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Corporate Finance > Corporate Finance - One > Flashcards

Corporate Finance - One Flashcards

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1
Q

What is the Efficient Markets Hypothesis (EMH)?

A

At all times, a security’s market price reflects the true, rational value of the security - fairly priced.

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2
Q

What is the Weak Form of market efficiency?

A

Price reflects all information contained in historical prices (identify mispricing with technical analysis).

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3
Q

What is the Semi-Strong Form of market efficiency?

A

Price reflects all public information (identify mispricing with fundamental analysis).

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4
Q

What is the Strong Form of market efficiency?

A

Price reflects all information, public and private (insiders earn abnormal returns).

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5
Q

What is the paradox of market efficiency?

A

If the market is already efficient with respect to the information gathered, investors will not benefit from engaging in costly security analysis, but the market can’t be efficient if no one gathers info. The market cannot be absolutely efficient because prices deviate from true values.

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6
Q

What is the Random Walk Hypothesis?

A

Cannot use past price movement to predict future price movement because stocks follow a random pattern, which is evidence against weak form.

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7
Q

What is the rationale behind an Event Study?

A

Based on semi-strong efficiency. As new info about a firm arrives, the market price of the firm’s stock should immediately and unbiasedly change to reflect this information.

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8
Q

What are examples of value-relevant information?

A
  1. Government Press Release
  2. Earnings Announcement
  3. Dividends and Stock Repurchases
  4. Investment
  5. External Financing (debt vs. equity)
  6. Merger or acquisition.
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9
Q

How do prices react to new good news?

A

Overreaction to ‘good news’ with reversion or delayed response to ‘good news’ vs. EMH increase on day 0.

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10
Q

How do prices react to new bad news?

A

Overreaction to ‘bad news’ with reversion or delayed response to ‘bad news’ vs. EMH drop on day 0.

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11
Q

What does mutual fund performance indicate about market efficiency?

A

If managers rely on public info to pick stocks, on average their risk-adjusted returns should not outperform the market.

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12
Q

Why have index funds become popular?

A

Index funds have become popular in recent years because of an increasing belief in EMH.

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13
Q

What do tests and studies of Strong Form EMH investigate?

A

Tests of strong-form efficiency investigate insider trading and show that insider trading is abnormally profitable.

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14
Q

What firms are good candidates for a Seasoned Equity Offering (SEO)?

A

A firm whose existing projects are profitable and that has profitable investment opportunities whose capital outlays exceed available internal funds.

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15
Q

What firms are bad candidates for a Seasoned Equity Offering (SEO)?

A

A firm whose existing projects are not profitable but has profitable investment opportunities, or a firm whose existing projects are profitable but which has few profitable investment opportunities.

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16
Q

What are the methods of SEO offering?

A
  1. Private Placement
  2. Grant
  3. ESOP (Employee Stock Ownership Plan)
  4. DRIP (Dividend Reinvestment Plan)
  5. Rights Offering
  6. General Public Offering.
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17
Q

What are the decisions involved in a SEO?

A
  1. Choosing an underwriter
  2. Compensating the underwriter
  3. Firm Commitment or Best Efforts
  4. Traditional or Shelf Registration
  5. Mix of Primary and Secondary Shares
  6. Stock-Only Offering or Units.
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18
Q

How does the market react to a SEO announcement?

A

Market generally reacts negatively to a SEO announcement (-1.5% - -3%).

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19
Q

What is the relationship between information asymmetry and SEO?

A

External equity is at the bottom of the pecking order and would be offered only if the firm’s insiders have private info that the firm’s equity is overpriced.

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20
Q

How do market expectations affect SEO?

A

Market values a firm by estimating earnings and assumes that the firm’s earnings generally are sufficient to fund all investments. An SEO announcement reveals lower earnings than expected, and the market price falls.

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21
Q

What are agency expectations related to SEO?

A
  1. Leverage: managers may use SEO to lower leverage and decrease risk of bankruptcy.
  2. Overinvestment: raise money for empire building.
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22
Q

What is the performance trend of firms before and after SEO?

A

SEO firms have positive run-up 1-2 years before and underperform 1-5 years after.

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23
Q

What role does earnings management play in SEO?

A

Earnings management may explain because firms inflate earnings in advance to hype up price.

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24
Q

Why is payout policy irrelevant for a firm’s value in an ideal world?

A

Payout policies are irrelevant in an ideal world, but become relevant when considering real-world factors such as principal-agent problem, info asymmetry, and taxes/transaction costs.

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25
Q

What is the ‘Homemade Dividend’ strategy?

A

Sell shares after dividend payment to create equal total wealth.

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26
Q

What are the empirical features of dollar amount dividends and share repurchases over time?

A

Evidence is consistent with pecking order theory, when financing > internal cash flow - debt increases. Dividends form the most stable series but grow slowly (4.5% annually). Stock repurchases are much more volatile and exhibit a much higher growth rate (17.7%).

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27
Q

What trends have been observed in dividends vs. stock repurchases?

A

1980-2000: dividend payouts decreasing and stock repurchases increasing.

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28
Q

Why have dividends become less popular?

A
  1. Transaction costs for selling stocks have fallen over time.
  2. Managers have increased their holdings of stock options that are not protected against the price-reducing effect of a dividend.
  3. Dividends may be less essential as a tool of corporate governance.
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29
Q

What are the types of dividends?

A
  1. Regular Cash Dividend
  2. Stock Dividends
  3. Dividend in Kind.
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30
Q

What is a Regular Cash Dividend?

A

Public companies often pay quarterly dividends, and sometimes firms will issue an extra cash dividend. The extreme case would be a liquidating dividend.

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31
Q

What are Stock Dividends?

A

No cash leaves the firm; instead, the firm increases the number of shares outstanding. This incurs costs but makes stock more liquid and increases purchase patterns due to price associations by investors.

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32
Q

What is a Dividend in Kind?

A

An example is when Wrigley’s gum sends around a box of chewing gum.

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33
Q

What is the Declaration Date in the cash dividend payment procedure?

A

The board of directors declares a payment of dividends.

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34
Q

What is the Cum-Dividend Date?

A

The last day that the buyer of a stock is entitled to the dividend.

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35
Q

What is the Ex-Dividend Date?

A

The first day that the seller of a stock is entitled to the dividend.

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36
Q

What is the Record Date?

A

The corporation prepares a list of all individuals believed to be stockholders.

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37
Q

What typically happens to stock price around the Ex-Dividend Date?

A

In a perfect world, the stock price will fall by the amount of the dividend per share on the ex-dividend date.

38
Q

How do taxes affect price behavior around the Ex-Dividend Date?

A

DPS is greater than the price drop because of taxes on dividends. The current price is discounted to reflect that some firm value will flow to the government.

39
Q

What is the Traditional Residual Dividend Policy?

A

Dividends should be paid only if the firm has excess cash after all cash needs are met.

40
Q

What is Dividend Smoothing?

A

Keep dividends stable relative to earnings. If earnings exceed the past year’s dividend, then there is a higher dividend.

41
Q

What does ‘p’ represent in Dividend Smoothing?

A

p = speed of adjustment (1=full adjustment, 0<p<1 means partial adjustment).

42
Q

What is the target payout in Dividend Smoothing?

A

Target payout = EPS * payout ratio.

43
Q

What is a potential cost of Dividend Smoothing?

A

It can be costly if earnings drop but dividends are still raised because the market doesn’t like dividend reductions.

44
Q

What is Free Cash Flow in relation to dividends?

A

The firm should impose dividends to curb management’s empire building and force out free cash flow.

45
Q

What is the Expropriation of Creditors’ Wealth?

A

Increasing dividends reduces the assets against which creditors have a priority claim, lowering the value of a creditor’s claim.

46
Q

What is the conflict between Management and the Board regarding dividends?

A

For a levered firm, both prefer lower dividends and lower leverage, but for different reasons. The Board presses for higher dividends to act in shareholders’ interests.

47
Q

How can dividends signal a firm’s true value?

A

Dividends can be an effective signal of a firm’s true value if they are costly to prevent mimicking.

48
Q

What is the market reaction to dividend increases?

A

The market generally reacts positively to dividend increase announcements and negatively to dividend cuts.

49
Q

What does a dividend increase indicate?

A

It suggests that management is confident in the permanent current earnings increase rate.

50
Q

What is the market reaction to dividend initiations?

A

3.7% abnormal return, which is greater because it is a surprise, and earnings volatility decreases.

51
Q

What is the market reaction to dividend omissions?

A

-6.94% return.

52
Q

What is an Open Market share repurchase?

A

A gradual, open-market purchase of shares.

53
Q

What is a Dutch Auction in share repurchase?

A

Shareholders can submit an offer to sell a specified number of shares at a specified price, and the firm purchases all shares at the average price.

54
Q

What is a Fixed Price Self-Tender?

A

The firm collects offers after specifying price and amount of shares.

55
Q

How does the market react to share repurchases?

A

The market reacts favorably because of value-relevant information.

56
Q

What is the signaling effect of share repurchases?

A

Management repurchases shares when stock is underpriced.

57
Q

What is the difference between share repurchases and dividends?

A

In a perfect world, an investor can sell or purchase shares to change her total equity position, making the choice seem irrelevant.

58
Q

What is the tax consequence of repurchases?

A

Repurchases have a favorable tax consequence.

59
Q

What is a merger?

A

Two firms combine to form a single firm, usually extinguishing the shares of one firm.

60
Q

What is an acquisition?

A

The shareholders of the defunct firm receive shares of the surviving firm and/or cash, while the surviving firm acquires the assets of the defunct firm.

61
Q

What is consolidation in M&A?

A

Both firms cease to exist and a new firm is established with a new name, board, and/or management.

62
Q

What is a horizontal merger?

A

Two competitors in the same line of business combine to create economies of scale or enhance market power.

63
Q

What is a vertical merger?

A

Two firms in different stages of the production process combine to stabilize the supply of raw materials or customer demand.

64
Q

What is a conglomerate merger?

A

Two firms in unrelated industries combine, often justified by diversification.

65
Q

What is operating synergy in M&A?

A

Improvements in management, labor costs, production, or distribution resulting from the merger.

66
Q

What is financial synergy in M&A?

A

The market equity value of the merged firm is greater than the sum of the separate firms’ market equity values.

67
Q

What is the hubris hypothesis in M&A?

A

Bidder’s management overvalues the target due to overestimating their ability to create value.

68
Q

What are legal hurdles for M&A?

A

Antitrust laws outlaw monopolies and actions against vertical and conglomerate mergers.

69
Q

What are the forms of payment in M&A?

A

No pooling of interest allowed; only the purchase method is used.

70
Q

What are the announcement effects of M&A?

A

Merger means positive abnormal return for the target and the acquiring firm is unaffected or has a small loss.

71
Q

What is the agency problem with M&A?

A

Managers with more equity-based compensation make better acquisition decisions, while cash-rich firms are more likely to destroy value.

72
Q

What is the post-merger performance of acquiring firms?

A

Merging firms exhibit improvements in asset productivity, but post-acquisition stock return performance is generally poor for five years.

73
Q

What is a takeover?

A

The purchase of an entire firm by another firm.

74
Q

What is a friendly takeover?

A

An acquisition made directly to management.

75
Q

What is a hostile takeover?

A

The bidder’s intention is to acquire the target and replace the target’s incumbent management.

76
Q

What is a takeover?

A

A takeover is the purchase of an entire firm by another firm.

77
Q

What is a friendly takeover?

A

A friendly takeover is an acquisition made directly to management.

78
Q

What is a hostile takeover?

A

In a hostile takeover, the bidder’s intention is to acquire the target and replace the target’s incumbent management, who vigorously resist the attempt. The acquirer bypasses the target’s management and approaches shareholders directly with an offer.

79
Q

What are some motives for a takeover?

A

Motives for a takeover include failure of target management, bust-up, hubris, and industry shocks.

80
Q

What is the free rider problem in takeover bidding?

A

The free rider problem emerges when target-firm shareholders withhold their shares, foreseeing that they will gain more after the takeover than in the tender offer. However, the takeover will fail if all shareholders withhold shares.

81
Q

How can the free rider problem be resolved?

A

Resolution includes establishing an equity position before the tender offer (‘toehold’) and a two-tier offer allowing the bidder to dilute the value of the shares of those who do not tender.

82
Q

Why do target-firm CEOs resist takeovers?

A

Target-firm CEOs are more likely to be replaced if a takeover succeeds than if it fails, creating a self-interest to resist.

83
Q

What are some reasons for takeover defenses?

A

Reasons for takeover defenses include the potential increase in bid by the bidder, which can reduce the chance of a successful takeover, and the fact that defenses may keep entrenched managers in power.

84
Q

What are some types of takeover defenses?

A

Types of takeover defenses include Golden Parachutes, Greenmail/Standstill Agreements, Poison Pills, Staggered Boards, Supermajority provisions, Anti-takeover legislation, White Knight, and Recapitalization and repurchases.

85
Q

What is a buyout?

A

A buyout differs from an acquisition because a group of individuals purchases the target, often converting a public firm into a private one.

86
Q

What are the motives behind a buyout?

A

Motives for a buyout include increasing management’s incentives, averting a takeover, and tax benefits.

87
Q

What are the types of buyouts?

A

Types of buyouts include LBO (financed by debt), MBO, and EBO (involving management or employees).

88
Q

How does the market react to buyouts?

A

The market reacts favorably to buyouts.

89
Q

What are the returns for stakeholders during buyouts?

A

Selling shareholders gain 14-22%, while bondholders suffer.

90
Q

What is the post-buyout performance focus?

A

Post-buyout performance focuses on the efficacy of operating performance.

Corporate Finance (1 decks)

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