model, financing costs are reflected in the WACC.

Question 10

Economic profit

Answer 10

EP = NOPAT - $WACC

= EBIT (1 - tax rate) - WACC X capital

Question 11

Market value added

Answer 11

The NPV based on economic profit is called the market value added (MVA) and is calculated as:

NPV =MVA =∑^∞_t=1 [EP_t / (1+WACC)^t]

The valuation using economic profit is the same as the valuation using the basic NPV approach. No matter which method is used for determining income, if it is applied correctly, the resulting NPV should be the same.

Question 12

Residual income

Answer 12

residual income = net income − equity charge

Question 13

Value of Equity

Answer 13

The value of equity is the PV of cash distributions to equity

Question 14

Weighted Average Cost of Capital

Answer 14

WACC = (Market weight of debt × After-tax cost of debt) + (Market weight of equity × Cost of equity)

Question 15

MM’s study is based on the following simplifying assumptions

Answer 15

• Capital markets are perfectly competitive: there are no transactions costs, taxes, or bankruptcy costs.
• Investors have homogeneous expectations
• Riskless borrowing and lending: investors can borrow/lend at the risk-free rate.
• No agency costs: no conflict of interest between managers and shareholders.
• Investment decisions are unaffected by financing decisions: operating income is independent of how assets are financed.

Question 16

MM Proposition (No Tax)

Answer 16

• MM Proposition I (No Taxes): capital structure is irrelevant, assuming no taxes, transaction costs, or bankruptcy costs
  
  • V_L = V_U
• MM Proposition II (No Taxes): the cost of equity increases linearly as a company increases its proportion of debt financing. Therefore, the benefits of using a larger proportion of debt as a cheaper source of financing are offset by the rise in the cost of equity, resulting in no change in the firm’s weighted average cost of capital (WACC)
  
  • r_e = r₀ + (D/E) (r₀ – r_d)

Question 17

MM Proposition (with Taxes)

Answer 17

• MM Proposition I (with Taxes): value is maximized at 100% debt
  
  • V_L = V_U + (d x t)
• MM Proposition II (with Taxes): WACC is minimized at 100% debt
  
  • r_E = r₀ + (D/E) (r₀ – r_D) (1 – T_C)

Question 18

Two component of financial distress

Answer 18

• Costs of financial distress and bankruptcy can be direct or indirect.
  
  • Direct costs of financial distress include the cash expenses associated with the bankruptcy, such as legal fees and administrative fees.
  • Indirect costs include foregone investment opportunities and the costs that result from losing the trust of customers, creditors, suppliers, and employees.
• Probability of financial distress is related to the firm’s use of operating and financial leverage. In general, higher amounts of leverage result in a higher probability of financial distress.

Question 19

Agency costs of equity

Answer 19

Agency costs of equity refer to the costs associated with the conflicts of interest between managers and owners. Net agency costs of equity have three components:

• Monitoring costs are the costs associated with supervising management and include the expenses associated with making reports to shareholders and paying the board of directors. Note that strong corporate governance systems will reduce monitoring costs.
• Bonding costs are assumed by management to assure shareholders that the managers are working in the shareholders’ best interest. Examples of bonding costs include the premiums for insurance to guarantee performance and implicit costs associated with non-compete agreements.
• Residual losses may occur even with adequate monitoring and bonding provisions because such provisions do not provide a perfect guarantee.

Question 20

Cost of asymmetric information

Answer 20

• The cost of asymmetric information increases as the proportion of equity in the capital structure increases
• Management’s choice of debt or equity financing may provide a signal regarding management’s opinion of the firm’s future prospects.
  • Taking on the commitment to make fixed interest payments through debt financing sends a signal that management has confidence in the firm’s ability to make these payments in the future.
  • Issuing equity is typically viewed as a negative signal that managers believe a firm’s stock is overvalued.

Question 21

Pecking order theory

Answer 21

1. Internally generated equity (retained earnings)
2. Debt
3. External equity (newly issued shares)

Question 22

Optimal capital structure

Answer 22

Where the additional value added from the debt tax shield is exceeded by the value-reducing costs of financial distress from the additional borrowing, this point represents the optimal capital structure for a firm where the WACC is minimized and the value of the firm is maximized.

Question 23

Target Capital structure

Answer 23

The structure that the firm uses over time when making decisions about how to raise additional capital.

Question 24

Factors explain the majority of the differences in capital structure across countries:

Answer 24

• Institutional and legal factors
  
  • Strength of legal system
  • Information asymmetry
  • Taxe
• Financial markets and banking system factors
  
  • Liquidity of capital markets
  • Reliance on banking system
  • Institutional investor presence
• Macroeconomic factors
  
  • Inflation
  • GDP growth

Question 25

Types of dividends

Answer 25

• Regular cash dividends: Stable or increasing dividends paid regularly are perceived as a sign of profitability
  
  • Dividend reinvestment plans
    
    • Open market DRP
    • New issue DRP (Scrip dividend scheme in UK)
• Extra or special (irregular) dividends: Special dividends are paid under unusual circumstances under the expectation that the dividend is not recurring.
• Liquidating dividend: This is paid by a company when the whole firm or part of the firm is sold, or when dividends in excess of cumulative retained earnings are paid. A liquidating dividend is considered to be a return of capital as opposed to a return on capital.
• Stock dividend: Because the market value of the company is unchanged, the market price per share declines, leaving the shareholders with no net gain.
• Stock splits: These are similar to stock dividends (non-cash) but generally larger in size.

Question 26

Cash dividends vs. stock dividends

Answer 26

• Cash dividend payments reduce cash as well as stockholders’ equity, resulting in a lower quick ratio and current ratio, and higher leverage (e.g., debt-to-equity and debt-to-asset) 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 (corresponding to the value of the stock dividend) is offset by an increase in contributed capital, leaving the value of total equity unchanged.

Question 27

Three theories of investor preference:

Answer 27

• 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 28

Double taxation effective tax rate

Answer 28

effective tax rate = corporate tax rate + (1 − corporate tax rate)(individual tax rate)

Question 29

Tax System

Answer 29

• Double-taxation system: Earnings are taxed a the corporate level regardless of whether they are distributed as dividends and dividends are taxed again at the shareholder level
• Split-rate system: Corporate tax system taxes earnings distributed as dividends at a lower rate than earnings that are retained.
• 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 30

Stable Dividend Policy

Answer 30

• Companies that use a stable dividend policy typically aligns the company’s dividend growth rate with the company’s long-term earnings growth rate.
• A stable dividend policy could be gradually moving towards a target dividend payout ratio. A model of gradual adjustment is called a target payout adjustment model.

Question 31

Target Payout Adjustment Model

Answer 31

expected increase in dividends = [(expected earnings × target payout ratio) – previous dividend] × adjustment factor

where:

adjustment factor = 1 / number of years over which the adjustment in dividends will take place

Question 32

Constant payout ratio

Answer 32

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

Question 33

Residual Dividend Model

Answer 33

• Dividends are based on earnings less funds the firm retains to finance the equity portion of its capital budget. The model is based on:
  
  • Investment opportunity schedule (IOS)
  • Target capital structure
  • Access to and cost of external capital/
• Advantages vs. disadvantages
  
  • Advantages: (1) easy for the company to use; (2) maximizes allocation of earnings to investment.
  • Disadvantages: (1) dividend fluctuates with investment opportunities and earnings: Company forecasts its capital budget over a longer time frame and attempts to pay out the residual in steady dividend payments.

Question 34

Share repurchase methods.

Answer 34

• Open market transactions: The firm buys back its shares in the open market. Used outside the US and Canada almost exclusively.
• Fixed price tender offer: The firm buys a predetermined number of shares at a fixed price, typically 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. All accepted bids are then filled at the (higher) price of the last accepted bid.
• Repurchase by direct negotiation: Purchasing shares from a major shareholder, often at a premium over market price. This method may be used in a greenmail scenario, or when a company wants to remove a large overhang in the market.

Question 35

Effect of a share repurchase on book value per share

Answer 35

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

Question 36

5 common rationales for share repurchases

Answer 36

1. Potential tax advantages: When capital gains are taxed favorably as compared to dividends.
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 37

Dividend Safety

Answer 37

• Metric used to evaluate the probability of dividends continuing at the current rate for a company.
  
  • Dividend payout ratio = dividend / net income
  • Dividend coverage ration = net income / dividends
• A higher than normal dividend payout ratio (and lower than normal dividend coverage ratio) tends to typically indicate a higher probability of a dividend cut (or a lower probability of dividend sustainability).

Question 38

FCFE coverage ratio

Answer 38

FCFE coverage ratio = FCFE / (dividends + share repurchases)

A FCFE coverage ratio significantly less than one is considered unsustainable. In such a situation, the company is drawing down its cash reserves for dividends and repurchases.

Question 39

2 major objectives of Corporate governance

Answer 39

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

Question 40

Major business forms and the conflicts of interest associated with each

Answer 40

• Sole proprietorships: Conflicts between management and owners do not exist. Conflicts typically involve creditors and suppliers
• Partnerships: Conflicts typically involve creditors and suppliers. Potential conflicts between partners are typically addressed by creating partnership contracts
• Corporations: Separation of ownership and control creates the potential for conflicts between management and shareholders.

Question 41

Policies of corporate governance that should be assessed

Answer 41

• Code of ethics
• Directors’ oversight, monitoring, and review responsibilities
• Management’s responsibility to the board
• Reports of directors’ oversight and review of management
• Board self-assessments
• Management performance assessments
• Director training

Question 42

Risk of ineffective corporate governance system

Answer 42

• Financial disclosure risk
• Asset risk
• Liability risk
• Strategic policy risk

Question 43

Core attributes of an effective corporate

Answer 43

• Delineation of the rights of shareholders and other core stakeholders
• Clearly defined manager and director governance responsibilities to stakeholders
• Identifiable and measurable accountabilities for the performance of the responsibilities
• Fairness and equitable treatment in all dealings between managers, directors, and shareholders
• Complete transparency and accuracy in disclosures regarding operations, performance risk, and financial position.

Question 44

Forms of Integration

Answer 44

Statutory merger, the acquiring company acquires all of the target’s assets and liabilities.

Subsidiarymerger, the target company becomes a subsidiary of the purchaser. Most subsidiary mergers typically occur when the target has a well-known brand that the acquirer wants to retain.

Consolidation, both companies cease to exist in their prior form, and they come together to form a completely new company.

Question 45

Type of Merger

Answer 45

• Horizontal merger: two businesses operate in the same or similar industries, and may often by competitors
• Vertical merger, the acquiring company seeks to move up or down the supply chain
• Conglomerate merger: the two companies operate in completely separate industries.

Question 46

Motivations behind merger and acquisition activity

Answer 46

• Synergies
• Achieving more rapid growth
• Increased market power
• Gaining access to unique capabilities
• Diversification
• Bootstrappig EPS
• Personal benefits for managers
• Tax benefits
• Unlocking hidden value
• Achieving international business goals
  
  • Taking advantage of market inefficiencies
  • Working around disadvantageous government policies
  • Use technology in new markets
  • Product differentiation
  • Provide support to existing multinational clients

Question 47

Bootstrapping

Answer 47

Bootstrapping is a way of packaging the combined earnings from two companies after a merger so that the merger generates an increase in the earnings per share of the acquirer, even when no real economic gains have been achieved.

Question 48

Merger Motivations in the Industry Life Cycle

Answer 48

Question 49

Key differences between forms of acquisition

Answer 49

Question 50

Method of payment

Answer 50

• Securities offering is based on three factors:
  
  • Exhange ratio
  • Number of shares outstanding of the target company
  • Value of the acquirer’s stock on the day the deal is completed
• Cash offers, 3 main factors:
  
  • Distribution between risk and reward for the acquirer and target shareholders: all the risk is borne by the acquirer
  • Relative valuations of companies involved: may signal that the acquirer’s shares are overvalued
  • Changes in capital structure

Question 51

Hostile merger offers

Answer 51

• Bear hug: acquirer submits a merger proposal directly to the target’s board of directors when the target company’s management does not support the deal
• Tender offer: the acquirer offers to buy the shares directly from the target shareholders, and each individual shareholder either accepts or rejects the offer.
• Proxy battle: the acquirer seeks to control the target by having shareholders approve a new “acquirer approved” board of directors. A proxy solicitation is approved by regulators and then sent to the target’s shareholders. If the shareholders elect the acquirer’s slate of directors, the new board may replace the target’s management and the merger offer may become friendly

Question 52

Herfindahl-Hirschman Index (HHI)

Answer 52

Herfindahl-Hirschman Index (HHI) replaced market share as the key measure of market power for determining potential antitrust violations. The HHI is calculated as the sum of the squared market shares for all firms within an industry.

Question 53

Basic methods to value target companies

Answer 53

• Discounted cash flow analysis
• Comparable company analysis
• Comparable transaction analysis

Question 54

Post-Merger Value

Answer 54

V_AT = V_A + V_T + S − C

where:

V_AT = post-merger value of the combined company (acquirer + target)

V_A = pre-merger value of acquirer

V_T = pre-merger value of target

S = synergies created by the merger

C = cash paid to target shareholders

Question 55

Cash offer vs. stock offer

Answer 55

The main factor that affects the method of payment decision is confidence in the estimate of merger synergies. The more confident both parties are that synergies will be realized, the more the acquirer will prefer to pay cash and the more the target will prefer to receive stock.

Question 56

Characteristics of M&A transactions that create value

Answer 56

• Strong buyer: Acquirers that have exhibited strong performance (in terms of earnings and stock price growth) 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 to the acquisition announcement is a favorable indicator for the acquirer.

Question 57

Ways a firm can reduce its size

Answer 57

• Divestitures: A company selling, liquidating, or spinning off a division or subsidiary. Mostly involves a direct sale to an outside buyer. The selling firm is typically paid in cash.
• Equity carve-outs: Shares of the subsidiary are issued in a public offering of stock, and the subsidiary becomes a new legal entity whose management team and operations are separate from the parent company.
• Spin-offs: Similar to carve-out, but shares are distributed to the parent company’s shareholders instead of public offering. Shareholder base will be the same as the parent company
• Split-offs: Shareholders are giving up a portion of their ownership in the parent company to receive the new shares of stock in the division.
• Liquidations: Break up the firm and sell its asset piece by piece.

Question 58

Holding period return

Answer 58

Holding period return in the increase in price of an asset plus any cash flow received from that asset, divided by the initial price of the asset

Question 59

Required return

Answer 59

• The minimum return an investor requires given the asset’s risk.
• If expected return is greater (less) than required return, the asset is undervalued (overvalued).

Question 60

2 types of estimates of equity risk premium

Answer 60

• Historical estimates
• Forward-looking estimates (ex-ante estimates)
  
  • Gordon growth model (constant growth model)
    
    • change through time and need to be updated
    • assumption of a stable growth rate is not appropriate in rapidly growing economies.
  • Supply-side models (macroeconomic model)
    
    • estimates are only appropriate for developed countries
  • Estimates from surveys
    
    • even when the survey is restricted to experts in the area, there can be a wide disparity between the consensuses obtained from different groups

Question 61

Gordon Growth Model equity risk premium

Answer 61

GGM equity risk premium = (1-year forecasted dividend yield on market index) + (consensus long-term earnings growth rate) – (long-term government bond yield)

= (D₁/P)+ˆg−r_LT,0

Question 62

Fama-French Model

Answer 62

required return of stock j = RF + β_mkt,j × (R_mkt − RF) + β_SMB,j × (R_small − R_big) + β_HML,j × (R_HBM − R_LBM)

where:

(R_mkt − RF) = return on a value-weighted market index minus the risk-free rate

(R_small − R_big) = a small-cap return premium equal to the average return on small-cap portfolios minus the average return on large-cap portfolios

(R_HBM − R_LBM) = a value return premium equal to the average return on high book-to-market portfolios minus the average return on low book-to-market portfolios

The baseline value (i.e., the expected value for the variable) for β_mkt,j is one, and the baseline values for β_SMB,j and β_HML,j are zero.

Question 63

Pastor-Stambaugh Model

Answer 63

Fama-French model + liquidity factor

Question 64

Macroeconomic Multifactor Models

Answer 64

The Burmeister, Roll, and Ross model incorporates the following five factors:

• Confidence risk: unexpected change in the difference between the return of risky corporate bonds and government bonds.
• Time horizon risk: unexpected change in the difference between the return of long-term government bonds and Treasury bills.
• Inflation risk: unexpected change in the inflation rate.
• Business cycle risk: unexpected change in the level of real business activity.
• Market timing risk: the equity market return that is not explained by the other four factors.

Question 65

Build-up Method

Answer 65

The build-up method is similar to the risk premium approach. It is usually applied to closely held companies where betas are not readily obtainable. The weakness is that they typically use historical values as estimates that may or may not be relevant to current market conditions. One popular representation is:

required return = RF + equity risk premium + size premium + specific-company premium

Question 66

Bond-yield plus risk premium method

Answer 66

The bond-yield plus risk premium method is a build-up method that is appropriate if the company has publicly traded debt. The method simply adds a risk premium to the yield to maturity (YTM) of the company’s long-term debt. The logic here is that the yield to maturity of the company’s bonds includes the effects of inflation, leverage, and the firm’s sensitivity to the business cycle.

Question 67

Blume method for beta drift

Answer 67

adjusted beta = (2/3 × regression beta) + (1/3 × 1.0)

Note that some statistical services use reversion to a peer mean rather than reversion to one.

Question 68

2 methods for building risk premia when investing internationally

Answer 68

• Country spread model: use a corresponding developed market as a benchmark and add a premium for the emerging market. One premium to use is the difference between the yield on bonds in the emerging market minus the yield on corresponding bonds in the developed market.
• Country risk rating model